Russia’s economy is recovering. Incomes are rising again. The budget is in surplus. Growth has returned, albeit modest. And Russian companies are paying the highest dividends in the world. Yet none of this matters, as Russian business is entirely overshadowed by the escalating US sanctions on business and businessmen. The leading RTS index has been range bound for almost four years. How is it possible to work in these conditions?
But under the bluster of the banner headlines, life goes on in Russia. The Kremlin has launched a major overhaul of the economy as outlined in President Vladimir Putin’s May Decrees that will see the government increase spending by 12%, or an extra RUB2 trillion ($30.4bn) a year, pouring money into the social sector and infrastructure.
The goals are ambitious: halve poverty, double the amount of affordable housing, double the size of the economy and accelerate growth to the point where Russia’s economy is expanding faster than the rest of the world by 2020. Russia watchers remain skeptical as to how many of these goals will be met, but even if the government falls short there is lots of business to be done while the attempt is ongoing.
And Russia’s top companies are still digging up metal, pumping oil, stacking supermarket shelves and building cars. The country has not been isolated, as its trade with China and the other BRIC countries is booming. The crisis catalysed the consolidation process the real economy has been through, which means the winners are increasingly sharing rising profits with shareholders. The savvy equity investor has done very well in the last two years, but it’s not a game for the faint hearted.
“The biggest impact of the sanctions lies in their effect on sentiment rather than any material changes,” says Roman Lokhov, CEO of BCS Global Markets, in an exclusive interview with bne IntelliNews. “There is always the threat that at some point sanctions could be extended and could include any business in Russia, not only state-owned. For instance, Russian aluminum producer Rusal was sanctioned because of the close connections of its owner to the Kremlin, while the company itself is private. The same logic could be applied to any major Russian company, as large businesses here cannot escape having connections to the government in one way or another.”
The April 6 round of sanctions imposed by the US Treasury Department (USTD) targeted individual private businessmen and their companies for the first time and made assessing the risks unpredictable. That is already affecting everything from capital flows and the transfer of technology through to international trade and cooperation, adds Lokhov.
All this presents a problem for international investors, which will gather at the Moscow Exchange (MOEX) annual investment summit in New York on October 2 to hear the Russian story. Ironically, through all of this portfolio investors have remained overweight in the MSCI EM index, but they have been selling as part of a general move out of emerging markets (EMs) this year as the US Federal Reserve is already well into a tightening cycle. Investments in Russia can be spectacularly profitable, but the rising risks make investors nervous.
The bulk of sanctions imposed until recently had little effect on business as they mostly target individual officials and military personnel and amount to little more than visa bans. But the sanctions imposed on Rusal were a shock to the system and had a major impact on both the company’s stock and the international metal markets — such an impact that the USTD has since backed off following through on the sanctions as the pain has boomeranged back on US and European businesses.
Next up is the threat that Russian sovereign debt could be targeted as part of the Defending American Security Against Kremlin Aggression Act (DASKAA) sanctions that are due to be considered in November. But here too if a harsh regime on Russian debt is imposed, US and European investors are likely to be as hurt as Russia. Whichever way the pendulum swings the heightened risk is already pushing asset prices up.
“The classic approach to estimating country-specific risk, including Russia, is essentially sovereign risk, which can be directly observed from yields on its publicly trading bonds, as well as inferred from its credit default swaps (CDS) spreads or sovereign ratings,” says Lokhov, whose bank scored a first by becoming a member of the New York Stock Exchange (NYSE) this year. “In practical terms, the Russia country premium has widened in 2018 by some 60 bps, and we now estimate it at c5.5% in dollar terms or 8.5-9% in rubles. From a macro perspective, Russia has one of the largest levels of foreign reserves in the world and relatively small external debt, and is running a double surplus now, which on paper makes it a lot safer than almost all the other EMs.”
The solidity of Russia’s macro-fundamentals set against the widening of the spreads between Russian sovereign debt and the US treasury bill benchmark is almost entirely due to political risk. But this kind of risk is not founded in business and is a Chimera that can disappear as fast as it appeared, leading the spreads on bonds to snap back to their underlying economic value.
