Ben Aris in Berlin -
Doom and gloom is sweeping the world as the US teeters on the edge of a recession. But investors are already flocking to Russia, which is on course to become a haven of prosperity in 2008 thanks to booming investment, rising incomes and cheap stocks.
"Amidst global gloom, equities across our region look remarkably well placed going into 2008. Accelerating economic growth, deep pools of liquidity, an improving risk environment, under-leveraged economies and record-high commodity prices define an investment environment which stands in stark contrast to the credit crunch plaguing developed markets," Renaissance Capital said in their 2008 outlook report. "We believe Russian equities are at the start of a re-rating which will drive the RTS Index above 3,000 in 2008."
Most of this optimism is based on the continued acceleration of Russia's economic growth, which is increasingly based on internal, not external, resources.
Between 2001 and 2006, economic growth has averaged 6.4%, but is now accelerating. GDP growth for 2007 is expected to come in at about 7.7%. The international credit crunch will probably take the edge off growth in 2008, but it will still be two or three times faster than in the industrialised nations of the West, say analysts.
One of main the reason GDP growth is picking up is that the Kremlin's mantra of diversification is finally starting to kick in. Analysts point to this more than anything else as the guarantor of Russia continued success. The change is maybe easiest to see in the make up of the RTS index: traditionally dominated by oil and gas companies, after the wave of IPOs in 2007 the share of oil and gas companies in the index fell from 80% to 50% in just one year.
"Diversification implies a new set of economic winners: A more modern and powerful economy implies a much larger contribution from technology, expanded manufacturing, a stronger focus on consumer focused industries, and a much more robust infrastructure (roads, telecoms, electric grids, generation) to support them all. The Russian consumer, which continues to benefit from the oil-led recovery, is still seeing disposable income increase at some 15% per annum" Alfa Bank said in their end-of-year note. "We forecast economic growth to continue the trend of this decade, adding 6.5% in 2008."
Russia sports economic fundamentals that are the wet dream of most Western European finance ministers. Over the medium term, analysts expect the economy to expand to $2.3 trillion by 2010, more than doubling from the 2006 aggregate of just over $1 trillion. And this is not to mention the size of the hard-currency reserves, the stabilization fund, the current-account surplus and the tiny amount of international debt Russia has.
On the flip side, one of the biggest causes of uncertainty for 2008 has also already been removed. The presidential elections slated for March have now become a non-event after President Vladimir Putin nominated his buddy Dmitry Medvedev for the job of president in December. And Medvedev was right back at'cha the next week with the "suggestion" that Putin should become prime minister (should he win the presidential elections, of which nobody is in any doubt).
The investment banks are unanimous in their belief that the Putin economic reform programme will continue with few changes and if anything the dark power of the so-called Siloviki Kremlin fraction has been curbed, which everyone agrees is a bonus: the Putin-Medvedev team has been hailed as a "dream-team" combination.
The meltdown in the US has clearly done a lot of damage, but the analysts argue that in every crisis there is one asset class that ends up being a winner. The majority of investment banks say Russia is in a very good position to be that asset class in this crisis.
There are two key factors that could make this a reality, says Roland Nash, head of research at Renaissance Capital: "First, will the gloom overshadowing developed market economies continue to be outweighed by an increased allocation to high-growth new markets? Second, will there be enough that is unique about CIS markets to suggest they can attract a disproportionate allocation of funds among new markets?"
The jury is still out on both questions, but given that Russia saw record amounts of fresh capital flow into the stock market in December suggests the first is true. And given that Russian stocks are now the cheapest in the global emerging market universe on a price/earnings ratio (bar Turkey), this suggests the answer to the second question is also a "yes."
Indeed, the makeup of the Russian market appears so attractive in light of the current pall hanging over global markets that several of the leading banks are predicting a bubble developing in the Russian stock market this year.
