Until the recent war with Georgia, the West's fixation with Russia was being fuelled by the country's attractive investment prospects. While some ethical investors may choose not to support the political regime with their money, the interest is bound to hold. But, as we have recently been reminded, this is not a country for the fainthearted. You are dealing not only with economics but politics, too. It remains an unpredictable and risky place to put your money, albeit one with huge potential.
When the late US President John F Kennedy was asked by Life Magazine to list his 10 favourite books, Ian Fleming's 1957 James Bond novel, From Russia with Love, was the only work of fiction included. Today, Russia no longer fuels the imagination of spy thriller writers or space race enthusiasts, but is popping up on investor radars due to the country's attractive investment prospects.
As the western economies stumble under empires of debt, Russia is largely unaffected by the credit squeeze. That's because it is virtually free of consumer debt and, as the world scrambles for natural resources, it also boasts a wealth of oil and gas reserves.
Meera Patel, senior analyst at Hargreaves Lansdown says: "Russia has built up a stabilisation fund of $160bn (£84bn) through the revenues it receives from its oil and gas, making the economy far more stable than the UK is at present."
Oil and gas accounts for nearly 20 per cent of Russia's economic output and 60 per cent of its exports, which explains recent concerns over Russian stocks being affected by drops in the oil price. However, Elena Shaftan, head of Jupiter's Emerging European Equity desk and manager of the Jupiter Emerging European Opportunities fund believes that the investment case for Russia remains intact.
"The country has the third-largest foreign reserves in the world and a stabilisation fund worth more than 10 per cent of GDP, which could cushion the economy if the oil price falls," she says. "Even if oil prices drop to $70 or $80 a barrel, the economy can still grow at 7 per cent a year. While the decline in oil prices is a significant issue for investor sentiment, the real impact on Russia’s economic fundamentals is likely to be less marked."
Consumer growth
Ms Shaftan adds that Russia is far from just an oil play and bases her 7 per cent growth prediction predominantly on the country's very strong consumer demand, which shows no sign of abating. She says: "The Russian middle class population was virtually non-existent 10 years ago, but now accounts for 20 per cent of the population. This rise has been supported by wage growth - average incomes have increased from $55 a month to $500 a month today - which should continue to support consumer spending."
One of the most exciting Russian stories is the growth of the domestic consumer, driven by a new-found confidence within the country. Robin Geffen, manager of the Neptune Russia and Greater Russia fund says: "Consumption patterns are tiered, with the aspirational middle-class in urban centres buying luxury products, while spending is also growing at the bottom end, as lower-income consumers are joining the middle-class for the first time and are now able to afford more basic household goods, especially in the regions surrounding the major cities. Furthermore, a major trend is the shift from open markets to more organised retail and high hygiene standards for food production and retail."
Growing domestic demand is also being supported by greater government spending on infrastructure - a trillion dollars is committed to beefing up the country's infrastructural capacity over the next 20 years. Ghadir Abu Leil-Cooper, manager of the Baring Russia fund, says: "The infrastructure built under the Soviet Union needs major upgrading in order to unlock the economy and, given the strong balance sheets of the economy, the Russian government can afford to do this."
So how does Russia compare with its emerging markets compatriots under the Bric (Brazil, Russia, India, China) veil? According to Ms Shaftan, in comparison with Indian and China, the Russian market is cheap on valuation grounds. "Russian companies remain highly profitable," she says. "Return on equity averages 20 per cent in Russia compared with just 8 per cent in the US. Earnings remain positive and valuations are very attractive. Overall, the market is trading on a PE ratio of 7.7 times 2008 earnings and 7.4 times 2009 earnings. A company such as Lukoil, for example, trades on a PE of around 5.5 times 2008 earnings."
Mr Geffen adds to this saying: "Trading between 10 and 11 times current earnings, [Russia's] RTS index remains one of the most attractively priced emerging markets. The index lagged its Bric counterparts through 2007, which meant it entered the financial turbulence of the credit crunch at less inflated multiples than emerging market peers. As a result, the Russian index has outperformed both the Hang Seng in Hong Kong and India's Sensex in the year to date and is well set for the remainder of 2008."
However, not everyone is so keen. Devan Kaloo, head of global emerging market equities, at Aberdeen Asset Management, says: "Russia has been in the news because of the events in Georgia, but recent headlines haven't really affected our view of investing in the country."
