Beyond Gazprom Stock and The RSX ETF
The Investment Case for Russia Right Now, Part 2

Published on January 29, 2021

Following last week’s piece, I wanted to delve into some specific names in Russia to consider and possibly avoid.  The background risks and tailwinds discussed in the last post apply to all of these names and should be incorporated into any analysis.

My Favorite Russian Investments

My favorite ideas for the Russian market are:

• Sberbank (MICEX:  SBER, LSE GDR: SBER, OTC ADR:  SBRCY)
• PhosAgro (MICEX:  PHOR, LSE GDR: PHOR, OTC ADR: PHOJY)
• Transneft Preferreds:  (MICEX: TRNFP)
• Surgutneftegas Preferreds:  (MICEX: SNGSP, OTC ADR: SGTPY)

I treat these as a basket, particularly the inclusion of the last idea.

Sberbank

I do not give myself a lot of credit for throwing this idea out there.  Most active Global EM equity managers have a position in Sberbank for a good reason.  There are secular and cyclical reasons that make Sberbank particularly attractive at this junction.

The bottom line is that Sberbank is one of the few global banks able to generate consistently high teens to low twenties returns on equity.  Current conditions suggest that they maybe be able to increase this further over the coming years, at least temporarily. 

Secular Rationale

Sberbank is Russia’s largest bank, with a market share of 43% and 53%  across retail deposits and mortgage loans, respectively, according to its 2023 Strategy presentation.  It is also majority-owned by the state.  As such, the bank can set prices on loans and attract the lowest cost deposits.  The chart below from the company illustrates. While loan rates have come down, deposit rates have come down faster, and net interest margins remain elevated compared with developed market peers.

Furthermore, Russia is an economy still in the process of financialization.  Credit within Russia is limited (likely stunted from the sanctions), and Sberbank has and will likely continue to be the major beneficiary.  The company estimates in its 2023 Strategy presentation that loans will continue to grow at a high single-digit rate or even higher in the case of retail loans.

Finally, Sberbank has created an ancillary suite of tech companies and services they call the ecosystem.  I have considered many of the underlying businesses low-cost lottery tickets. Still, some of them, such as DomClick, the company’s real estate servicing platform, have a huge benefit for cross-selling and underwriting.

With DomClick facilitating the legal and title aspects of real estate closings, Sberbank can learn a great deal about real estate trends.  This can inform their loan underwriting and selling. Sberbank is the leader in the Russian mortgage market, and DomClick has helped to seal this position.

Other businesses include cloud services, online grocery shopping and corporate administrative services.  Sberbank intends to bundle and link many of these features with its financial products to increase demand.  Although these services will require additional investment, the market does not appear to be ascribing any value.  Sberbank trades with a single-digit P/E multiple and price-to-book value around 1.25x, hardly demanding for its metrics.  You get the tech business optionality for free. 

Now onto the current environment.

Current Tailwinds

Remember that Russian yield curve I talked about last week?  Well, this is a boon for Sberbank for a couple of reasons.  First, checking accounts usually do not pay interest, so the higher the yield curve’s absolute level, the greater the spread (the difference between deposit and lending rates) the bank is naturally able to earn.  This is doubly true when we talk about the steepness of the yield curve, i.e., the difference between short-term and long-term rates. 

Due to its mortgage and corporate books, 42% of Sberbank’s loan book at the end of 3Q20 had a maturity greater than 3 years.  This percentage is likely to grow as the bank focuses on mortgages. Thus, as the curve steeps, all else being equal, Sberbank can make more money.

There is optimism over global financials as the US yield curve has been widening, which has sparked the US and EU financials’ strong performance.  Well, Russia’s curve is still wider!  This, combined with pricing power, allows Sberbank to earn net interest margins much higher than global peers.

Risks

Aside from the macro risks already covered, I would highlight that some of the return may be lost to currency depreciation.  Most of Sberbank’s earnings are in roubles, and, in the current market regime, interest rate differentials do not seem to be the driver of FX.  Could FX moves dramatically worsen returns over a short period? Yes, but I do not think they singularly impair or cause a loss on their own. 

Technicals

Looking at the Sberbank London-listed GDR, prices broke out in November from the post-COVID price consolidation.  After trading in a range of $14 to $16 since they are testing the lower end of that range again currently in what I believe is a counter-trend move.  This could provide an opportunity to start a position or add to an existing one.

If the shares broke back below $13, that would be a cause to reevaluate the position.  