"A stimulative investment environment, the lifting of political risk, the improved management of state assets and relatively low valuations should combine to make Russian equities look surprisingly attractive in a global environment where generating positive returns will be challenging. Indeed, it is quite possible that Russia's relative health will attract the sort of fund flow that could push valuations into the bubble-like territory that is afflicting the more obvious new markets," says Renaissance Capital.
Money goes downhill
For the best part of the past decade, global capital has been flowing uphill from countries where capital is relatively scarce, to countries where capital is relatively abundant. Commonsense suggests that money should flow in the other direction, as clearly there is more opportunity in the countries short of cash. But in several studies economists were surprised to discover this doesn't happen. The reason is still being debated, but one answer to this riddle is that conservative investors fear losing their money more than they are tempted by the large returns on offer.
However, as the risk profile in all the CIS countries is clearly diminishing fast, commonsense is expected to start prevailing and 2008 could come this year when the flow of money reverses and starts to go downhill.
"And when it happens this will be on a scale unlike anything we have ever seen before," says Nash. "It will either happen because of opportunities increasing in new markets or because of a decrease in the opportunities available in developed markets. The shift in capital flows will involve a seismic change in the relative size of the economies and markets of the current lenders and borrowers."
This downhill flow of investment seems to have already hit China, India and Brazil over the last few years, but Russia has noticeably been the black sheep of the BRIC flock and received very little attention; partly as the international press have had a field day lambasting the Kremlin at each and every opportunity. The Russian story has been cloaked in a fog of misrepresentation, selective reporting and outright bias. However, the numbers don't lie and businessmen are increasingly waking up to the money to be made in Russia and have started to ignore the press.
The last weeks of December saw the heaviest inflows of portfolio investment on record, peaking on December 17 with $11bn, more than 20% above the previous best and a good chunk of that recorded in London and the US, confirming the optimism for Russia stocks in this time of uncertainty. Uralsib's Chris Weafer opines that international funds are still 7% underweight Russia.
"The biggest threat to both economic growth and stock market growth is the ongoing international liquidity crisis. To date, Russia has been able to shrug off the crisis, and there is reason to think it is unlikely to have a material impact on economic growth, although the threat to the stock market is a bit larger. Indeed, after an initial drop in August, the Russian market has outperformed most world indices handily (+18% versus the Dow, +22% vs. the FTSE, +6% vs. the MSCI EM index)," says Alfa Bank. "We think that Russia is likely to become perceived as something of a safe haven in 2008, as the Russian economy is fairly well insulated from the US troubles."
Despite the record crop of IPOs in 2007, analysts are expecting this year to be even better partly because of the huge volume of shares have depressed growth of the domestic bourse. While other emerging markets saw their stock markets soar over the first half of 2007, Russia's market took in only $5bn of fresh money in the first half of 2007. Existing investors sold shares to buy the two bank share offerings and the leading RTS index was more or less flat as it struggled to absorb these two huge issues.
However, being left behind by the other emerging markets in 2007 means that Russian companies now have the cheapest stocks in all of the global emerging market universe. While stocks in the likes of China and India trade at price/earnings ratios of over 19 times, Russia is at the bottom of the table with an average ratio of just over 10 times.
"By December, attention was already swinging round Russia's way," says Chris Weafer, head of strategy at UralSib. "We had record inflows of new capital at the end of the year, while the other BRIC countries [Brazil, Russia, China and India] all saw outflows. This should be an excellent year as now it is Russia's turn."
Stock picking is key
Russia's RTS index had a relatively lacklustre year in 2007, rising only 19.2% to finish at 2291.46 - just points shy of most banks' forecast of 2300. At the same time, Russia's fellow BRIC countries all saw their stock markets soar. Even the benchmark MSCI GEM, which measures the performance of all emerging markets, rose by 37%; 2007 was only the second year out of the last nine years where Russia underperformed the MSCI GEM index.
