I'm one of those weirdos, those "contrarians." I happen to believe that it is both safer and more profitable to be a contrarian. Not everybody agrees with that, and that's OK.
I don't always reject the consensus, of course. I'm just perpetually skeptical of it. With easy-to-forecast variables, consensus gets it right far more often than not. But with things that are impossible to forecast, like future prices, consensus is not a herd I want to be a member of. I'm far more comfortable by myself.
Perception is a funny thing. I'd say that right now most of the developed world views Russia as a corrupt bureaucracy, "democratic" in name only and with a heavy-handed connection between the government and its major industries. If you think inequality in the U.S. is bad, it's even worse in Russia. This is a state in which virtually all of the wealth is controlled by just a few interests.
The evidence and the data all back those perceptions up. So the criticisms are fair and warranted. I have no interest in arguing against that. And the negative sentiment has only worsened in recent months thanks to a combination of a strange new direction for Putin's perpetual PR campaign, an... interesting Olympics, and most importantly, the geopolitics of the moment and the situation in Ukraine.
There's no question. Russia as a nation, culture, and economy is unpopular right now. Perhaps the most hated market in the world right now. Their stock market is down on the order of 50% since 2011. It's the worst performer of the year.
As a contrarian investor, the way I usually get started is by figuring out what the rest of the world hates. By definition, you've gotta push against the mainstream to be a contrarian. This is the easy part, too. The assets that the world hates are usually quite obvious. The trick is being able to cut through the noise to see if there's a legitimate investment case to be made.
Separating What Matters From What Doesn't
We know the world hates Russia right now. But that's not what will make it a good or bad long-term investment. There are only two factors that will determine whether it will be a good or bad long-term investment:
- Its future fundamentals, GDP, earnings, dividends, etc.
- Its current valuation i.e. how much we're paying for those future fundamentals.
If you need a reminder of how big a disconnect can exist between cultural sentiment and future investment performance, consider 2007. The investment world was in love with Russia and that could not have mattered any less for its market's future performance.
This should be a reminder of just how completely we have forgotten where we came from. The Russian economy has been pretty darn awesome over the last decade.
I suppose that's why we all fell in love with it way back when, because we knew the economy was going to double in size over the coming 5 years. It was a new era! Oil exports and natural gas!
Let this also be a reminder that valuations matter. For investors, growth is only worth it if the valuation is sensible. I repeatedly go back to the tech-bubble to illustrate this point. Back in 1999, we were totally correct. Microsoft (NASDAQ:MSFT), Intel (NASDAQ:INTC), Cisco (NASDAQ:CSCO), and the like would all go on to grow and dominate and become systemically important companies. We just paid too high a price for their shares and it took a decade for these stocks to grow into their multiples.
Russia's economy appears to have done exactly what we thought it was going to do. But it's clear now we paid too high a price in 2007. The last 5 years have been terrific for the economy, but the market has simply grown (shrunk) into that original multiple. It's been a disappointing ride.
In any case, none of that matters. Not the past economic growth or what's happened to the Russian stock market. What matters today is what future growth will look like and what we're paying for it right now.
Future growth gets a great big "meh." OECD is projecting around 2.5% for the next two years, and that'll probably get revised a bit lower when they update the forecasts in May. Current consensus is closer to 2%, and the ten- and twenty-year growth projections are closer to 1.5%. Russia has had a string of sub-50 PMI numbers, so it's possible the next few quarters or year is even lower than consensus' latest figures. The market has had quite a bit of time to digest this news, though, and nobody really expects it to get too bad or last too long.
The point is that if you're looking for long-term economic growth, there are much better places to go. But don't look to Russia for any sort of economic collapse, either. That isn't going to happen. Their demographics are fine and their economy will keep expanding, if slowly and with stops and starts over the next year or so.