PhosAgro

Want agricultural exposure but don’t want to or cannot buy farmland? Do most developed market fertilizer names feel too expensive?  PhosAgro is for you!  This company provides exposure to the price of phosphate-based fertilizers at a discount to global peers.  It is fully integrated with phosphate production and in the lowest quartile on the cost curve.  All this comes at a high single-digit cash flow and dividend yield. 

Quick Industry Overview

Fertilizers are a global business, and there are three main types: phosphates, nitrogen and potassium.  The use of these is dependent on soil conditions and crops, but generally, some combination of the three is required for most commercial farming.

Nitrogen-based fertilizers are produced from natural gas.  Potassium fertilizers start as ore to be mined, as do phosphates.  While most countries have domestic production of some of these, few large agricultural producers are self-sufficient.  Thus, these markets are global.

Demand for these products is principally driven by crop prices.  As one can guess, the higher the crop price, the more a farmer will plant, the more fertilizer s/he will need. Supply is obviously a bit different.

Honing on phosphates as they are PhosAgro’s main product, Morocco is to phosphate ore what Saudia Arabia is to oil.  It has most of the world’s reserves and is a low-cost producer.  While PhosAgro is not nearly as large in its ore production, it has high quality and equally low-cost production.  Morocco does not process all of its ore but instead ships the rock to other countries for processing, while PhosAgro uses nearly all its ore for internal processing. 

The main phosphate-based fertilizer is DAP, diammonium phosphate. There are no futures contracts, so you have to use alternate sources to put together pricing.  Indexmundi provides monthly prices for FOB at the US Gulf Coast.  I suspect top-shelf data providers (Bloomberg and Reuters) also have various delivery points across the world. As you can see, DAP prices have been in a downtrend, along with agricultural commodities for some time.  The recent rebound in agricultural commodities has begun feeding into DAP prices, as seen below.  If you believe agricultural prices have room to run, DAP should be a beneficiary.

According to Phos Agro’s 2019 annual report, there is a lot of idle capacity on the supply side.  I speculate that much of this capacity is high cost and would require much higher prices to reactivate.  As such, DAP prices should be able to increase before increased supply hits the market.  Plus, PhosAgro is already quite profitable at current levels.

Why PhosAgro?

It is the Russia discount, and that sanctions on Russia have forced most Russian companies to maintain pristine balance sheets.  This, combined with the dark cloud over Russian companies, means you can find solid balance sheets at attractive absolute valuations.

In terms of publicly traded global fertilizer peers, here is a large sample below from January 28, 2021.

Most of these players are diversified across fertilizers, other agricultural services and even other chemicals.  PhosAgro is at the smaller end while also being at the lower end of the valuation spectrum.

Perhaps more importantly, the absolute valuation for PhosAgro is compelling.  The company trades at a high single-digit FCF yield based on LTM 3Q20 numbers and provides a high dividend.  If I am bullish on the sector but want a bit of security, this combination provides a margin of safety.  I can get my return from earnings and cash flow growth, and anything that happens on the multiples side is a welcome extra.

Beyond the discount and valuations, two other factors are also in PhosAgro’s favor: vertical integration and, intertwined with that, a focus on phosphates.  If you are a true commodity bull, then such distinctions are crucial.  By being low cost and integrated, PhosAgro can capture the full value chain in production rather than only a portion and be subject to margin pressures on both sides.  This same factor is why investing in industrial companies is so hard. PhosAgro ticks that box.

Secondly, I think there may be value in focusing on a single silo of fertilizers.  There has been a lot of consolidation in the space, and most of the larger players run across multiple lines or are hidden in other companies: Monsanto within Bayer, BASF and K+S.  You end up buying a bit of everything.  I also want to avoid any pure-play or majority nitrogen players because I am concerned about natural gas prices moving more swiftly than agricultural prices, which could hamper things.

Finally,  PhosAgro exports over 50% of its product (according to 3Q20 financials), and global fertilizers are priced in USD.  This means that the company has a natural long dollar position and benefits from devaluations in the rouble in terms of cash flow.  This is particularly useful in a portfolio of Russian assets where some only earn in roubles.

Risks

The main risk I see for PhosAgro is that the recent move in soft commodities is merely a counter-trend rally in a bear market (see commodity risk in the last post).  Looking at the DAP prices at InvestorMundi earlier, we’ve had a countertrend rally, but not to a level that would suggest a change in the primary direction yet.  With wheat, soy and corn breaking out to 52-week highs, however, there’s a good chance DAP price may be headed higher.

Wheat

Soybeans

Corn

A secondary risk is the size of the float, only 30.55%.  This means investors are at the whim of the major shareholders.  The company does have its GDRs listed on the LSE, which does impose certain governance requirements. I would also add that several independent directors’ high profile, including the chairman, provides additional comfort.  Should such directors resign or be rotated out, it would be a natural point to review the company’s direction.  

