Ben Aris in Moscow -

Key reforms

Reforms have moved ahead quickly in the last two years. However, all the progress has been made with reforms in the fiscal sphere and those covering industry or the micro-economy are only just beginning.

Amongst the notable fiscal reforms are: capital markets reforms are moving quickly and the Central Securities Depository has been set up so that Russia will be fully hooked into the global financial system from about February; a fiscal rule has been imposed that goes some way to breaking the budget's dependence on fluctuating oil prices; the bank sector supervision has been beefed up and Basel III rules will be imposed in 2013; and the Central Bank of Russia (CBR) has almost entirely switched over to inflation targeting so the ruble is de facto a free floating currency, to mention some of the most important reforms.

However, on the real economy front things are going much slower. There are some set piece reforms going on, but the bulk of the effort is to launch 22 "roadmaps" for each sector that lay out the course of change through to 2018. Of these five have already been approved, but this is still very much as the planning stage. However, some positive effects have been seen and Russia moved up the World Bank's "Doing Business" ranking from 120 to 112 in October, but the bulk of these reforms will only start to be implemented in 2013 and are unlikely to make a really big difference to the Russia story before 2014.

The jury out is on how big an impact they will have and there is clearly significant resistance to change. For example, the customs service has received orders under its roadmap, but blatantly ignored them so that Russia's ranking in customs went backwards in the World Bank's survey. This story highlights that making real reforms is going to be tough, will take time and requires that the Kremlin bashes some heads together.

Still, in general we are more optimistic about the prospect for real reform, albeit slow moving, than at any time since the start of the last decade.

Of those things over which the government has some control, 2013 could be a crucial year for reform. The roadmaps hold the greatest hope for a big upside surprise in Russia's performance, both in terms of domestic growth and of attracting more foreign investment, but the reality is that it will probably take several years for these changes to take hold and have a noticeable impact.

Nevertheless, it is worth paying attention to even incomplete reforms, as in the past the set piece reforms the Kremlin has introduced have often produced the investment theme of the year.

Some previous examples are the telecommunication reforms of 2001 that created the mobile phone market; the banking sector reforms of 2004 that led to an explosion in Sberbank's share price; the dropping of the ring fence around Gazprom shares in 2006; and the break-up of the electricity sector that finished in 2008, which led to a soaring of utility asset prices.

The roadmap reforms that are already in hand include: sorting out a market basis for power distribution; making it easier to get construction permits; streamlining the customs regime as well as tax administration (and lots of progress has already been made here); and making it easier to start a business.

Equity

It has been a real roller-coaster ride for Russian equities. The RTS was up by about 25% in the first quarter, down by 27% in the second quarter and up again by 16% in the third quarter. As November came to a close, the market was up by only 3% and is likely to finish the year flat. This is unusual, as in all the non-crisis years since the stock market was set up the RTS has returned at least 20% over the year.

In 2012 the fear of a crisis in Europe was enough to pull equities down, despite the rally in bonds. Russian equities were in a strange place at the end of 2012, as they have decoupled from both the strong macroeconomic story and also the boom in the bond market that is predicated on not only solid economic fundamentals but also the clear policy and reform agenda from the government as far as the fiscal and macro economic policy are concerned. However, all the ducks are lined up for a recoupling, although when this will happen is a matter for debate. The bond rally still has some space to run and the government needs to make clear it economic and reform policies.

This is a similar pattern to what happened in 1999 and 2000: investors like the relatively stolidity of bonds as well as the coupon payouts and rushed to buy bonds. But as yields were driven down and equity valuations continue to shrink, investors then switched into equities and started an eight year long rally that really took off in 2004 - six years after the 1998 crash.

Something similar could happen in 2013 (five years after the 2008 crash) or at least begin in the third quarter, which is typically the start of a season rally that usually runs form September to May each year and also typically returns 20%.

Of all the factors to consider usually you can disregard all except one. The "cheapness" of Russian stocks on p/e or other basis (average p/e was 5 as of the end of 2012) is a red herring as the only thing that matters over the last decade and half is earnings - Russian stocks have never performed on the basis of what they "should be worth" but have risen consistently over the years on what the companies actually earn. Forward earnings in 2013 are projected to be 20% and 30% in non-commodity names and at some point equity prices will have to catch up with these earning gains.

A gain of 20-30% fits in with most of the bank's year end 2013 targets (for those that issued one - over the last two years many banks have given up forecasting RTS levels as a bad job).

The RTS has been trapped in a "recessionary" range of 1300 to 1500 for nearly all of 2012 and unable to break out without more clarity in the situation in Europe. However, in June 2011 when growth was gathering speed and the expectation was going back to a robust recovery then the RTS was trading between 1900 and 2000 is "strong growth" range. The 3.5% growth expected next year suggests the RTS range will be somewhere in the middle of these two limits.

For example Uralsib predict the RTS to finished 2013 at 1,740, or a 24% gain in 2013 on end of 2012 result and Citi bank predicts 1,500. Goldman Sachs marked up Russian equity as one of its outperformers for 2012 as it predicted that the Russian economy would be an outperformed - but while Goldman was right about the economy it was wrong about the equities, which have remains more of less flat.

• price/earnings

The RTS index was trading with a 2012E price/earnings (P/E) of 7.5 as of November, which is primarily due to the low multiples of energy stocks, according to Uralsib, and about 25% below Russia's EM peers (an improvement from the depths of the crisis when the EM discount fell to 50%). But excluding oil then the P/E is 10.5% as of November, which is in line with the MSCI average.

EV/EBITDA, again thanks to the heavy weight of oil and gas names, the RTS index trades with a 2012E multiple of 5.1, while excluding energy names and banks, the multiple stands at 7.1. That is just 3% lower than the MSCI EM index.

RTS index trades at a hefty 21% discount to DMs and a 31% discount to EMs. The 11% premium to DMs in 2012 based on EV/EBITDA (due to the low valuations of oils globally) will shrink to a 6% discount in 2013. Compared to EMs, the discounts are more appealing for 2012E and 2013E EV/EBITDA - at 17% and 22%.

• themes

-- dividends: this was a popular theme in 2012 and funds that followed it significantly outperformed the market. The government is now committed to dividends and committed the state-owned companies to pay a minimum of 25% of their profit out as dividends from January 1.

-- These payments will get an added impetus when IFRS accounts are introduced for many sectors from January as the profits under the international accounting system are several times higher than the Russian accounting system that companies use to calculate the size of their dividends in 2012.

-- Reform sectors: given there is some heavy state spending on the way in several sectors like power and pharma, which should also get a leg up over the benchmark in 2013.

The power sector could be a surprise as a major revamp of the rules of the sector is in the works and is supposed to be ready by November 2013 and implemented at the start of 2014. Any clarity on the valuation methods used to fix tariffs and how the distribution system will work could provide a trigger and this is one of the most advanced of the reform plans so should be one of the first to be settled.

At the same time the Kremlin has earmarked shipbuilding and ports for privatization and modernization. Several major assets like Fresco and Sovkomflot are due to be sold and Russia is a natural shipping hub in the global trade network.

- Consumer: this is a staple of any portfolio and the leading companies continue to expand and become more efficient. The share of organized retail more than doubled in the last few years, but it still only accounts for a total of 14% of total retail turnover. The rest is markets.

, Confused picture for Russia Part 1

, Confused picture for Russia Part 3