By Joseph Dayan
It’s been over six years since markets around the world began selling-off ahead of the global financial crisis. Six long years is not enough time, so it seems, for the Russian equity market, which remains 50% below its October 2007 levels. At the same time, Russia’s economy expanded from $1.3trn to $2trn.
There are varying hindsight explanations for this underperformance ranging from corporate governance concerns and geopolitical worries to a whole host of macro and micro economic fears. Some of the explanations are more valid than others but they all fall short. This usually means an investing opportunity.
So is there value in Russia? The traditional way to answer that question is to look at some run-of-the-mill valuation ratios. Russian equities are valued at give or take 7x 2014 earnings, 1x the aggregate expected book value and 5x enterprise value (EV) over earnings before Interest depreciation and amortization (EBITDA). So around 30%-40% discount to its beaten up Global Emerging Market equity peers. Russian equities also pay a healthy dividend which will yield you 4-5%.
But in a world where investors no longer buy red hot “BRICs” and would rather sell the “Fragile Five”, an investment opportunity (especially in emerging markets) needs to offer an aspect of protection. So we need to argue that Russia is not only attractively valued, but that it is also defensive.
Which brings us to the focus surrounding the “Fragile Five” (as a side note, lumping South Africa, Turkey, Brazil, India and Indonesia together makes as much sense as lumping Brazil, Russia, India and China together: none at all). Now, fragility is defined as “a quality of being easily broken or damaged”. The genius who came up with it was looking to highlight serious vulnerabilities these economies have to foreign capital flight. The opposite of fragility, according to Nisim Taleb, is “anti-fragility”. For example, if an economy is one that can not only survive a high impact shock but also grow stronger from the experience, then that economy is not only robust but also anti-fragile.
Russia is certainly robust but it is far from being anti-fragile. In order to become anti-fragile it needs to reform, restructure and decentralise. We’re not there. Nevertheless, the sovereign has learned a great deal from its previous experiences, namely the 1998-99 crash, and has recently embarked on a mini perestroika of its financial sector. The reforms are quite dramatic and include an ongoing purge of bad players in the banking sector, curbing of capital flight, on-shoring, a path towards a free floating ruble, equity market reforms and euroclearability of bonds to name just a few items. This sort of bottom up reform is much more powerful than the top down reform by decree we were accustomed to.
Russia’s President Vladimir Putin came to power in 1999, amidst the chaos that can only grip a country with a defunct currency. For all his faults, and there are quite a few of those, President Putin is not a reckless financial individual.
Consider this: Russia’s external liabilities are around $730bn. This is mostly corporate debt. The government’s liabilities are minuscule at $65billion. These are small numbers relative to the $2 trillion Russian economy. Oh wait. Russia also holds foreign currency reserves, and a lot of them. $510bn of international reserves, to be precise. According to number crunching by Schroders, these reserves cover almost 70 years of Russia’s gross external financing requirements (current account deficit and short-term external liabilities). For India and Turkey, part of the “Fragile Five”, the number is closer to one year. Brazil, for all the hype, has around 2 years of reserves to fall back on.
But that’s only part of the story. Russia holds another important source of reserves. The natural kind. Russia holds the biggest pile of minerals and hydrocarbons reserves in the world. Potash, Nickel, Phosphates, Diamonds, Gold Copper, Zinc, Iron ore, Bauxites, Titanium, Uranium, Silver, Platinum. You name it, Russia has it. Take hydrocarbons as an example. Russia holds 87.2bn bbl of oil and 33tcm of gas reserves, or 287bn barrel of oil equivalent (boe) of hydrocarbon reserves. Under a conservative assumption, these reserves alone are worth another $2.5 trillion.
True, Russia’s internal and foreign politics will continue to draw fire. But Russia remains a rarity. The equity market is dirt cheap, the economy is growing, the financial sector is going through major reforms and the macro picture is surprisingly defensive. A rarity.
Joseph Dayan is executive director and head of markets at BCS Financial Group
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