Russian ETFs Deserve Consideration

Includes: ERUS, RBL, RSX, RSXJ
by: DoctoRx

Russia's stock market, which has not participated much in the post-2009 global bull market, may be ready to join the party.

Global investors have been bidding up one laggard stock sector or national market after another, including that of troubled Spain. Often what happens after the easy and obvious choices have been identified after a major global shock occurs, such as that of 2008-9, is that value-oriented investors look around for any ignored opportunities. This article puts forth a set of reasons why in this context, Russia's stock markets may soon see a revaluation upward. Russia may have been changing for the better, at least economically.

Thus I believe that exchange-traded funds that invest in Russian companies may be good investments for investors looking to take a decent amount of risk for what might be substantial reward and to gain exposure to a market that has a relatively low correlation to the U.S. stock market.

One reason to consider Russia is that Jim Rogers (the Quantum Fund co-founder with George Soros) said last year that for the first time in his life, he is long Russia and is involved in a financial venture there.

Another reason is that probably few, or none, of your friends are invested there. Who has cleverly picked a Russian ETF in the post-crash period and made a bundle? In fact, one of the large cap Russia ETFs, run by Van Eck, Market Vectors Russia ETF (NYSEARCA:RSX), not only remains far off its 2008 peak but is also almost 30% off its spring 2011 secondary peak.

It is child's play for Westerners to identify numerous reasons not to consider investing in Russia, despite Jim Rogers' views and actions. Russia is at least a capitalist democracy, (as opposed to Communist China). There is, for now, political stability in Russia. Tax rates are low and there is a flat tax. The formerly-French actor Gerard Depardieu has become a citizen there. More importantly, the country has not been forced to expend much effort or treasure in foreign wars since its humiliation in Afghanistan in the 1980s.

The Russian story has stronger points than the above, though.

There have been dramatic changes in the financial system since the hyperinflationary 1990s that followed the dissolution of the Soviet Union. This is shown by a degree of central bank rigor that some in the U.S. might wish for. Reuters reports:

The central bank hiked all its interest rates last autumn after inflation overshot its 6 percent target, and shows little eagerness to cut now, even as economic growth weakens.

The bank's determination to bring inflation down is hardening as it completes the transition to a formal inflation-targeting regime -- due by 2015 -- similar to central banking practice in developed economies.

But while Putin has also voiced concerns over the slowing economy, the betting is that he will pick a successor who will continue Ignatyev's (ed.: the Russian Central Bank's chairman) tough-minded approach. Whatever the current policy tensions, Ignatyev's long-term record is hard to ignore.

"Probably of all the state institutions, the central bank has the highest trust of the people, which is obviously a big change," said Clemens Grafe, chief Russia economist at Goldman Sachs.

Who is the favorite to succeed Ignatyev? Sound money advocates may like the answer, also per Reuters:

DAVOS, Jan 24 (Reuters) - The Russian central bank will continue to buy gold as it seeks to diversify its foreign reserves away from paper assets it views as risky, First Deputy Chairman Alexei Ulyukayev said on Thursday.

"We are buying metal and will continue to pursue this course," Ulyukayev told reporters in Davos.

The Bank of Russia has built up the world's fourth-largest foreign reserves, worth $530 billion, by buying oil export dollars to keep the rouble competitive. The hoard includes two rainy-day budget funds that guard against fiscal shocks.

The bank has also been a bullion buyer and the share of gold in its reserves is approaching a medium-term target of 10 percent, raising questions over whether it would keep buying gold.

Ulyukayev, speaking during the World Economic Forum, said the central bank would continue to buy gold, but gave no indication on whether there would be any change in the share of its reserves it allocates to the precious metal.

"We are buying metal and will continue to pursue this course," Ulyukayev told reporters in Davos.

It appears that as with other countries that have suffered hyperinflation, Russia appreciates the benefits of maintaining some degree of control over inflation. Thus, there is a reasonable chance that the Russian ruble will act predictably, which is a "must" for foreigners considering investing in an emerging market.

A further reason that Russia may be timely is that the Federal Reserve is engaged in open-ended quantitative easing, also called money-printing. In prior periods of QE, the price of oil has risen rapidly. (Whether it will do so again is to be determined.)

The Russian economy appears healthy enough to be worthy of investment, at least from the data I have seen. Here is a part of the recent Markit report on Russian manufacturing PMI data:

Manufacturing output in Russia rose at a solid rate in January. Production has increased during every month since August 2009, and the latest pace of expansion was in line with the average shown over this period.

To summarize my understanding of the above points: Russia's economy is doing pretty well, and its central bank is committed to a fair degree of rigor and is predicted to continue on that path. If correct, those facts meet my core tests for potential investment in a foreign stock market. The investment decision then turns on whether Russian stocks already reflect the good news. Arguably, they do not and thus may be under-valued, at least compared to alternative investment choices.

For example, consider the valuation of the two Van Eck Market Vector Funds that invest in Russian equities. Their large-cap Russia ETF, (RSX), has the following average valuations (from the Van Eck website, and then click on the fact sheet):

P/E of 7.67, trading at 1.12 book value with a stated dividend payout of 2.3%. Almost 2/3 of the market value of this fund's holdings come from energy and minerals.

I was also interested in the Russia Small-Cap ETF (NYSEARCA:RSXJ), and spoke with a Van Eck representative last week. The fund only has $10 million of assets under management, with a fee structure that is effectively capped at 0.67%, he said. Why, I asked, are they sponsoring such a small fund? His answer was that their investment committee truly believed that Russia was developing a stronger consumer economy, and that domestically-oriented companies had a bright future. Thus they believe that RSXJ has a bright future.

Van Eck's view gibes with the information I have from a friend who was an emigrant to California and who once held an important position in the Soviet sports system. His family owns retail stores there, and he travels from California to Russia to make investments there. He reports that Russia is friendly to business, and believes that the authorities truly want to grow the Russian economy in an investor-friendly manner.

The fundamentals of RSXJ are suitable for value investors, though it is also hoped that there is significant organic growth coming as well:

P/E of 8.64, price:book of 1.12, and dividend yield of 2.29%. The sector breakdown is much less oriented to raw material production than is that of RSX.

Russia is a risky place to invest, of course. Permanent loss of capital may occur from an investment in a Russian ETF.

Russia may not be more risky than several other well-regarded emerging markets, however. Zero Hedge has published Citi research that rates emerging markets in terms of riskiness. Russia was rated as medium risk, right at 50%, and slightly less risky than Singapore, Brazil and South Korea.

I wish to advise readers as follows. I am not an investment advisor, and nothing in this post constitutes investment advice. My goal is to stimulate investigation to see if this specific asset class is appropriate for you. In addition, it takes little imagination to name the political and economic risks that would be harmful to an investment of the sort described herein. Russia, and before that the USSR, and before that the Russian Empire, have quite a turbulent history, and no guarantees regarding the future of this country can be made.

Nonetheless, I have instituted a moderate allocation to Russian ETFs in my portfolio and in some of the accounts that I manage, with due respect for the risks of capital loss.

Disclosure: I am long RSX, RSXJ, ERUS, RBL. 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.