“The notorious 'Russia discount' has been exaggerated as it mostly comes from the sector structure of the equity market. Oil, gas and other raw material producers dominate the weighting of the index and they always trade at lower multiples,” says Lokhov. “Take the internet giant Yandex, for example, which trades with a lot bigger multiple than many US tech names at a P/E of more than 30 times, or supermarket giant Magnit, a couple of years ago, which was the largest and most expensive name in the EM consumer universe; they show that investors’ attitudes to the best Russian companies vary greatly.”
Russia’s stocks sold off heavily following the annexation of the Crimea in 2014, but the market rerated in 2016. Political tensions and fears of war receded and that year investors decided that Russian stocks were too cheap to ignore anymore: the market returned 52% in 2016 making it the best performing market in the world, geed along by the expectation US President Donald Trump could remove the sanctions regime.
A number of factors were coming together at the same time, Lokhov says: Russia’s recession began to recede; oil prices bottomed out at $30 that year; and EMs in general came back into fashion with the weakest ones – Russia and Brazil – putting in the biggest gains. Finally, commodity prices have rallied, which is always good for the Russian cornucopia of minerals.
“This is exactly right, global money was looking for cheaper names, and Russia offered them those in the metals space on the back of the devalued ruble. The RTS metals and mining index rose by 75% in 2016 and another 11% in 2017,” says Lokhov.
Shopping for commodities
Metals have given way to oil this year as the average oil price climbed to $65 per barrel in the first quarter, then over $75 in the second, and Brent futures were trading at over $80 at the end of September.
“In 2Q18 the aggregate Ebitda of oil names grew by 61% y/y, the best among all major sectors in Russia. Using Rosneft as an example, note that its 2Q18 Ebitda surged by as much as 70% y/y — a truly outstanding performance by any standard! Overall, the oil and gas space has taken the helm from metals this year and led aggregate net income for the Russian market to more than double in 2Q18, surging by 115% y/y — all thanks to exporters,” says Lokhov.
But this bonanza doesn't reach down into all sectors of the economy. Those who do business primarily in rubles have been going through a soft patch, says Lokhov, where the real disposable income of the population has been putting in anaemic growth and companies in the real economy are struggling to make a profit.
“Retail is not in a particularly sweet spot in Russia at the moment — the Russian consumer has been a laggard, not a leader in terms of economic benefits in the past couple of years. That was reflected in the underperformance of both Russia’s two leading supermarket chains, Magnit and X5 Retail, relative to the market,” says Lokhov.
X5 saw its share price double in 2017 and it overtook its long time rival Magnit to become Russia’s largest retail company in terms of revenue, but this year its Ebitda is down 7% in the second quarter and that of Magnit is down by a whopping 22% in the same period.
“So, in relative terms, X5 Retail looks better prepared than Magnit to go through the consumer demand weakness, but neither can be compared to what is going on in amongst the market leaders in the commodity space,” says Lokhov.
Banks blowing in the wind
That is Russia all over. Both corporate growth and share price appreciation can be spectacular, but they are often concentrated in one sector or another, rarely across the whole economy at the same time.
Another sector that has been enjoying the post-recession recovery is Russia’s banking sector. “Banks led the Russian market out of recession for very good reasons: rates were coming down, the ruble was strengthening and valuations of all banks had been very low during the recession. Russia’s leading online bank, Tinkoff bank, was trading at $1.60/share at the end of 2015, down from its pre-crisis IPO price of $17. Again, this is a typical story of a banking sector in recession — financials are the biggest swing cases, they suffer most in recessions, but bounce back the strongest on the way back up.”
Tinkoff illustrates the problem that investors at the MOEX summit are facing. Those brave enough to buy into Tinkoff during the 2014 sell off would have made a 1,000% return in under two years, says Lokhov, but it goes the other way too if you get the timing wrong.
