Play the rally with Russia

After enjoying a strong first quarter, emerging market shares have suffered in recent months as the prevailing mood among investors shifted from 'risk on' to 'risk off'. The Russian equity market has been particularly badly hit - after rising more than 25 per cent over the first two months of the year, it now stands at around -3 per cent. Russia's political environment is not well perceived by international investors and, as political protests continue following Vladimir Putin's election as president, investor fear is mounting.

"Nobody expects anything good to happen under Putin, but the scope for positive surprises is significant. For instance, the equity risk premium has risen by an extraordinary 20 per cent," says Plamen Monovski, chief investment officer at Renaissance Asset Managers.

The current valuation of the market at 0.6 times price to book value is cheap relative to history and the cheapest of the global bourses. This discount and Russia's incredibly low share valuations clearly reflect the country risk attached to Russia and the country's persistent reputation as a hostile investment location. Yet Russia's macro picture remains very robust thanks to rising consumption, strong fiscal management and a flexible currency. At 6 per cent of gross domestic product (GDP), Russia has one of the highest current account surpluses in the world - on a par with some of the most dynamic Asian economies.

Elena Shaftan, manager of the Jupiter Emerging European Opportunities Fund, believes the Russian market is misunderstood and suffers unduly from the negative perception of the political environment. "The economic fundamentals (in Russia) are strong and companies are performing well operationally."

David Reid, analyst at the Eastern European Trust, agrees, saying that poor global risk appetite, rather than the current state of the Russian economy, is the main driver behind the cheap share valuations. "Russia's GDP is growing at almost 5 per cent. The country has record low inflation and unemployment levels, achievements for which it has achieved little credit. It is currently running a budget surplus, has almost negligible levels of sovereign debt and over half a trillion dollars of foreign exchange reserves, a position that would be enviable to almost all developed economies at the present time."

Inflation in the country is at an unprecedented low level of 3.7 per cent and likely to stay below 4.5 per cent to the year-end. This is the lowest inflation in Russia in two decades and has given way to a real uplift in wages. Coupled with one of the lowest unemployment rates in the world, this has sustained the country's domestic consumption story.

Mr Monovski adds that the Russian economy is continuing to defy sceptics as strong consumer spending rebalances GDP growth despite falling commodity prices in 2012. "High real wages, low inflation and a banking system in rude health are pushing company profits to high double digits."

While most of the western economies suffer under the burden of government debt, exemplary fiscal management in Russia has left the country with an enviable credit standing. "With some of the lowest government, private and corporate debt in the world, Russia is unlikely to suffer the effects of deleveraging and, like Switzerland, Russia runs a modest fiscal surplus," says Mr Monovski.

Russian companies themselves evidently see the value in their own shares. Mr Reid points out that a number of the largest companies have announced and started conducting unprecedented share buy-back operations over the past few months, with a total value in the tens of billions of dollars range.

Russian companies are historically criticised for not paying money out to minority shareholders, but this has changed radically over recent months. The state-owned enterprises have been encouraged by the government's pro-investment policy to raise their dividend payout ratios, and now a number of Russian blue-chip companies have sustainable dividend yields of 5-6 per cent or more. For the first time Russia has a dividend yield comparable with that of global emerging markets, meaning that investors are being paid to hold Russian shares in hard cash rather than relying largely on price appreciation to make gains.

Contrarians and critics

Compared with the other Bric nations (Brazil, India and China), many argue that Russia, unloved and under-owned, is the most compelling contrarian investment story. "While Russia is far cheaper, the country's return on equity is superior to that of the other Brics; it has the lowest structural rigidities; the deceleration in GDP is the lowest; and, it is the most disliked and least represented in portfolios," says Mr Monovski.

He says domestic sectors such as retail, infrastructure and financials look interesting while for the contrarian investor, gas and utilities are likely to present the most compelling opportunities.

But not everyone is convinced. Tim Cockerill, head of collectives research at Rowan-Dartington, says: "Of the Bric countries, Russia is the one most investors are wary of and with good reason. Although Russia is now very different compared with the communist era, threads of the political past remain. Russia's stance on Syria is an example and the ease with which companies can be influenced and controlled illustrate the continuing presence of the old ways. The re-election of Putin as president and the questions about the elections being free and fair all add to the feeling that as an investor you're very much an outsider. This uncertainty brought by the politics of the country add an element of risk to investing that most other countries are free from."

Robert Pemberton, investment director at HFM Columbus, says the Russian economic model is still hugely dependant on commodity prices, but capital flight and a lack of competitiveness means that Russia needs an oil price well in excess of $110 to have any attraction for investors. "More disturbingly, the re-election of Putin shows that Russia will continue on its insular and investor unfriendly course with no reform to its autocratic and corrupt systems."

Mark Harris of Eden Financial agrees that while there are very significant risks to Russia, of which arguably the dependence on commodities and the political situation are the greatest, these risks are well understood and more than priced in to valuations. On key metrics Russia is cheap, while GDP looks healthy. Like any emerging market, there are political risk factors, but the value opportunity is compelling in terms of both the potential for capital gains and income, the economic situation is healthy and corporate governance is improving and it would appear that the regulator of state industries is becoming more aggressive.

While the country is heavily influenced by global macro events - Europe being a major factor - making it a higher-risk investment, the returns are likely to be high, too. Should conditions improve, having exposure to Russia will be one of the higher-beta ways to play a market rally.

Beyond the short-term promise, Mr Reid says the most striking feature of the Russian market at the moment is the compelling value it presents to the long-term investor. He says: "Russia is in the bottom decile of its historical valuation range on an earnings multiple basis, and also trades at near-record lows relative to other emerging markets. Essentially, this means the market is presenting investors with a buying opportunity they have not enjoyed since the very trough of the financial crisis. Compare that with perceived 'safe haven' assets such as German bunds, which have never been more expensive. Buy low and sell high may be a tired investment cliché. But, as with current markets driven by fearful sentiment, it does bear repeating."