Nicholas Watson in Vienna -

A clear sign of where Raiffeisen Capital Management sees the greatest value in emerging Europe over the next few years is its new Raiffeisen Russia Equities fund. "We are quite bullish on Russia and have added to our positions continuously there over the recent months," says Angelika Millendorfer, head of equities emerging markets, referring to the other funds, such as the Eastern European Equities fund, that have exposure to Russia.

Such optimism about the country's prospects led to the launch on May 5 of the new Russia Equities fund, to be jointly managed by Raiffeisen Capital Management in Vienna and Raiffeisen Capital Moscow, which will seek to buy a mix of large-cap stocks and, under advisement from the locals, small caps. This way, says Millendorfer, the fund will take advantage of the current performance of Russian large caps and, later, the expected improved performance by smaller-cap stocks. "In the short term, given the positive environment for commodities and the current trend where large caps tend to outperform small caps for reasons of liquidity and risk aversion, we will have a strong focus of about 80% on large caps," says Millendorfer.

Thanks to its vast natural resources - 33% of Russia's economic output, 52% of government income and 63% of all exports stem from the oil and gas sector - Russia ranks as one of the main beneficiaries of soaring global demand for energy and raw materials. Helping this, says Raiffeisen, has been the smooth transition of power from the now Prime Minister Vladimir Putin to President Dmitry Medvedev in May, and the subsequent push by both to lower the onerous tax regime on the oil sector, which is strangling those companies' ability to explore and produce for oil in the more inaccessible regions.

In April, official data showed that Russian oil production had declined for the fourth month in a row as production at the ageing fields in western Siberia continued to decline. This prompted Putin, in one of his first moves as prime minister, to announce the government's intention to reduce the tax burden on the oil sector by amending the formula for the oil mineral extraction tax by raising the minimum price threshold for calculating it from to $9 per barrel to $15. The effect would be to save the oil industry an estimated RUB100bn ($4.2bn) per year and, say analysts, transfer about $25bn-30bn of extra market cap to the oil sector. Likewise, the gas sector too is expected to benefit form the rise in commodity prices - Gazprom chief Alexei Miller stunned the markets on June 10 by saying that gas prices in Europe could triple to $1,500 per 1,000 cubic metres (cm) by 2009 on the back of an oil price of $250 per barrel - as well as the liberalization of Russian domestic prices and a delay to planned legislation to reform the favourable tax regime the industry currently enjoys.

The much-ballyhooed oil service sector, by contrast, is not on Raiffeisen's to-buy list. "A while ago there was huge growth in the oil services sector, but all of them have, more or less, shown disappointing results," says Millendorfer. "It looks like competition is quite heavy, which put pressure on prices, and at the same time cost pressures has clearly hurt profits."

Over the longer term, Raiffeisen is looking to its Moscow office to eke out the opportunities in the consumer sector as fast rising wages in Russia drive personal consumption. "There are a lot of interesting opportunities in the small- and mid-cap sectors because they're more focused on consumer stocks than commodities," says Millendorfer. "But on the other hand, retail is already pricing in a lot of growth and so some valuations look a bit lofty."

The fund won't be solely concerned with Russia, but will also look to invest a small proportion of the fund, which started out with paid-in capital of €8m, elsewhere in the former Soviet Union. "Obviously, we will be focused on Russia but also off benchmark positions in other CIS countries like Kazakhstan, Ukraine and Georgia. More could come there in future, however it won't be big percentage for now, 5-10% maximum."

Kazakhstan offers the most opportunities for large funds. It has developed a proper stock market and is strong on the commodity side, so has a good environment from that perspective, though Millendorfer points out that the Kazakh banks were hardest hit by the credit crunch due to their overdependence on external financing and there have been related problems with the country's construction industry.

For Georgia, hopes were high when President Mikheil Saakashvili swept into power following the "Rose Revolution," with many assuming he was very westernised. Since then, however, the violent suppression of protests and a state of emergency in November, which placed heavy restrictions on the mass media, has tarnished his and Georgia's image with investors. "Maybe he's not as westernised as it was hoped," says Millendorfer.

Elsewhere in CEE

While the Eastern European Equities fund also reflects Raiffeisen's optimism on Russia, with around 57% of the €900m fund invested there, it also has significant exposure to Poland, Turkey and Hungary. The fund has pretty much tracked the benchmark index over the past five years, though over the 10-year span has outperformed it by around 8 percentage points.

Millendorfer likes Turkey (a neutral 10%) because it has a lot of good companies at low valuations. But she, like many others, is becoming increasingly concerned at the deteriorating political situation there as a legal case brought by secularists to close down the ruling AK Party over its Islamist roots rumbles toward its predictable conclusion. "The banning of the AKP is now a serious risk and we're hearing voices that it's becoming more likely by the day," says Millendorfer.

Poland has the opposite problem, with valuations there typically high, though now coming down to more reasonable levels as domestic funds, which are required by law to invest 95% of their assets in Polish stocks, see large outflows. In June, redemptions from Polish mutual funds amounted to PLN18.5bn (€5.6bn), falling for the eighth consecutive month in a row. In the last six months, the money invested in mutual funds has fallen by over €11bn. As such, Raiffeisen is "somewhat underweight in Poland and somewhat overweight in Hungary" because, as bottom-up investors, it see a lot of cheap companies in Hungary. "Although obviously it's not such a spectacular macro environment, we're seeing some strength in the forint, which is certainly helpful from our investment perspective."

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