"We have been significantly underweight in Russia for some years, largely due to concerns regarding corporate governance, financial disclosure, treatment of minorities and the growing role of the state in the private sector. Although some Russian companies may appear cheap on the surface, the operating environment is unpredictable and the risks can be significant."
"We have found better opportunities to invest clients' money elsewhere in the world, including India, Brazil and Mexico, where we find high-quality companies operating in a lower-risk environment with a more predictable growth outlook."
Threats
While the tide is certainly turning for the country, whose economy once stagnated under the heavy hand of communism, there are still some very real threats, the most imminent being political. While many have welcomed Dmitry Medvedev's appointment as president, the country’s former president, Vladimir Putin, still very much holds the political strings, as was recently demonstrated when Mr Putin, in his capacity as prime minister, managed to wipe out half of New York-listed steelmaker Mechels' share value by uttering a few controversial sentences about majority owner Igor Zyuzin.
BP's recent problems with its BP-TNK joint venture also served as a sobering reminder that there will always be a degree of concern about corporate governance and business practices in Russia.
Despite this, Mr Putin is credited for implementing numerous changes that have made both foreign and domestic investors more open to do business in Russia. Ms Shaftan says: "While his methods may be clumsy, Putin's main objective is to make Russia richer and stronger. Putin's government is not driven by considerations of personal gain nor is it about to revert to the Communist era. Although his objective of strengthening the country may cause some volatility in the short term, it is supportive of the long-term case for investing in Russia."
Political dangers aside, the other lingering threat to the rebirth of Russia is that of escalating inflation. According to Mr Geffen, inflation is being driven by surging domestic demand and capital inflows which Russia's monetary framework is poorly equipped to deal with. However, Angelika Millendorfer, head of the emerging markets equities team at Raiffeisen Capital Management, believes that the Russian Central bank has reacted to the problem of inflation with interest rate hikes and by allowing a slight appreciation of the Russian Rouble. She says: "We believe that Russian policymakers are well aware of the macroeconomic threats arising from such high inflation rates and will take measures to curb further price increases, including monetary and fiscal tightening and accepting a faster appreciation of the Rouble."
BEST RUSSIAN FUNDS
While the number of UK domiciled funds investing in Russia is limited, investment advisers say the Neptune Russia and Greater Russia funds offer good exposure to Russia, with decent performance figures.
Martin Bamford, joint managing director at Surrey-based independent financial adviser (IFA), Informed Choice says: "Neptune has delivered excellent performance since launch at the end of 2004. While it is looking less attractive in terms of performance relative to the sector average for the year to date, over the longer term this is a fund in which we have a high degree of confidence."
Gary Potter, co-head of Thames River Capital's multi-manager calls it is a "straightforward fund" and adds that fund manager Robin Geffen understands the Russian market. The fund outperformed Western markets last year.
Another popular fund is the Jupiter Emerging European Opportunities fund, which offers some exposure to Russia but also diversification by investing in the wider region's investment opportunities. Elena Shaftan, who manages the fund, has made a number of changes to its portfolio in recognition of the recent volatility in Russian equities. "We have recently reduced our Russia weighting from 70 per cent to 56 per cent by cutting our exposure to oils and steel."
Tony Yousefian, chief investment officer at OPM Fund Management favours JP Morgan Russian Securities. "We hope to benefit from active management, the use of gearing and the fact we purchased the holding at a 10 per cent discount to its net asset value," he says.
Exchange-traded funds (ETFs) provide low-cost access to the Russian market. Lyxor and Deutsche Bank both offer Russia ETF products with annual management charges of 0.65 per cent. However, Mr Yousefian warns: "It is important to look at the underlying constituents. These two trackers hold 15 per cent-plus weightings to the two largest stocks in the market, Gazprom and Lukoil. Depending on your investment outlook, you may feel that an active manager may be able to add more value."
Mr Potter agrees that investors need to be aware that oil and gas stocks are a significant part of the Russian index. He says: "If you buy the Russian index, you are buying a predominant exposure to oil and gas and there is a lot more to the Russian market than just commodities. There is a huge developing market below the oil and gas stocks. Buying an ETF is not giving you exposure to Russia's growth story and I won't advocate buying an ETF in Russia if you want exposure to wider investment areas. Look towards banks, consumer stocks and food companies - that's where the action is."
