Liam Halligan and Denis Spirin of Prosperity Capital Management -

International investors rightly complain that Russia's stock market is rather volatile. What's less widely appreciated is that, amidst the mood swings, the overall trajectory of the RTS index of leading Russian shares has most definitely been up.

Between the start of 2000 and the end of 2009, the RTS rose no less than 724% in dollar terms - including the sub-prime related lurch. During the same period, the S&P500 and the FTSE-100 lost more than a fifth of their value. Mainstream western investors should keep that in mind given the near-constant drumbeat of negative media coverage associated with Russia.

Other big emerging markets also posted strong returns during the "noughties". China's Shanghai A index and India's Sensex gained 191% and 226% respectively. But none did as well as the RTS - which easily outperformed every other major stock index in the world. This market isn't for the faint-hearted or impatient. Looking back over the last 10 years, though, would it really have been "so stoopid" to have invested some of your money in Russia?

More important than previous returns is the market's current valuation. Despite rising seven-fold since 1999, the RTS is still trading at a composite multiple of 8x 2010 earnings - similar to 10 years ago. That's astonishing. In 1999, Russia had just defaulted and was still shouldering huge Soviet-era debts. The country had no reserves, annual inflation was almost in triple-digits and oil was below $20 a barrel. Spool forward a decade and Russia has paid off almost all state debts and still boasts the world's third biggest foreign exchange haul; per-capita incomes have ballooned from $1,200 to $10,000; annual inflation is 6%; global commodity demand is accelerating; and Russia's burgeoning service sector now accounts for two-fifths of GDP. The general business environment - while still tough - is also unrecognizably better than 10 years ago. Yet despite such progress, the RTS has the same valuation now as during the chaos of 1999.

Under-rated

Why do global investors value India at 17.9x and China at 15.1x, but Russia at only 8.2x? One reason is that the RTS comprises some big oil and gas companies that are heavily taxed and operate on a low profit "cost-plus" basis, weighing down average valuations. Even after last year's meteoric 129% rise, the market is also still recovering from the 2008 credit crunch - when bouts of forced selling by leveraged investors pushed stocks way below "fundamental value." The main reason for the "Russia discount," though, is that many view this country as uniquely "dangerous".

Prosperity Capital Management is Russia/CIS-focused and controls $4bn of assets. We've been "long-only, buy-and-hold" equity investors in this region since 1996, but all our funding derives from elsewhere. Over the last 14 years, our flagship Russian Prosperity Fund has gained an annual average of 25% in dollar terms, while the Prosperity Quest Fund, launched in 1999 and with a lower-tier restructuring emphasis, has returned an unmatched 46% a year.

PCM has a large on-the-ground team in Moscow and sits on numerous Russian boards. It's our experience that most of the reasons put forward for Russia's low valuation don't stand up to scrutiny. Global investors generally cite macro, political, liquidity and corporate governance risks when explaining why they "won't touch Russia." The first three, at least, are heavily exaggerated.

Russia's macro economy is strong. Total leverage - consumer, corporate and state - amounts to less than 50% of GDP, compared with 250% and 350% in the US and UK. Last year, the economy contracted, but has since bounced back, growing by 5% during the first half of 2010. When the oil price fell sharply in 2008, Russia still ran a big external surplus - and has done for the last 10 years. Commodities anyway now account for 20% of national income, down from 40% in 2003.

Political risks are also over-stated. Viewing Russia as a malign influence suits Western prejudices and lingering Cold War clichés. But for 20 years now, Russia's political elite has been dismantling the state. There are lurches and some reversals, but the direction of travel is clear.

Liquidity is also better than perceived. Trading volumes are under-reported due to OTC deals and fragmented exchanges. A local presence also helps. Despite the volatility, PCM has never gated its clients - maintaining the weekly/monthly liquidity provisions on our open-ended funds.

The corporate governance risks, though, are real. Tackling such issues and standing up for shareholder rights is a large part of what we do. Over the last decade and more, PCM has built a strong reputation for shareholder activism, while making meaningful contributions to the development of Russian corporate law. Our ability to resolve complex issues, and untangle disputes, has been a significant source of our long-term out-performance.

That notwithstanding, a legal battle we're currently fighting at TGK-2 - one of the 14 combined heat and power generators spun off during the wholesale privatisation and restructuring of Russia's power sector - is among the worst we've ever seen.

Power struggle

In March 2008, Russia's Kores group took majority control of TGK-2 during the final privatisation auctions and, as such, was legally required to offer to buyout minority shareholders at the same price. PCM tendered its shares along with other minorities. But by the time the proceeds were due, prices had fallen. Ever since, Kores has done everything possible to create legal diversions to avoid meeting its obligations.

Over the last two years, we've campaigned against this blatant legal subversion. Kores owes PCM funds over $300m. The group effectively sued itself and obtained an injunction preventing the buy-back. Since then, this "blocking case" has been repeatedly adjourned - for months at a time - on flimsy technicalities.

Kores has also prevented the mighty Sberbank from meeting a guarantee to pay TGK-2 minorities buy-back receipts if the principal owner failed. The triggering of that mechanism would be official recognition of Kores' default. So the group sought and - incredibly - obtained a second injunction.

Kores then opened up a third front of legal obfuscation, claiming the buy-out obligation was null and void, as the group shouldn't have taken control of TGK-2 in the first place. The pretext for this is Russia's Strategic Investment Law (SIL) - and the fact that TGK-2 is involved, in a very minor way, with the treatment of radioactive material. That matters, Kores claims, because the group has affiliated companies based offshore - apparently rendering Kores' majority control of TGK-2 invalid, seeing as "foreign entities" need prior state permission for "strategic" transactions.

This is absurd. At the time of the buy-back, the TGKs were excluded from the SIL precisely to attract foreign investment. Kores is domiciled in Russia and controlled both directly and indirectly by Russian citizens. The offshore affiliates had absolutely no involvement in the TGK share offer.

Together with other minorities, PCM has tried disproving Kores' line of argument in the Moscow arbitration court, and then several courts of appeal. Yet at every turn - in four separate cases, involving leading international leading investment banks, 49 Russian defendants, 23 foreign defendants and Sberbank - the courts have backed Kores. This can only be described as a travesty of justice.

PCM is now leading to an appeal to Russia's Supreme Arbitration Court. In early August, the court will decide if our appeal can proceed. If approval is granted, it would be the first time litigation involving SIL has been heard at this level. Even before that decision, the case is front-page news in Russia. On July 21, Vedmosti published a full-page open letter written by PCM, urging Anton Ivanov, Russia's most senior commercial judge, to force Kores to give way.

Lots of leading Russian companies - including Gazprom, Rosneft, Gazprom Neft and Novotek - have offshore affiliates. All these companies, of course, are treated as "domestic" for the purpose of the SIL. If the Supreme Court fails to overturn successive rulings in favour of Kores, many of Russia's most important commercial entities, including those which are partially state owned, will be in breach of the law. Some of the most significant transactions in post-Soviet Russian history could be rendered null and void.

Russia has massive economic potential. It also boasts a stock market which, while volatile, is capable of generating enormous shareholder gains - not least because this country is so under-rated. The trouble is that, even though most of the bad things you hear about investing in Russia aren't true, corporate governance in this country, while improving, remains a major impediment to commercial progress.

Liam Halligan and Denis Spirin are, respectively, Chief Economist and Director of Corporate Governance at Prosperity Capital Management