Analysts have been saying this for a few years, but it is baldly obvious now: buying into Russia is no longer a plain vanilla deal where the timing of an investment is more important than what you buy. Nearly all the banks agree on an end of 2008 target of about 3000 for the RTS.
"We think that 2008, much like 2007, will turn out to be a stock-picker's year. Investors in the overall market will likely enjoy decent, but not stellar, returns of some 30%. However, as with 2007, investors willing to take bets on individual sectors or stocks can add significantly to that number," says Alfa bank.
The performance of the various sectors was very different in 2007. Only metal and industrial stocks outperformed the GEM. Metal stocks were up by an average of 54% in 2007 and industrial companies by 67%. Some companies like Avtovaz did spectacularly well, rising 165%, and also underline a new theme: stay close to the government in 2008, as it is the state that is expected to drive investment for the next few years.
"We believe the best investment strategy in 2008 will be to invest with the state, as the government plans to sharply raise spending and use administrative/political tools to promote growth in several key industries and in the nation's infrastructure," UralSib said in its end-of-year note. "The first priority is to promote growth in industries in which the state already has national champion companies or those that are dominated by companies close to the state."
Analysts are universal in their recommendation to buy Gazprom. It is one of the few stocks in the Russian universe that has not gone through a restructuring as it has no competition. The management has more or less sat on its hands while the politics of building new pipelines and finding partners to develop new fields was played out. However, as this process is almost finished, this is the year when the Kremlin may turn to actually fixing up what is called "a state within the state," along with the other national champions it owns.
Banks obviously did badly, hit by the brouhaha on international credit markets caused by the subprime debacle: Russian banking stocks were only up by 14% over the year, the worst performing sector in the economy.
Amongst the individual companies it was the metals and telecom companies that stood out. Amongst the most liquid blue chips, eight names rose by 100% or more in 2007: Uralkaly 362%, Mechel 281%, Evraz 202%, Vimpelcom 176%, AvtoVAZ 165%, Golden Telecom 116%, MTS 103%, and Severstal 103%.
The worst-performing were: bankrupt oil company Yukos -60% (trading at $0.21/share on the day it was de-listed down from an all time high of over $16), Sitronics -52%, Amtel -41%, Chelyabinsk Zinc -32%, Sistema-Hals -26%, Surgutneftegaz -20%, TNK-BP -14%, and Polymetal -8%.
VTB's IPO in May was the biggest in 2007 and Russia fared much better in the global IPO rankings in 2007 than ever before.
Between January and November, a total of $255bn was raised globally in IPOs, $9bn more in 2006. The biggest single IPO in 2007 was that of VTB bank, which raised $8bn in May, according to Ernst & Young, but the emerging BRIC countries (Brazil, Russia, India and China) are playing an increasingly important role on the world stage: 14 out of 20 largest placements were held in the BRIC countries against 9 out of 20 in 2006.
China beat Russia and ranks number one in terms of the total amount of capital raised from floatations. Chinese companies sold shares worth $52.6bn in the first eleven months of 2007. China also leads in terms of the number of IPOs with 209 issues, followed by Australia (189) and the USA (178). Russia had about 30.
London will remain the key exchange for Russian companies in 2008. London was the venue of choice in 2006 for Russian companies with where $24bn was raised and 8 IPOs raised $15.4bn between them.
Investment the growth driver
The biggest change this year from the preceding years will be the start of large-scale investment by the state in 2008. For all of the last 17 years, the government has tried to spend as little as it possibly can in its never-ending battle with inflation. "Until 2007, economic growth was driven by a commodity price-driven expansion in net exports and consumer demand. This year saw the first signs of a boom in investment," says Renaissance Capital.
After languishing in the low teens for most of the last decade, fixed-investment growth took off in 2007, ending the year at 18% year-on-year and analysts expect this to accelerate past the Asian-Tiger rates over 25% year-on-year.
However, despite the surge inflation in the summer of 2008, Russia has reached a point where the state must spend on rebuilding the country's crumbling infrastructure or growth will stall regardless of what is happening with inflation.
