Investing in Russia and Brazil: Contrarian or just contrary?

Russia: Safe to come out now?

Russia was not a fun place to have invested in 2014. "What happened in Russia last year was arguably the perfect storm," says Darius McDermott, managing director of Chelsea Financial Planning. "You had geopolitical conflict with Ukraine leading to severe sanctions from the west, leading to stock market and currency weaknesses and then the oil price halved in very short order."

MSCI Russia fell by 42 per cent during the year, following a 1 per cent drop the year before, on the back of a dramatic drop in the oil price. But already this year MSCI Russia has gained 42 per cent compared with a return of 13 per cent from the wider MSCI Emerging Markets index.

Add to that the climbing rouble, which rose rapidly against the euro and the dollar in the first quarter of 2015, and valuations of 5.4 times forward price/earnings (PE) - down from a 10-year average of 7.2 times - and the market looks interesting.

Paul Taylor, managing director at chartered financial planner McCarthy Taylor, says: "News from Russia has become more positive, with economic sanctions appearing to have no further ongoing discernible effect." According to him, the market fundamentals are appealing: "Corporate sales figures are up, the Central Bank's currency reserves have increased." Manufacturing figures have also been better than expected, with April's price market index (PMI) figure moving from 48.1 to 48.9 in March. However, total new orders continued to fall.

Meanwhile, Jan Dehn, head of research at Ashmore says: "The Russian Central Bank deserves an A+ for its handling of the Russian economy over the past year."

Proceed with caution

Others urge caution on the Russian market. "I like Russia, I always have," says Ben Yearsley, head of investment research at Charles Stanley Direct. "I think in the long term you will make money, but you are looking at a 10-year horizon as a lot of reform is needed. You either need profits to come through or you need structural reform or both."

"The long-term outlook for Russia is cloudy," says Gary Greenberg, head of emerging markets at Hermes. "Unlike China and India, Russia is not modernising through structural economic change. Its market may rally sporadically on positive headlines - a higher oil price, a trade deal with a neighbour - but its real economic promise is unlikely to be realised without root and branch political reform."

Brazil

The markets in Brazil have not rebounded to the same extent as Russia, but reasons to be positive include a lift in the price of oil, raising the price of shares in Brazilian oil giant Petrobras and political reform. President Dilma Rousseff has also taken a tougher stance on tackling the deficit in recent months, including a new corporate tax and spending cuts. These could spell short-term pain for long-term gain.

That short-term pain is a major part of Brazil's appeal. Tim Cockerill, investment director at Rowan Dartington, says: "There comes a point where you think valuations are so appealing and that the economy is going to recover in the long term."

James Butterfill, global equity strategist at Coutts, says: "When a country's at its worst point it's a good time to invest because everyone's bearish," but he adds: "We don't think it's there yet."

Brazil does not look overly cheap relative to its history, with a forward PE ratio of 12.2 times compared with a 10-year average of 10.1, according to JPMorgan's April 'Guide to Markets'. But it is yielding 4.3 per cent relative to a 10-year average of 3.4 per cent and further devaluation in the real could spell another boost for equities.

Consider currency risk

A main issue when investing in Russia and Brazil is the uncertainty of currency movements. The rouble has appreciated in the past three months while the real has devalued - good news for domestic exporters, but bad news for UK investors. Charles Tan, analyst at Cantor Fitzgerald, says that the Brazilian real is now "among the most undervalued in the emerging market universe", but "was among the most overvalued currencies only a few years ago". Meanwhile, the rouble's rollercoaster ride will be good news for investors while heading upward, but will hurt if the currency slides again.

Mr Butterfill says: "The biggest challenge with Russia is hedging the rouble and it turns out to be prohibitively expensive to do so. That increases the volatility of the investment view."

But Mr Yearsley says: "In Brazil the currency hasn't really rebounded so you are buying a fair value market with potential kickers to come if the currency rebounds and, in the meantime, you are being paid a good yield to hold it."

BEST RUSSIA FUNDS

There are few options for those seeking direct access to Russian equities. Two possible funds are Neptune Russia and Greater Russia C Acc (GB00B86WB793) and JPMorgan Russian Securities (JRS), the only actively managed Russian closed-end fund available in the UK listed market.

Mr Tan thinks JRS is a well-structured way for investors to access the region, with the potential to add value.

In the year to date the fund has returned 38 per cent, a stark change from 2014 when returns fell by 46 per cent. The managers are underweight Gazprom and Sberbank of Russia compared with the index due to their focus on bottom-up stockpicking and tendency to avoid state-owned firms. Mr Tan says: "The fund leans towards companies with earnings supported by consumer demand, trading on attractive valuations and yielding 5 per cent or more." The fund is trading at a discount of 15 per cent.

Mr Yearsley likes Neptune Russia, also tipped by Mr McDermott. He says: "It does tend to deviate massively from the benchmark and is more consumer-orientated. It's not a market fund and will take different positions, which will or won't work in different time periods."

According to Lena Tsymbaluk, analyst at Morningstar, Neptune "remains a solid choice within its category, even if its risks were on show in 2014". Fund manager Robin Geffen, who boasts almost 15 years experience in Russian equities, prefers domestically orientated sectors rather than energy and the fund's unconstrained approach results in volatile performance. It has a higher weighting to state-owned companies Gazprom (4.5 per cent of portfolio) and Sberbank of Russia than JRS.

Eastern European funds are also a good route into Russia. Mr Cockerill likes Baring Emerging Europe (BEE), trading on a 13 per cent discount and yielding 3.25 per cent. The trust's share price has risen since the start of the year and has returned 23.02 per cent in the year to date due to its 58.2 per cent exposure to Russia. However, that has not made back the loss of 2014, when it fell by 32.81 per cent.

BEST BRAZIL FUNDS

Mr Tan likes JPMorgan Brazil Investment Trust (JPB), the only retail investment trust with focused exposure to quoted Brazilian stocks.

However, the fund has underperformed its index, the MSCI Brazil 10/10 index, and has posted negative returns for successive years. Mr Cockerill also says he steers clear of JPB because of its size, at just £27.5m. He says: "It’s an interesting window into Brazil and the domestic market, but it's not one that I would look at right now." He says: "If we're wrong about the Brazilian market, it could be pretty unpleasant and will be all the more unpleasant in a very small trust."

The majority of commentators prefer exposure to Brazil through a Latin American fund. Mr Yearsley says: "I would use a Latin American fund rather than a Brazil one as you will always get a large weighting to Brazil anyway" - the country makes up half of the MSCI Latin America.

He likes Aberdeen Latin American Income Trust (ALAI), which has a 56 per cent weighting to Brazil and says: "I topped this up recently". Mr McDermott also mentions ALAI "although it's had a bad time recently." The fund is trading at a wide discount of 9.97 compared with its 12-month average discount of 9.41 per cent, but has been delivering negative returns for the past three years. In the year to date it returned a fall of 2.75 per cent and in 2014 experienced a greater drop than JRS, at 9.31 per cent.

Mr Cockerill says BlackRock Latin America (BRLA) is another option. Brazil has a 48.6 per cent weighting and exposure to Mexico is at 39 per cent. The trust has returned 1.10 per cent in the year to date and only fell by 3.99 per cent in 2014. It is currently trading at a discount of 11.88 per cent and yields an appealing 4.98 per cent.

Returns from the MSCI Russia (% total share price return)

Price/earnings valuations for Emerging Market equities

Total share price returns (%) for mentioned funds

Source: FE Trustnet, as at 7 May 2015

Biggest losses and gains from mentioned funds

Source: FE Trustnet, as at 7 May 2015