Technicals

PhosAgro’s LSE-listed GDR, like Sberbank, appears to be in a primary uptrend as it has broken out of the post-COVID range of $11-14.   Unlike Sberbank, it remains within striking distance of 52-week highs.  I would wait for a pullback of 3+% to add, but you should follow your own rules on how you look to scale in.  $14 is the level of support I see for the current move. 

Transneft Preferreds

Transneft is the state-controlled operator of crude oil and product pipelines within Russia and the majority owner of the NCSP, which operates a predominantly oil-focused port terminal on Russia’s eastern coast.  By the nature of its business, Transneft is a play on the return of oil production, not price necessarily, within Russia.  This, I believe, is a more conservative approach and is buttressed by its strong balance sheet and low absolute valuations.

Transneft has an 83% market share in crude oil transport in Russia and 28.8% for products, according to the company’s 2019 annual report.  It makes its money by charging companies for the right to transport oil through its system.  Because of its market share, its prices are set by the state.  According to the company’s 3Q20 presentation, the regulator has advised that prices will be kept constant in real terms for the near term.

As such, the company will only make more money in a couple of ways: reduce costs or transport more oil.  They have been working diligently on the former, and I would argue that the latter is an implicit supposition of an economic recovery globally.  Russia exports the overwhelming majority of its oil.  So, for production to grow, it will be due to global, not domestic forces.

So with a utility-like payout, you’d expect valuations commensurate with a utility or investment-grade bond. No, Transneft is both relatively and absolutely cheap.  The company trades at 7x on an FCF basis and is only modestly levered, especially when compared to pipeline peers in, say, the US.  If it were only to close a modest portion of the valuation discount, that would imply strong capital appreciation in addition to the high single digits dividend yield.

One last point here.  Preferred shares in Russia mean something different.  Preferreds in Russia do not provide a liquidation preference.  Like all preferreds, you receive no voting rights. In exchange in Russia, a company guarantees preferred shares a certain payout of statutory profits, which must be paid for the ordinary shares to receive dividends.  In the Transneft Preferreds case, the only guarantee is that the dividend must be equal to or greater than the ordinary shares.  The government cannot take out more via dividends than private shareholders. 

Risks

Aside from the macro risks already covered, there are two.  The company was subject to theft and tampering that led to several customers receiving contaminated products in 2020.  The company is nearly done settling this issue and has set aside the remaining balances.  While this incident likely has reduced the near term risk of such things repeating, it is always the issue of a pipeline company operating over great expanses of wilderness.  This is a headline risk.

The other is long-term.  Over decades, I suspect more of their flow will be diverted to Asia, which is the source of marginal demand globally.  They have already begun to address this via lines that connect directly to China and the NCSP acquisition.  However, I believe that further expansion in that direction may be required, and this will be a drag on cash flows. Again, I think this is a long term problem but may show up in the medium term. 

Technicals

The Transneft Preferreds remain in the same consolidation pattern seen since COVID started, unlike the other names we’ve mentioned so far.  I am trying to patiently wait to add on a break above RUB 150,000 or around RUB 140,000, in the middle of the current range. 

Surgutneftegas Preferreds

Surgutneftegas is one of the top 5 oil producers in Russia and also operates a few local refineries.  It is not a transparent company in terms of ownership and does not disclose much beyond the statutory requirements.  I want to own these shares, however, for a more subtle reason.

Surgutneftegas is a liquid company, and I mean super liquid.  It has effectively no operating debt and a massive USD cash balance.  This cash balance is so large that it has a material impact on P&L.  How so, you ask?  Well, as the USD/RUB exchange rate varies, the value of the cash in roubles also varies.  The difference in value is then booked as profit or loss in the income statement.  This is a non-cash event, but it’s important for the Surgutneftegas Preferreds.  The table below illustrates the scale of such amounts under the company’s IFRS accounts.

FX differences are a material figure and usually act as a dampener.  In 2015 when the rouble collapsed, FX gains accounted for 77% of net income.  On the other hand, when oil and the rouble rallied, FX wiped away more than the net income from the company’s production of oil.

The Surguteneftegas preferreds are entitled to 10% of the company’s income (based on Russian standards) as a payout while they constitute 25% of the capital stock.  Since FX moves are such a material driver of P&L, Surgutneftegas Preferreds almost function more like a cheap rouble hedge than they do an oil company.    The shares pay out more in years after a large devaluation (like 2020) and substantially less (but still healthy) dividends in leaner years where the rouble (and typically oil) price rallies.  It is important to note that they have even paid a small sum in years of negative income, including 2017 (based on 2016 net income).

