Financial Times: Momentum of Russian rally will overcome most obstacles

Published: January 4 2007 02:00 | Last updated: January 4 2007 02:00

Russia’s international reputation has suffered a series of blows over the past year.

Controversy over the poisoning of a former intelligence officer in London, several high-profile assassinations in Russia, a raft of energy disputes with neighbours and moves by the Kremlin to take control of domestic energy resources have rattled the international community. None of this has seemed to bother investors in Russian shares, though.

The RTS index of Russian stocks rose 70 per cent in 2006 to a record high – while the value of the Russian equity universe breached $1,000bn for the first time. In the past five years, the MSCI Russia index has risen nearly 500 per cent in dollar terms.

Russia has benefited from surging oil prices, increased risk appetite and interest in emerging markets, the transformation of the country’s finances and economy, and a recovery of sentiment following the Yukos affair, which led to the imprisonment of Mikhail Khodorkovsky, oneof the country’s oligarchs.

Jonathan Garner, head of global emerging market strategy at Morgan Stanley, says the biggest driver has been Russia’s negative real interest rates. “This has forced domestic investors – particularly high net worth individuals – to seek real stores of value, such as property and equities,” he says. Foreign investors have also had an impact but they are marginally underweight the Russian market, Mr Garner believes.

Investors in Russia may face more testing conditions in 2007, particularly with the onset of parliamentary and presidential elections in late 2007 and March 2008, respectively. The key uncertainty is that it is far from clear who will take over from President Vladimir Putin in the presidential election.

Christopher Weafer, chief strategist at Alfa Bank, believes that one of the greatest single risks is a government failure to come up with a meaningful plan to diversify the economy away from the oil sector.

This is important in a market that remains dominated by natural resources and it makes the equity market prone to volatility in commodities prices. Some 40 per cent of the Russian stock market is made up of just two companies: state-backed Gazprom and Rosneft.

“If the economy should become even more vulnerable to movements in the oil price, a higher risk premium will be required for Russian equity,” says Mr Weafer. “General concerns about the country, both politically and economically, if added to or if they becomeeven more controversial could start to have a negativeeffect on fund flows into international Russia funds.”

State-controlled companies are likely to play increasingly significant roles in strategic sectors. But that is almost certainly going to benefit the shareholders of those companies, even if it is bad for international companies such as Royal Dutch Shell, which has ceded control of its Sakhalin-2 oil and gas project in Russia to Gazprom.

Another issue for investors in 2007 is the appreciation of the rouble, which rose by 9.2 per cent against the dollar last year.

The strengthening Russian currency means domestic industries are facing increasing foreign competition, according to analysts at Citigroup.

Moreover, the Russian stock market will be increasingly competing for investors’ attention – and cash – against the primary market. The pipeline of initial public offerings and other share sales by Russian companies in 2007 is heavy. Some estimates put the total value of the 2007 pipeline at about $30bn.

UES, the electricity monopoly, is contemplating about $10bn of equity-raising deals.

Sberbank, the country’s largest savings institution, could launch a secondary issue in London.

Will investors sell their existing stock holdings to buy shares in these companies?

In spite of such concerns, analysts believe the Russian market could rally further. Mr Garner says Russian equities are still trading at a trailing price/earnings ratio of only 13.5 times, which is at a 10 per cent discount to the emerging market average. Moreover, there continue to be more analyst earnings upgrades than down- grades in sectors such as banking, telecommunications and retail.

He says one negative for the market is that, although return on equity is at par with other emerging markets, the dividend yield is only half the 2.3 per cent EM average.

Others, however, are more cautious, believing Russia is at risk of a sell-off once investors become more risk averse.

“Anyone fortunate enough to have been invested there over the past five years should bank the fantastic profits,” says Jim Wood-Smith, head of research at Williams de Broë.

Copyright The Financial Times Limited 2007

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