I have spent the past two years focusing on Russia. I live, travel and work in between London and Moscow giving me a strong understanding of where Russia is today. Russia is a greatly misunderstood country by journalists and investors worldwide. Mafia and bears do not walk the streets like they once did (well only the mafia once did) but neither is it true to say that Russia is a safe and golden land. The unavoidable truth is that Russia is still far behind the rest of the developed and emerging world politically, economically and commercially. The legal system is corrupt, highly inconsistent and far from independence. As a consequence minority shareholders if abused do not have any defence. That being said, do not think that Russia has remained stagnant since its inception 30 years ago. Growth is the highest in the G8, while debt both public and private is lowest. Russia also continues to hold a large portion of high quality commodity assets ranging from diamonds to natural gas. Russia is a great opportunity but should be treated with as much caution as excitement.
Growth and Opportunities: The Russian Consumer Story
To start with the positive side of things. The consumer sector is where Russian growth has been and will continue to be. The country's population has been fairly stable at around 140 million, while national income has surged. As a result it has created a middle class; GDP per Capita (PPP) is around $17,000 in Russia against $12,000 in Brazil, $8,000 in China and $3,000 in India. A middle class that is growing in number every year as real wages grow around 4% per annum. So, what do middle class families do? They take out debt buying cars and houses. This can be seen by Russia's 40% loan growth in 2012 - albeit from a very low base. The biggest winners are the consumer retailers such as Magnit (OTC:MGJCL), and London-listed companies; O'Key and X5. These are all fantastic investments due to the early stage of the Russian retail market; around 25% of the food retailing is controlled by the big five players, as compared to 50-90% in most countries around the world. This transition will occur over the long run as supermarkets are substantially much cheaper than other retail formats. For instance take the local orange juice such as Pepsi's (PEP) J7, in a supermarket like Magnit it will sell for around 70 RUB while in a local "Produkti" (a sort of local newsagents store) it will sell for 110 RUB. Expanding store footprint will increase the power of economies of scale, thus enabling even lower prices for consumers while still maintaining margins. As a consequence, consumers are and will continue to switch their main shopping outlet to the supermarkets. This story is still early days but is already having a big impact; Magnit 2012 profits grew 98% while revenues were up 34%. One huge plus for western investors is the zero ownership by Oligarchs and Government for most of the retailers such as Magnit.
The biggest opportunities in Russia, however, come from the private equity and start-up side. Within the fresh food produce sector for instance; the price of potatoes, oranges or tomatoes are roughly the same as in developed economies and yet the quality is substantially lower - blackened fruit is extremely common. There is a significant opportunity to develop greenhouses to produce high quality fresh fruit and vegetables and sell at or above market prices. Other products such as pharmaceutical products; same label cough syrup costs up to 200% more in Russia than in western countries such as the UK. Importation of foreign goods, particularly now that Russia has joined the World Trade Organisation has huge potential through joint-ventures or franchising. Opportunities for listed companies, outside of the consumer sector come from an increase in dividend payouts. Russian companies are beginning to wise up to the demands of shareholders, at 30% pay-out ratios Russia has greatly improved but remains below other similarly compared countries such as Brazil and Turkey. Critically dividend payouts of 30%+, if sustainable, on PE multiples of 6x creates a very attractive dividend yield.