If we’re constructing a basket of Russian stocks, having these shares in the mix help to neutralize some of the USD/RUB impacts.

Risks

There are two major intertwined risks here.  The first is management spending all of the cash.  The best indicator here is that they have not spent the cash during all of these years despite being allowed to do so.   A trigger here may be a material change in management or other items.

The second is transparency.  It is not clear who owns the company.  Other media and investors have done some work suggesting that management owns a material portion of both the ordinary and, more importantly, the preferred stock.  This should mean under the current system that incentives are aligned for management and minorities.  This is a supposition, however, so this should be borne in mind.

Technicals

Longer-term readers will note that I harp on risk management.  Most of the time, it works such that it makes sense to do it all the time.  Once in a while, though, it gets you out of a trade you should have stayed in.  Surgutneftegas Preferreds were such a trade for me in 2020.  I got knocked out of the OTC ADR (SGTPY) near the end of October 2020 lows, and I have been trying to find a good point to get back in. The shares look to be retracing, and I will be trying to get back in around $5.25.  Support appears to be around the $5 level.

What I Am Not Investing In

There are a couple of areas of the Russian market I am, for various reasons, not focused on.  Other investors may be keener on these names.  These fall into some of the other state-owned companies or Russian tech.

Gazprom Stock

Gazprom is one of the big gorillas of the Russian economy and is one of the world’s largest suppliers of natural gas.  I am personally avoiding Gazprom for two main reasons.

• I don’t have a strong view on natural gas prices.  I think they are going up but am always confounded by natural gas’ volatility every year.  I have more conviction in oil prices, oil production going up in Russia and agricultural commodities.  
• The state’s need for cash is a double-edged sword for minority shareholders.  With the Russian state filling a large portion of its budget via dividends from companies Gazprom, minority shareholders should benefit from dividends.  It does, however, mean that capital allocation is being subverted to state needs.  This is not in and of itself bad, but it does mean you can run the risk of under-investment in a business that really requires continuous development. 

Yandex Stock

Yandex appears to be a popular name for many Russia-focused investors and has been described as the “Google” of Russia, given its dominance of the local internet search market.  It has experienced high growth and trades at a high premium versus other Russian stocks AND many internet peers like Baidu, Alphabet, etc. 

I am not a tech analyst, but I am skeptical that this company can truly grow outside of the Russian market, which should be the only real justification for trading at this type of valuation.  Per the company’s 2019 20-F, Yandex derives less than 10% of its revenue from outside of Russia.  I suspect that number will be difficult to increase, and maybe it will add or develop profitable silos beyond search, but that is not proven.  For this main reason, I am staying away from one of the only Russian companies listed in the US and, therefore, the easiest one to buy.

Having also gone through Sberbank’s 2023 Strategy Presentation, Sberbank might be more a sticky tech ecosystem at a much more attractive multiple. I would go as far as to say investors appear to be valuing Sberbank’s platform at close to zero. 

Caveat

Much like I suggested in my prior post, I am not saying that these shares won’t make you more money over whatever your investment timeframe is.  I am merely saying that I am not comfortable with them at the moment for single stock holdings.  Both will be beneficiaries of indiscriminate inflows into Russia when they arise, possibly making them outperform.  Still, I try not to base my ideas solely on inflows.

Gazprom is already outperforming since the beginning of November based on the rally in natural gas prices.

Conclusion

Like the Greek stocks in my prior post,  Russian stocks are not straight forward to purchase.  None of the names I am focused on can be purchased on a US exchange, but nearly all can be purchased in the US OTC market or on the London Stock Exchange.  The only exception to this is the Transneft Preferreds, which can only be purchased on the MICEX.  Interactive Brokers is the only discount brokerage I know that allows clients to trade shares on the MICEX.

In what is becoming a well-worn phrase in Emerging Markets, money is made by identifying situations where actual risk is much lower than the risk perceived by the market.  Many companies in Russia fit this definition, proving compelling absolute valuations in sectors with favorable tailwinds.  In many cases, deeply discounted relative valuations also suggest investor views towards Russia need only turn modestly more favorable for investors to make additional returns on multiple expansion.

As always, I hope you’ve found this article useful. Finally, kindly note the disclaimers at the bottom of the page.

To your investing adventure,

The Castaway Capitalist

For questions, comments, and feedback, please email contact@castawaycapitalist.com.

IMPORTANT DISCLOSURE: As of the date of publication, the Castaway Capitalist owns the following Russian stocks: SBER, PHOR, SGTPY and TRNFP

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