Russia is tipped for a recovery after a poor 2017. The stocks are cheap and the fundamentals are compelling, according to investment professionals interviewed for this Morningstar, UK article.

Emerging markets rallied 37 per cent in 2017, making that the best-performing sector of the year. But one significant laggard within the group was Russia, surprising, considering the strength of the oil price.

The Russian stock market and the oil price are tightly correlated, but diverged last year. Russian equities eked out minimal gains as investors worried about further international sanctions.

But now Russia is being tipped for a recovery, and with valuations so incredibly cheap this could be the perfect time to buy. Robin Geffen, manager of the Neptune Russia and Greater Russia Fund, says the market currently trades at 0.8 times price/book compared to a historic high of 2.5 times. That’s a 55 per cent discount to emerging markets generally.

Russia currently trades at 7.5 to 8 times price/earnings compared to a historic high of 20 times. While Geffen does not expect these highs to be re-visited, he sees scope for the market to trade at 1 times price/book and 12 to 15 times price/earnings.

That’s supported by a dividend yield of 5 per cent and an “incredibly low” pay-out ratio of 20 per cent, compared to 40 per cent for emerging markets as a whole--meaning companies could return more cash to shareholders.

Warning: Could this be a value trap?

Cyrique Bourbon, portfolio manager at Morningstar Investment Management, likes Russia, but accepts some may worry about the market being “perpetually cheap”.

He says that a long-term deterioration of the oil price could lead to a downward shift in fair value, but notes that the index is transitioning away from being overly dependent on the large oil firms. Gazprom, for example, used to account for 35 per cent of the MSCI Russia index. It now represents 15.5 per cent.

“The first element of the Russian puzzle is to realise that it is not reasonable to just look at the evolution of the price/earnings ratio and declare that Russia is cheap,” Bourbon continues.

Russia is volatile, though, and not for the faint-hearted. “The Russian opportunity could experience a very wide range of outcomes, from negative annual returns to strong double-digit returns,” he adds. “But the probabilities are skewed to the upside.”

How Russia responded to oil price crisis

Winston Churchill in 1939 said he could not “forecast you the action of Russia”.  Well, it’s certainly easy to forecast March’s Presidential election. “Russia has the strongest and most secure President and the most capable central bank Governor,” says Jan Dehn, head of research at emerging markets specialist Ashmore.

This helped Russia weather the storm when the oil price crashed in 2014 and 2015. Inflation shot up to 17 per cent by early 2015 and the country entered a recession. The reaction was “textbook how to get yourself out of a crisis”, according to Naomi Waistell, investment manager at Newton.

The Russian central bank hiked interest rates from 5.5 per cent in 2013 to 17 per cent the following year. It also managed to keep a current account surplus, which stands at 2.5 per cent of GDP today. “Russia really is the poster child for how to do a crisis right,” says Waistell.

Now, inflation is down to 2.5 per cent--well below the 4 per cent target--and the interest rate is at 7.75 per cent, giving a real interest rate of 5.25 per cent. “That gives them huge scope for rate cuts,” says James Dowey, chief investment officer at Neptune.

Currently, 100 basis points are expected to be cut from the headline rate in 2018, but Dowey reckons that’s too conservative. “We think 150 basis points is really do-able.” This would take it to 6.25 per cent, lower even than the 6.3 per cent priced in by the end of 2019.

Elsewhere, consensus forecasts for real GDP growth is currently 1.8 per cent for 2018. Dowey thinks 2.5 per cent is realistic, giving a positive macro backdrop for the Russian market.

Energy Matters to Russia

Many contrarian commentators are bullish on the outlook for oil prices, which is ultimately what really matters to Russia, according to Colin Croft, manager of the Jupiter Emerging European Opportunities Fund.

He likes Lukoil, the most widely owned Russian oil company, and owns preference shares in oil and gas firm Tatneft, which have outperformed the ordinary shares by 40 per cent.

Two analysts have calculations based on oil at $60 a barrel and forecast significantly higher income for Lukoil. “If oil stays at $70 for the rest of the year, Wall Street will have to upgrade their income forecasts for Lukoil by over 20 per cent, which is pretty big,” Croft concludes.

He also recently bought into natural gas company Gazprom because “it had just got too cheap”. “Everything has a price, even the companies you might not like,” he says. While the dividend is not growing, this will change in the future once it reaches the end of its capital expenditure cycle.

“In 2006 all these Russian oil companies were trading on quite high multiples, yet they were paying no dividends,” continues Croft. “Nowadays they are paying fantastic dividends and nobody’s paying any attention. As soon as they start paying some attention, these things will go through the roof.”

Geffen does not hold state-owned Gazprom and Rosneft, but he likes gas producer Novatek. He says management has an excellent track record of execution and value creation. It’s delivered 20 per cent return on equity consistently and grown free cash flow considerably over the past three years.

Unloved tech

Technology has been a huge driver of equity market performance in recent years. That’s been characterised by the efforts of the major tech stocks FAANGs in the US and the BATs in China.

The MSCI Russia Index has zero weighting to technology stocks. This is something that Geffen believes works to his advantage. He owns internet service providers Yandex and Mail.Ru.

The US giants are not allowed to enter the Russian market, Geffen notes, which means Yandex and Mail.Ru have a Google, Amazon and Facebook-free marketplace in which to compete. This gives them the ability to earn “supernormal profits”.

“Not only that, they also have a very good relationship with the Government so are not in any way going to be threatened by legislation going forward.”

Lesser-known opportunities

On the two big supermarkets, Croft prefers X5 to Magnit. The latter is a former stock market darling but has recently seen a real deterioration in earnings due to its regional bases. X5, meanwhile, is based in Moscow and Saint Petersburg, which gives it more durable earnings. It’s also less owned and cheap.

Ewan Thompson, manager of the Neptune Emerging Markets Fund, says that mobile phone penetration in Russia is actually over 100 per cent because most people have more than one phone. Geffen adds it’s the strongest market for luxury mobiles in the world.

“Mobile phones are an essential tool,” says Geffen. “Even in the hard times when people were cutting down on their food baskets, they were not cutting down on their phone usage.” He has smaller positions in mobile telecoms provider Mobile TeleSystems.

How to play Russia

No pure play Russia funds are rated highly by Morningstar analysts. Geffen’s fund was downgraded from Bronze to Neutral in February 2017 due to “heightened analyst team turnover and the fund’s risk profile”.

For his part, Geffen says he “makes no apology for taking a defensive position when everybody was far too euphoric” in the first half of 2016.

Of the Morningstar UK Silver Rated wider emerging market funds, Lazard Emerging Markets has the largest net weighting to Russia at 8.79%, followed by the Robeco Emerging Stars Equities Fund with 6.71%. Both hold Sberbank and Lukoil amongst their top holdings.

More from Morningstar

• Where to look beyond blue chips

• Oil may present rare investment opportunity

• Make better investment decisions with Morningstar Premium | Free 4-week trial

 

David Brenchley is a reporter for Morningstar UK.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.