The other good news is that -- drama aside -- their government is in rather good shape. Strong, even. Their bonds are rated BBB with a stable outlook. Debt to GDP was a scant 8.4% last year and it's falling. There's no debt crisis and there's no fiscal crisis. They run a massive trade surplus and it's odd that those who are so quick to criticize countries running a deficit aren't as quick at praising Russia for the huge surplus in their current account.
I totally concede the point about a currency problem, though:
The Rouble has been a complete mess. Just the other day they hiked rates to 7%. The stock market was not pleased.
But look on the bright side! Maybe now with a cheaper currency their surplus will get even bigger! (I'm only half joking.) And, short-term volatility and geopolitical actions aside, they at least are acting in a way that communicates seriousness about stabilizing the financial situation.
In any case, these are all just more pieces of the puzzle. What really matters, especially for long-term investors, is how much you're paying for that growth. We can quibble over what the next decade will look like for Russia's economy, but we shouldn't quibble over today's valuations.
The Russian market is dirt cheap.
Depending on which ETF or index you look at, the Russian market is trading under 5x earnings and about 0.5x book.
Now, this is Russia, after all, so I'll understand if you're skeptical about the book values that are being reported. I came of age as an analyst during the accounting scandals, so I'm skeptical of the numbers U.S. companies report. Most of this stuff is controlled or "influenced" by the State.
Gazprom (OTCPK:OGZPY) tells me that there are nearly 13 trillion RUB worth of assets on their balance sheet. Even if that's overstated by a factor of two, you're still picking up these businesses right around tangible book. That means you're getting the actual businesses for free. Last time I checked, exporting energy resources to developed Europe was a pretty sweet business.
This isn't like the banks, either, where there's debate over what fair price a particular CDO-squared ought to carry. I may take the numbers with a grain of salt, but at least these assets are physical in nature -- plants, property, equipment -- and much easier to value. Also, cash. Most of these companies are flush.
When you get down into the low- mid-single digit P/E range, you have to start asking a different set of questions. It's like trying to use Newtonian physics to explain the stuff you see on the atomic level. It just doesn't make any sense. You need a new framework for analysis.
Seriously, who wouldn't want to own a bunch of profitable businesses at less than 5 times earnings? As long as these things don't go poof in the next few years, you'd own the companies and all their assets for free after the cash these things will create in a couple years. What rational individual would pass that up?
Instead of automatically saying, "Yeah, 5x earnings is a buy" and responding as though the market had corrected from 18x to 16x, we have to ask new questions.
For starters, is the Russian economy going to go -poof- over the next few years?
Well, retail sales are now projected to contract meaningfully over most of 2014. As of right now, it doesn't sound like it'll be enough to push the economy into recession. But here's the other thing: whatever domestic economic baggage Russia has right now, I'm not totally convinced it matters.
The way most investors are getting exposure to Russia is through ETFs, and these things are dominated by one industry: energy.
We all knew about that, of course, but the extreme weight of the energy sector is actually less interesting that the sectors that aren't represented at all.
No consumer cyclical, no real estate, no industrials, no technology. I would submit that given the composition of this ETF and similar funds, what happens in Russia may have little or no influence in whether these turn out to be a good investment.
Most of Russia's oil & natural gas gets exported to Europe. The other sectors with meaningful weights -- utilities, durables, and communication -- are all defensive. In other words, these are the exact sectors you want to overweight during times of economic turbulence, aren't they?
The banks are obviously a huge risk. There are some financials in these ETFs and those are definitely leveraged to the fate of the domestic economy. However, those have already been heavily discounted in the last few months given what's happened with the Rouble and interest rates.
So back to that original question of why Russia is so cheap. Why aren't investors gobbling up a 5x PE? Traditional attempts to understand that totally break down.
The obvious answer is "headline risk." I'd state that a bit more precisely though. The answer is that the fundamentals have stopped mattering. Completely. This happens from time to time in various markets. These funds could lose another 50% and it wouldn't matter for the short run. During moments of fear and complexity, the desire to avoid risk and protect capital trumps every single other thought and emotion.
