VOX: Smaller Russian equity market pie, but bigger pieces

VOX: Smaller Russian equity market pie, but bigger pieces
VOX: Smaller Russian equity market pie, but bigger pieces
By Ben Aris in Moscow December 14, 2018

Interest in Russian equities is picking up again as the economy recovers and earnings rise again. Russian companies just had their most profitable September in three years, earning a collective RUB1,580bn ($23.7bn) in the month and cumulative profits for the year to date of RUB$154bn – about a third more than they earned over the same period a year earlier.

The growth in earnings is not reflected in the RTS index, which has been range bound at around 1000 points for the last four years, but it is reflected in the individual names, some of which have doubled in value in the last year. Moreover, the irony of the sanctions and instability is that Russia is paying the highest dividend yields in the emerging markets (EM) world; current yields are circa 7%, which about twice the benchmark MSCI EM average.

There is some good money to be made for the fleet of foot, but most of the big international investment banks have scaled back their equity research or simply relocated to London. The iconic investment bank names from the 90s are also gone – either sold to state-owned banks or a shadow of their former selves. The pie has become smaller, but the slices are bigger, argues Kirill Chuyko, the head of research at BCS Global Markets.

The up-and-coming broker-dealer sees this setup as an opportunity. Internationally the number of mid-size broker-dealers has also shrunk following the 2008 global financial crisis and BCS is attempting to step into these gaps left in the market. It has opened offices in London and New York and at the same time expanded its Moscow research department, which now also covers the biggest and best names in neighbouring markets like Kazakhstan and Ukraine.

bne IntelliNews editor-in-chief Ben Aris sat down with Chuyko to talk these issues over. Below is an abridged version from the full podcast that can be heard here

BA: Please give me some background of what you are doing and why.

KC: We have built a very strong team in the last several years and especially in the last half a year when we hired five talented new analysts, which will help us to get into a leading position for analysis.

We have a very strong product in metals and mining, which is one of the best sectors in the EEMEA [Eastern Europe, Middle East and Africa] space. Last year our research was number one and this year we got a number two ranking on the individual basis. The new hires will help us build a new franchise in all sectors.

Following the tie up with our partners, [the US based fund manager] Tigress Financial Partners, we plan to diversify our product into the US and other markets. And we started covering the CIS this year. Of course there are not so many companies there as we have in Russia, but still we have our expertise and now we are expanding outside our home market.

We started with Ukraine and now plan to cover Georgia and Kazakhstan. Later we plan to cover fixed income instruments in Belarus and Azerbaijan.

It’s not a huge market. Most of the liquidity is in Russia, but there are clients that want to diversify their exposure and those markets are very under-covered by research and that is how we can add value to our clients that need that coverage. And adding these market doesn't need big additional resources.

BA: Many of these stocks are listed in Warsaw, which BCS is also going to cover?

KC: Yes, because the location of the listing is not that important. Our clients have access to most of those exchanges. They need to understand the fundamental value of the company and that is not affected by the location where the shares are listed.

BA: The big change on the cards for this year is that many of these more exotic markets are going to be hooked up to Clearstream, which means traders in London and New York can trade them directly. That caused a revolution in Russia with inbound capital skyrocketing when Russia did the same in 2012. Do you expect the same to happen to these exotic markets?

KC: This will be a cherry on top of the pie, but the investors are driven by the fundamental attractiveness of the company. If trading can be facilitated by the changes in the process this helps. But we have seen a lot of interest in companies from Kazakhstan, Ukraine and Georgia in the past as well. So we chose the countries based on the available liquidity and if our research can be of value to clients.

BA: There has also been a general trend of emerging market investors moving progressive from the so-called emerging markets and increasingly into the so-called frontier markets, because that is where the really big gains can be made. Is that what is going on here?

KC: I wouldn't say that the returns are extremely high. You can look at these CIS companies and they have very solid liquidity and fundamentals, like Ukraine’s Ferroexpo or Kazakh Minerals. They enjoy healthy margins comparable to those in Russia. They have healthy liquidity so there are no problems with investors buying or selling a big stake.

If you look at banks or other production assets like [Ukraine’s leading sunflower producer] MHP then investments will depend in some part on the story of the country in general. But in general they are good companies. The risk to return is not far from that in the Russian market. Our plan is expand into Georgian banks and [Kazakhstan’s leading bank] Halyk as well.

