MOSCOW BLOG: Four reasons to buy Russian equities now

By bne IntelliNews October 8, 2013

bne -

Over the last few months, stock pickers and financial market commentators have started wondering if now is a good time to buy Russian stocks.

Here are four reasons why now might be a good time.

1. Russian stocks are super-cheap

"Buy low and sell high," goes the old investment saw. Russian stocks have always been cheap compared with their peers - and today they have never been cheaper. Russian stocks are priced with a deep discount to their already deep Russia-risk discount.

"According to Bloomberg, Russian equities have the cheapest valuations among 21 emerging markets at 3.8x 12-month estimated earnings, compared with a multiple of 10.5x for the MSCI EM Index," Prosperity Capital Management said in its most recent newsletter.

2. This is not a crisis year

"Investing into Russia is easy. The only thing you need to decide is if this is a crisis year or not. If not, then the market always returns a handsome profit for investors," Roland Nash, chief strategic office at Verno Capital once famously said in the boom years.

This pearl of wisdom is still true, but it has been tempered somewhat by the crisis. Between 1996 and 2008, the RTS index returned between 8.3% and 197% each year (and the 8.3% in 2004 was an aberration because all the other years were over 30%), except in 1998 when the market lost 85% of its value, 2000 when it dropped 18% and 2008 when it fell 72%, according to Bloomberg. Since 2008, the RTS returned 128% in 2009, 22% in 2010, 10% in 2012, but lost 22% in 2011.

In other words, over the last 18 years Roland's Rule, as it should be dubbed, worked in every year except in 2000 and 2011 - two years that weren't "crisis" ones, but the market fell anyway.

While obviously predicting when a crisis is going to hit is a mug's game, by the same token saying when one is not going to hit is a little easier.

Russia's economy has fallen into something of a slump, but it is still growing. The World Bank reduced its outlook for growth last month to just 1.8% (the same as the official prediction), but the consensus view for 2014 and 2015 is on the order of 3%.

As Prosperity Capital Management pointed out in their September newsletter, the actual growth number is pretty irrelevant for the stock market as long is it is not a big movement either up or down. The trick is not how fast the economy is growing, but to invest into quality companies. "Economists are often focused on indicators which are rather meaningless for investors. One of them is obviously changes in real GDP. It does matter when it's a significant negative number or a significant positive number, but if it's 2% or 4% hardly makes any difference to the stock market," Prosperity said in its investors' newsletter.

With Russia's robust macroeconomic fundamentals today - almost unique in Europe - a crisis this year seems highly unlikely. Going on Russia's track record, this would suggest Russian equity should return at least 8% this year - and probably a lot more.

3. Russians stocks always rally over the end of a year

"Sell in May and go away," is another worn investment saw, but in Russia's case it works remarkably well.

Aton Capital found in a study at the start of this year that if investors had followed this advice, then in all but three of the last 18 years their investments would have returned at least 20%.

The reasons why it works are varied. Obviously trading volumes (and price-impacting news) fall during the long Russian summer holidays. Funds also tend to allocate fresh money, dividends, pension plan contributions and capital gains contributions at around the end of the third quarter, which means there is simply more cash in play chasing the same stocks at the start of the last quarter.

And there are budget funds around, as much of the federal spending is rushed through in the last few months of the year and any superfluous funds left over in the budget are spent in the first quarter of the following year, or lost when the next budget is drawn up around Easter. Aton found that March was the strongest month of RTS returns over the last 12 years, which traditionally marks the end of the "Santa Claus" rallies.

May usually sees a sell-off, because funds need to report and tend to lock in profits at this time of year. Also once dividend payments have been made at around this time of the year, the appeal of shares drops. And then you are into the slow summer months again. "What if an investor committed $1,000 at the beginning of December and sold by the end of April and then stayed in cash in May-November? For 2001-12, this strategy would have returned 1,193%, beating the 1,000% return of the RTS Index for the full period," Aton said in its report.

On this basis, it seems that Russia is already starting to enjoy something of the "Santa Claus rally". For most of the last three years, the RTS Index has traded in a band between about 1250 and 1350, but in September it broke out and was trading at 1430 at the time of writing.

The classic rule of thumb for guessing where the RTS "should be" is to multiply current oil prices by 20, as Russians stocks and the economy in general are heavily dependent oil. On the whole this has worked well in the past. Indeed, the RTS broke above 2000 in May 2008 ahead of the crisis when oil was about $100. This would imply that the index should be again at about 2000, but in the current global economic malaise Russia's leading investment banks are predicting the RTS will finish this year at somewhere between 1400 and 1750.

4. Upbeat earnings forecasts

The cheapness of Russian stocks on a price/earnings basis is one of the huge red herrings of stock picking in Russia. Russians stocks have always been cheap on a P/E basis - in the boom years as well as the bad years. It is beyond the Kremlin's ability (or desire) to address the Cold War fears that kept the specific Russia-risk discount in place.

The way to pick Russian stocks is to look at a company's earnings, not its P/E multiple. And thanks to more than a decade of oil money-fuelled growth and rising incomes, the increase in earnings have driven a steady growth in share prices.

The autumn reporting season is coming to an end and Russian companies on the whole have done pretty well for themselves. "60% of Russia's companies managed to exceed consensus expectations [for earnings]. 36% missed to the downside on revenue and 26% on EBITDA," VTB Capital said in a recent note.

Stock pickers should be looking through these winners for the best companies and here one in ten managed to beat expectations by more than 5%. Even the ones that missed their targets only missed by 2-3%, says VTB, and none missed the target by more than 5%.

The coverage of Russia is swamped by negative political news, but behind all this noise there are a handful of world-class companies getting on with business of building a new economy.

No company exemplifies this better than the regional supermarket chain Magnit. When the company IPO'd in 2006, it had outlets in 500 small cities and town, with plans to open 400 more a year. Now it is achieving scale and opening 1,000 stores a year. It is already in 1,700 towns and cities and will open another 900 over the next five years as it concurrently begins to branch out into new business lines like cosmetics.

Overall, its organic sales growth has been running at 37% a year to reach $15bn by the end of 2012 and could top $20bn by the end of this year. This story would be remarkable in any country - but doubly so as it has happened in Russia. And the company's stock reflects this astronomical growth; the company's shares trade on a multiple closer to 30 than 3 as a result.

Magnit is not alone; there is a range of companies with similar stories in obvious sectors like telecommunications, and less obvious ones like clothing, footwear and apparel, furniture, or e-commerce. However, most of their names are unknown to investors and the massive gains have remained the preserve of Russia's specialist investors like East Capital, Verno Capital or Barings Vostok Capital Partners.

At some point the rest of the world is likely to wake up to what is going on and the whole market will rerate. But no one is expecting this to happen any time soon.

RTS returns for full year

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