"The fundamental investment case for Russian equities is changing. Whereas previously it revolved around the restructuring of the ownership of the country's most important industries, it is now turning to a phase emphasizing investment in these assets, and in the country's infrastructure. We expect a doubling of state spending in key industries, such as electricity, railways and extractive industry processing, over the next three years, which should act as the main growth driver," says UralSib. "We believe this will have a broader effect on Russian industry, driving earnings growth and providing a significant degree of insulation against slower growth in the global economy through next year."
The Kremlin has earmarked over $1 trillion of investment over the next five years and plans to spend over RUB1 trillion ($40bn) just this year on everything from power stations to ports. Although this is likely to send inflation back up from the low of 9% at the end of 2006, Finance Minister Alexei Kudrin says he is confident he can bring inflation back from the 12% recorded at the end of 2007 to about 8% by 2009. But it will not be easy and the jury is out on where inflation is going with many banks predicting Kudrin will fail in this task.
In addition to the massive state spending programme, more encouragingly private investment is rising fast, which will (hopefully) make the economy more efficient and so better able to absorb the increased spending without having as big an inflationary pressure as in the past.
On top of the domestic investment, foreign direct investment has begun to flood into Russia. Foreign investors have long been shy of committing their money to Russia - and despite a massive uptick in foreign direct investment (FDI) - they still are.
The final number for 2007 FDI is not out yet, but Russia attracted a record $87.9bn in the first 10 months of last year - or a bit more than $600 per person. This is up from the $25 per capita FDI that Russia attracted at best during the 1990s.
However, this still pales in comparison to FDI per capita in Central Europe and even Kazakhstan, which have seen per capita investment in the thousands of dollars.
While the tide has clearly turned, the inflows are only just starting and Russian remains one of worst performing markets in all of CEE in terms of FDI.
This may change in 2008 if money starts flowing downhill. Despite the impressive all but doubling of FDI in 2007, most of the money is still coming from Cyprus and the Netherlands, ie. it is Russian flight capital returning home.
While the share of "real" FDI is clearly increasing coming from "real" foreign companies like General Motors and Kraft Foods, this kind of FDI is still clearly in the minority. But as the floodgates begin to open the amount of money coming in is very likely to increase dramatically. Russia saw the biggest increases in estimated FDI last year after Latin America with a 70% and about 90% increases respectively.
"A few international suppliers have begun to set up shop in Russia, including Siemens VDO Automotive, Robert Bosch, ZF Friedrichshafen and Johnson Controls, but they have also noted that sourcing quality Russian materials is difficult," says Alfa Bank. "More impressively, and in what may become a model for further development of the Russian economy, Oleg Deripaska's Basic Element, which owns carmaker GAZ, has bought a significant stake in Canadian car part producer Magna, with a view of importing manufacturing know-how. The company has also bought a decommissioned production line from Chrysler, and will begin producing a Russian version of the Sebring sedan sometime in 2008, initially using imported parts."
Picking stocks will be key to beating out the 30% returns that just following the RTS index is expecting to produce. Below is an outline of what the main banks think each of the leading sectors are going to do.
Hydrocarbons: In the hydrocarbon universe, the stock that stands to benefit most from the positive developments we highlight in this document for 2008 is Gazprom. With Medvedev's nomination for president, the interests of minority investors and those of management will become more closely aligned. The potential for value creation in the company is vast and expect to see some of this unlocked next year. Momentum is building behind the stock so expect it to continue, according to Renaissance Capital.
Steel: Steel excelled in 2007 and will struggle to repeat the performance. Nonetheless, consolidation and focus on higher margin business will likely drive some companies to outperform and steel will remain a popular sector, according to Renaissance Capital.
Real estate: Real estate is a sector that has experienced perhaps the most rapid growth in our universe in 2007. This time last year, Renaissance Capitalcovered two real estate stocks. Today, the universe encompasses 13. As performance has illustrated, management is an absolute priority in the sector, and exposure outside Moscow also helps performance.