Russian Energy: Un-investable
Unfortunately the opportunities in the consumer sector are limited, and the index is dominated by commodity companies. These companies are swamped with government influence, corruption, over-stated earnings and poor corporate governance. Gazprom (OTC:OGZPY) is a fantastic example. It is owned with a majority by the Russian Government, as a consequence it must buy up assets that have nothing to do with the business: football teams, media companies, banks etc. It has probably the largest leakage of shareholder cash of any Russian company through corruption; Gazprom is not inefficient because it has poor quality managers, Gazprom is inefficient because it chooses to be. It can pay the real price for a pipeline, but instead will choose to pay seven times the price to benefit others. The earnings of the company are overstated at 3x. Depreciation is simply too small for an Oil & Gas major. Whether Gazprom is a good investment or not is another story. The company is now worth under $100bn, with profits ranging in a $30 to $40bn window and with a 25% dividend payout ratio, it looks attractive. Downside risks of worse European gas prices appears to have reached its climax given that most of its restructuring of gas contracts with European clients has ended. With potential deals with China and the UK seemingly close, and a short squeeze there is a lot of trading upside in the name. The biggest problem with Gazprom and any other Russian government owned company such as Rosneft (OTC:RNFTF), is that the government does not care for shareholder value. It will never attempt to boost underperforming shares by a stock buy-back, or greater dividend policy. Do I recommend Gazprom as a buy? No. I used to like it, but given recent events in the Energy sector in Russia, it is not a safe long term investment, nor is any commodity or government or Oligarch owned name in Russia.
Corporate Governance a shambles
Corporate governance in Russia today is still a shambles. The recent events of TNK:BP (OTC:TNKBF) minorities tell you everything you need to know about what the Russian government and oligarchs think about western investors. TNK:BP, which is now 95% owned by Rosneft, has ceased paying dividends and is now siphoning cash away to Rosneft without paying the minorities anything. The shares are down 50% in a couple of months in reaction to this and the refusal to buy minorities out as part of the BP deal. The significance of this deal is huge. It tells us that Russia has not advanced in protecting minorities shareholders and that if an Oligarch wants to take from minorities he can. What is critical to all this is the courts. In another country even if the government attempted to steal all it could or a couple of Oligarchs, the courts would prevent them or at least compensate the minorities. In Russia the courts are corrupt and in the hands of the leading elite. The TNK:BP Rosneft is not an exception, it is all too similar occurring in other companies like Mechel (MTL).
Misappropriation of shareholder funds is all too common. Even in banks like Sberbank (OTC:SBRCY) and VTB (OTC:JSCVL) the ability to hand out profits in dividends is undermined by corruption and government influence. Cheap loans are given out to well connected and politically important companies at low rates despite the huge credit risk. Bankrupt companies are bought up, such as Moscow Bank by VTB in the financial crisis, resulting in large losses for VTB. Sberbank has a good reputation among western investors and analysts. I disagree with this greatly, I am as concerned about Sberbank as I am about VTB. Retail lending has been excessive, credit control is in its infancy, and government control is rife. In a relatively weak banking crisis equity holders could quite easily be wiped out. Net Interest Margins are high and unsustainable, thus earnings will continually be under pressure. I would avoid all Russian banks.
Politics "The old need to die and the young need to grow up"
Politically, Russia is a quasi-dictatorship. This is something that to a westerner feels particularly ugly. However, I would be careful before criticizing it. Russia is not the west. Russia needs a strong leader: Liberal leaders like Medevdev are weak and unpopular. Authoritarian leaders like Putin are strong and popular. Thus there is only one natural outcome. One problem is that there is no "opposition" in Russia, there are just two "ideological" parties. The communists who probably have about 40% support, and Putinism which has about 60% support. Support when looking at people who will vote. Most Russians when asked about politics reply with the answers "I don't care" or "They are all corrupt, all the same". Critically, this point of view won't change unless growth stays below 3% for a sustainable period.
Russia will change in the long term though. One of the first times I went to Russia I was told a quote that is too true "the old need to die and the young need to grow up". If one compares a Soviet like Putin or Sechin, to someone like Medvedev we can see how Russia will progress. Putin is KGB, Soviet, anti-West and quite simply the opposite of liberal. Medvedev, on the other hand, is a professor, Soviet, pro-West, liberal. Is Medvedev himself the future? The truth is no one knows. No one will truly rule Russia until Putin has died and then politically Russia can evolve. After Medvedev comes western style leaders who grew up in the age of internet and Russia. In the long run Russia is a very good bet on a positive political transformation which will impact shareholder rights and the strength of the legal systems. But today is not that day.
Additional disclosure: I am also long M.Video and O'kei. I have a working relationship with Sberbank, but this article does not reflect any of their opinions.