The banking rally is probably over now thanks to sanctions. The Central Bank of Russia (CBR) ended its four-year long easing cycle in September and surprised the market with a 25bp hike partly to head off building inflationary pressures, but mainly in anticipation of harsher sanctions in the autumn that could undermine the value of the ruble. At the same time the regulator said it will halt currency purchases for the rest of the year after making some record interventions in the market over the summer, as it builds up a war chest in case it’s needed. Russia’s international currency reserves have increased by almost than $100bn over the last three years and topped $460bn as of the start of September — just shy of the CBR’s goal to amass a cash pile of $500bn.
Cashing in on the dividends
In this volatile environment picking stocks is very hard, but the very volatility means that the best companies are able to earn outsized profits as the crisis has led to an increasing consolidation: the smaller players, battered by the winds of economic misfortune, have increasingly been bought by their larger and cash-rich rivals.
“This investment strategy of picking the strongest companies has worked best in times of a stable economic environment. Emerging markets are less stable, and in Russia specifically, there are sanction threats and slow economic growth by historic standards. Hence, in the absence of strong top line growth, we advise focusing on the most efficient companies with superior profitability and transparent earnings distribution practices — this brings dividends into natural focus, and the stock price levels are very attractive now,” says Lokhov.
That has caused investors to focus on companies that pay outstanding dividends. There has been a sea change in the attitude of owners to their stock in the last decade. In the wild 1990s owning shares was only a way to get access to a company’s cashflow that was then siphoned off using various transfer pricing schemes. Today, now that companies are increasingly profitable, some Russian owners have taken to paying out extremely generous dividends as the way to tap a company’s wealth. Moreover, the government has gotten into the game, having decided to increase the state-owned enterprises’ (SOEs’) dividend payments rather than tax its own companies more heavily. And the stocks of companies that pay the best dividends are outperforming the index by about 17% YTD, according to BCS GM calculations.
“On our estimates, the 12-month forward dividend yield for the Russian market, as a whole, is closer to 7% — about twice the MSCI EM average — another unprecedented number and a major attraction point for global income investors. We agree with our investor clients who point out that lack of economic growth should lead to superior cash payouts. If companies do not see many attractive and profitable new growth projects, why hold on to cash? Give it back to shareholders and be rewarded for superior corporate governance practices,” Lokhov says.
And the increasing attractiveness of the domestic stock market comes at a time when the traditional investment vehicles for the population — bank deposits with high interest rates and real estate — are paying less and less. With the falling interest rates, ordinary Russians have been casting about for something else that pays a better return for the first time.
“This is an important secular trend for the Russian market as local investors are taking, at least partially, their money from under the mattresses and deposits and putting it to work in financial markets. That trend accelerated in 1H18 as ruble inflation and rates hit all-time lows,” says Lokhov.
BCS has gone into partnership with Tinkoff bank to offer a retail investment portfolio to give regular Russians easy access to the stock and bond market. The government is also supporting the trend with a “People’s bond” — a fixed income instrument specifically tailored for retail investors — and tax-free investment accounts.
“The government has made coupon payments on bonds tax-free, and this really helped, as it technically puts deposits at par with bonds when held to maturity in the eyes of investors. The line of reasoning is fairly straightforward in this case — why should I keep my money in a bank that pays me some 6% in rubles at best, while I can buy its bonds at higher yields, or even shares of large stable companies that yield double-digit dividend yields,” says Lokhov.
BCS is already attracting about $1bn of new investment into the capital markets from its Russian audience and Lokhov estimates there is a total of circa RUB2-3 trillion ($30-$45bn) in domestic investment that will enter the market in the next few years from the existing deposit base.
“This is a lot of money for the local financial market, but a large part of this cash should rightfully diversify into the global financial markets, not putting it all domestically,” says Lokhov. “There have been important supportive developments on taxation incentives, such as individual investment accounts and tax-free bond coupons, as well as market infrastructure improvements to facilitate the process. We are at an exciting early point on this road to success for the Russian market.”