Banks: The combination of the increased cost of credit internationally together with substantial liquidity in Russia and demand for capital across the region places the financial sector in a particularly interesting position. We expect there to be consolidation across the region and good opportunity for those banks with access to liquidity, according to Renaissance Capital.
Infrastructure: The state plans to double investment spending over the next three years. Many of the companies involved in this are not listed or are listed overseas (eg. Strabag of Austria). The steel sector is the best way to get exposure, but some planned IPOs will also provide exposure. Transport, which includes Aeroflot and Novorossiysk Port, will also benefit from infrastructure spending, in our view, say analysts at UralSib.
Fertilizers: The trend globally is for increased demand for fertilizer. This is partly because of the effect of global warming on agriculture, and partly because of increased demand for bio-fuels, which is pushing up fertilizer demand. As the state emphasizes agriculture in the future, increased domestic demand will add to export volumes and drive up revenue and profits in this sector. Uralkali, one of this year's IPO successes, is the main way to get exposure to this theme, say analysts at UralSib.
Pipes: Major oil and gas projects, both offshore and in East Siberia, are expected to begin next year, as Russia starts to deliver on some of its energy deals, such as with China. That, combined with increases in capex spending by oil and gas companies, will be positive for the pipe makers. TMK and Vyksa are our two picks here, say analysts at UralSib.
Utilities: While utilities should represent an ideal sector to overweight - the amount of capex demanded by the sector to keep up with galloping electricity demand, and reforms that are turning generation pricing over to market mechanisms, ensure that profitability growth should be strong - at $700-800/kw, most generators are already looking fully priced. UES shows upside to our fundamental valuation, but its impending breakup into constituent parts, many of which will be quite illiquid, will continue to cause investors to shy away. The only significant fundamental value we can spot at this time is in the distribution companies, which properly belong in our mid- and small-cap portfolio, says Alfa Bank.
Telecoms/IT: As with all other infrastructure, the telecommunication systems of Russia, although significantly improved compared to their state in the early 1990s, still significantly lag the quality seen in developed economies. Mobile systems are relatively well developed, and penetration rates are high, but ARPUs are still quite low. We see substantial room for increased revenues per user as the mobile companies move their clients into higher-value services, which users will be more and more able to afford as the disposable income of the average Russian citizen continues to grow. Meanwhile, much like the electrical grid, fixed-line infrastructure needs substantial investment to serve a more sophisticated economy. On the IT side, broadband penetration is still quite low and of spotty quality, and should provide substantial growth opportunities, says Alfa Bank.
Consumer and Retail: We expect 2008 to be the year of the consumer, in particular the consumer and retail sectors. In consolidated consumer sectors such as beverages, we expect per capita consumption to drive growth and operational improvements to drive profitability. Diversification will be made possible by new offerings in FMCG, pharmaceuticals and agriculture. Consolidation and regional expansion will drive the retail sector in 2008. Investors can currently gain exposure to this explosive sector via four traded food retailers, one pharma retailer, a fast-food chain and a home electronics retail play.
Transport: The Russian airline industry collapsed in the early 1990s. Today, the Russian market as a whole is only 35% the size of Delta Airlines and has only 30% of the passengers it did in the late 1980s, but it is now taking off. The combined effects of sustained GDP growth and swelling disposable incomes are accelerating the demand for airline travel. The IATA forecasts that Russian passenger volume will grow at a 9.3% CAGR for 2006-2011, the second highest worldwide and the highest of any large country.
Other: Two sectors in particular which are only just beginning to unlock value are agriculture and engineering. In neither sector is it particularly easy to gain exposure, but we would highlight Razgulay, Silvinit and NCCP as the type of opportunity,
RTS End-2008 Targets
Troika Dialog 2,800
KIT Finance 2,750
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