The Russian Bear Is Fishing Again

| About: iShares MSCI (ERUS)

Summary

Russia is growing again in the shade.

They have strengthened their economy and will surprise the world.

Local knowledge is critical in investments in Russia.

There are many stories about Russia that are floating about in the media at the moment that signals that the Russian economy is weak and the Russian people are on the verge of revolution but this could not be further from the truth.

Instead of deviating from their planned course of action like the US Fed, the Russian central bank has acted decisively to take four actions that I believe are critical to their long term success.

  • They have consolidated financial control and oversight under the jurisdiction of the Central Bank of Russia.

This move will help them to make quicker decisions in the event of a financial or liquidity crisis. It will also allow them to marry fiscal and monetary policy in a much more streamlined manner than was previously the case.

  • They have worked hard behind the scenes to consolidate their partnership with the other nations of the Eurasian union.

The Eurasian union is very important because it integrates the enormous landmass connecting Asia to Europe. There has been a lot of work done in this region to integrate the various nations that forms this union particularly with regards to removing tariffs on goods passing from one region to the other. This is extremely important as it will lay the foundation for the new silk road transport connection linking China to Europe.

  • They have built bridges with the European Union and with China.

Since the sanctions were imposed, we have seen Russia strengthen its ties with China in various areas with the intention of creating a counterweight to US hegemonic interests.

Within Europe, they have continued to build relationship with the EU particularly Germany as the Germans realize the importance of Russia to EU trade and global security concerns.

  • They have worked hard to gradually diversify their economies and bring productivity higher.

Russian agriculture especially is beginning to yield fruits after years of investments and diversification efforts by the government.

We are seeing huge vertically integrated agribusiness in Russia in areas like grain, dairy, meat products, oilseeds and vegetables. Over the next decade, I expect to see Russia become a net exporter of agricultural products and totally self-sufficient in food.

Furthermore, I really like Russian financial instruments as investments. When you compare it to Germany, the gap between the two is very significant for example while the interbank rate in Germany is -0.25, in Russia, it is 11.25, interest rates in Russia is currently 10.5 but in Germany is 0%.

The difference between these two strong nations is simply down to market perception and the best way to take advantage of the huge differential between these will be to structure an options trading strategy like a box spread that will allow you to take advantage of the inevitable narrowing of the spread between the two underlying positions.

While I like Russia, I believe the risk rating has pushed the interest rates too high for a country with a debt to GDP at 10.12% as of December 2015 and on the other hand, I also like Germany and believe that their interest rates are too low and will be between 1.5-1.7%.

This is why one should play these two on the basis that they will narrow especially because the better the Russian economy does, the lower the risk premium that will be assigned to it by the market.

As I said, I like Russian for the reasons I mentioned above and I will also like to point out two tailwinds which are working in Russia's favor.

The first is that the lifting of the economic sanctions is imminent especially as the Russians seems to have the Europeans advocating very strongly on their behalf. This is likely to mean that behind the scenes, a solution for Ukraine has been found and Europe know that Russia will not risk its economic stability over Ukraine or Crimea; furthermore, a strong Russia is very good for the EU particularly Germany that sees Russia as a major market.

The second tailwind is the gradual increase of commodities prices that we are now seeing, the price of oil was rising tentatively but over the last few weeks, we have seen it solidify due to supply fears and rising demand.

Between these two, we have the ingredients for a very successful comeback for Russia. What I have been most impressed with has been their ability to make good strategic decisions under challenging conditions.

Risks

It is unavoidable to speak about investing in Russia without also speaking about investment risks. At the same time, people will tend to disbelieve me if I say that investing in Russia is actually very safe. I did not believe it myself while I lived in London. It was only after I moved to Eastern Europe that I saw for myself that this is the case.

The main challenges for investing in companies in Eastern Europe as a whole are firstly; a large informal cash economy to avoid -paying taxes. This affects companies on all levels in Russia even the large listed companies because it can make it difficult to analyze companies correctly with regards to efficiency and profitability rations. This correspondingly makes it difficult to make sensible valuations.

The best way to overcome this is to do your own homework and for smaller companies, it is best to do your own cash flow statement using the indirect method and have good advisors who know that market well and can advise on revising your estimates upwards or downwards.

When you have the cash flow correct, all of the other financial documents fall into place.

This leads me to the second challenge which is the inaccuracy of statements that come out of Russia, this is not a market that you can invest in from afar, you need to be in Russia or have spent time developing a familiarity of the way they work.

This is because Russians have an eastern rather than a western perspective of life that places a very heavy emphasis of personal meetings and relationships.

Furthermore, because of the communist history, there is still a tendency to hide the truth, this is why most of the news from Russia is designed to misinform and mislead.

An investor needs to be there in order to separate the wheat from the chaff, despite the perception from the outside, the Russians are very warm people that will always go out of their way to help others.

Finally, while I know that the stock market presents a good opportunity because it is severely undervalued, I will not necessarily advise investors to jump into the stock market because it is not really representative of the diversity of the Russian economy. The modern Russian economy is very diverse and includes technology companies, social media companies, payment processing, services of all kinds, healthcare and modern transportation among others.

The stock exchange on the other hand are dominated by heavy industry, mining and banking. Most of these companies were created either during the Soviet era or just afterwards during the privatizations.

They were the low hanging fruits that made early Russian investors rich but they largely have a bad reputation on the global markets because even though the practices may have changed on the surface, the Soviet thinking still prevails at the core as BP and other oil majors have found out to their cost.

I advocate private equity because there are many good opportunities and many good SMEs in Russia but they have a problem that is all too familiar to European SMEs and that is a challenge in raising scaling up capital, their challenge is compounded by the fact that in many respects, Russia is cut off from the global markets.

It is essentially a cash starved economy, if it were to have the access to financing on the scale of their counterparts in the USA, the rate of growth will be very significant indeed. With a population of closer than to 180 million which is bigger than the 145 million that is widely circulated, the potential for services and consumer products is significant. Three of the ripe areas for growth are healthcare, education and logistics.

In conclusion, indeed the Russian bear is fishing again and investors will do well to position themselves to share in her catch.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.