We also have a very strong demand from the developed markets as there is a lot of volatility so people are looking for stability. Thanks to our cooperation with Tigress we have access to research in the developed markets and including the US.

BA: The deal with Tigress opens up more US clients to you and they have a strong research team as well?

KC: They already have a very strong model including one analyst with a model that allows him to cover 80-plus stocks. That model proved to be very efficient and his hit ratio is one of the highest in the States.

We want to make our research responsible. We open trade ideas. We close them. Even the worst of the trade ideas; sometimes we have had very poor calls, but on average we have some products that generate up to an 85% hit ratio – in other words 85% of our recommendations generated a return of 10% or more in US dollar terms.

BA: So who are your clients?

KC: They are mainly international, spread all over the western world. We have a concentration in London and we are heavily present in Scandinavia. We are expanding right now into the US, with an office there. It's the same guys like Fidelity, Blackrock – the international players.

BA: But surely there is a huge crowd of broker-dealers in New York you have to compete with?

KC: Most of that crowd is dead. This makes the competition relatively easy. We would prefer much healthy competition but the market is shrinking. There is a much smaller pie for everyone.

What we have seen on research side is the big brokers can no longer justify having research in Moscow. The flow has gone down substantially. The number of analysts and sales people that work on accounts was too high a few years ago, but now lots of brokers are shutting down in Moscow and cover the Russian space from London. But that is good for the local brokers. We have a better understanding of the local markets – including the politics, which is very important.

Sometimes weird comments made by the Russian politicians stress out the other analysts and they tend to be willing to run away. It is important to have someone who can interpret the news – and interpret it correctly.

BA: But the Russian market is completely out of fashion and oil prices remain volatile, which makes it risky and unpredictable too.

KC: The volumes in the Russian market are $1bn a day. It’s huge. The market is not going to die. Even if it falls by 50% that half a billion in daily turnover someone needs to manage it. There will still be a job for us, or someone like us.

The Russian market is unique. It is not an emerging market. This a big theme for me, because it is not really emerging from anywhere at this point. There is no decoupling of Russia from oil and it is ultimately dependant on oil and the budget (which is also dependent on oil) and other exporters like metal and mining companies.

But this gives Russia a unique advantage as among all the other emerging markets Russia has the lowest dependence on foreign capital. Whenever foreign capital leaves other emerging markets they have a problem and can fall into recession. For Russia as long as oil is high we are good. And this makes Russia a safe haven. The Russian dividend yield right now is about 7%. It's the highest in all emerging markets.

This creates a very solid foundation for real profits for the investors into Russia. If the Russian market halves then the dividend yields would not be 7% but 14% — it’s crazy money.

There is downside risk for the Russian market, despite the sanctions environment, but the market tends to overestimate those risks. Investors like dividends and they are still looking for growth stories, but dividends and growth is mostly what the investors are asking about.

BA: Why are dividends so good in Russia? Is it because the owners of companies now take their money out of their companies with dividends and are willing to share with investors?

KC: In Russia it’s not just because the businessmen suddenly decided to share profits. The origin of the dividend yield is mostly if you look at the highest paying sectors, which is metals and mining, the reason is because there is nowhere to invest. They earn lots of profits now but they understand that if they invest into production it will ramp up in three or four years from now. But we don't know what is going to happen in three or fours from now. Who knew we would be enjoying US President Donald Trump? Things change fast. China turns on and off rapidly. China closed its steel production off, which impacted the rest of the world economy. Something is always coming up.

Imagine you are a Russian oligarch. You have uncertainty about the funding. Uncertainty about the markets. The uncertainty of the political risk. Also being a metals oligarch, you have risk that your products won’t reach the market. There are all sorts of trade barriers. Other markets are not happy with lots of steel coming from Russia and China. It’s like a perfect storm now. So despite the fact they are earning crazy money, now there is nowhere to invest. So they pay dividends.

Most of the investments in the metals and mine industry were loss-making – huge losses. So the owners don't see any opportunities in Russia on a big scale, which would kill the cashflow sufficient to stop dividends. And they don't want any western exposure because all of them lost money. The only one that made money was Norilsk Nickel thanks to a stake in a gold field.