Usually those environments are good entry points for investors that do understand the fundamentals and can divorce themselves from the emotions of the moment. Ultimately, those fundamentals will be the only thing that matter. There will undoubtedly be some volatility in the meantime, and there are literally a thousand bad (worse) things that can happen to Russia in the next few weeks or months. Boycotts. More surprise rate hikes. War. Any outcome is in play.
The point is that picking up a basket of assets at 2.5x cash flow is never free. Here, the cost you pay is psychological.
It's a steep cost, too. Stepping into a market with the awful constellation of geopolitical and sentiment factors that Russia has right now is a nightmare for our subconscious. There's a reason why you never get to buy U.S. stocks for 2.5x cash flow. The U.S. exists in that Newtonian world where it never, ever makes sense to let the market trade with such a depressed multiple.
If you are invested in Russia, one thing that could help you sleep at night is to remember that the world still needs Russia's oil. Europe doesn't have a whole lot of choice in the matter. It also may help to know that, strategically, it's probably safe to assume Russia knows the score. That could explain some of the reasons why they act in such a bold (petulant?) manner, and it'll also explain why they probably won't do anything too dramatic that destroys all the success they've created for themselves over the last decade.
These situations rarely resolve themselves quickly, either. Don't expect a 10% rally in the coming weeks. More often than not, it gets worse before it gets better, though to be fair, it's been getting worse with Russia for a while now. There's no shortage of excellent geopolitical analysis elsewhere, but I do think that Ukraine represents a new chapter for them and that there may be more new chapters ahead.
Conclusion & How to Play It
There are many ways to play it, though the easiest and safest is with an ETF. The Market Vectors fund (NYSEARCA:RSX) is the biggest by far, but I'm partial to the iShares version (NYSEARCA:ERUS) for its slightly higher yield and cheaper valuation. Neither one of these are very big funds, though, at least not big enough where size would matter. SPDR has a Russian ETF (NYSEARCA:RBL) too; there's only $16 million in AuM though. VelocityShares' offering (NASDAQ:RUDR) is even smaller. I guess the market for Russian equities is only so big.
If you really know what you're doing, there's the Russian Small-cap ETF (NYSEARCA:RSXJ). It's not heavily weighted towards energy like RSX and ERUS, so if you have some key insight into the Russian economy you can probably do better with this one in terms of future risk-adjusted returns. I prefer the energy angle, though. I wouldn't touch either of the 3x levered ETFs (NYSEARCA:RUSL) or (NYSEARCA:RUSS) with a 10ft pole. Those aren't for long-term investors and this is a long-term thesis.
Being a contrarian investor isn't just about finding the stuff that everybody else hates and then getting long. There has to be a legitimate investment thesis and, even better, it has to be a situation where the rest of the world has assigned a too-large probability on a too-dire economic outcome.
I don't have a clue if the Russian economy is a truly good investment right now. The outlook is weak relative to the rest of the emerging world and you can obtain similar growth with a whole lot less drama from the developed world. At least there will be some growth, however.
The Russian thesis right now is 100% about valuation. That economic growth may not be stellar, and there may be an endless list of headline headaches, but the growth you are acquiring, you're acquiring for as close to "free" as markets typically allow.
This was the essence of the research report I issued on Greece last summer. Also, with OPAP here at Seeking Alpha. I wasn't enthusiastic at all about the Greek economy in an absolute sense. But if I can just get stability -- a simple cessation of the economic depression -- for 3-4x earnings, then my investment can easily double based solely on a return to normalcy and a quieting of all the chaos that created the fear.
On a cyclically-adjusted basis, Russia will finish today with the second lowest PE in the world. Only Greece is cheaper on this basis. Russia is now less expensive than Argentina!
If you fancy yourself a contrarian or don't think the Russian economy is going to fall off the face of the earth or just think there's a mismatch between the probabilities and potential outcomes, here's your opportunity. Russia could absolutely be worth a look.
That's assuming you don't mind some heartburn and a few sleepless nights along the way.