Beyond Gazprom Stock and The RSX ETF:
The Investment Case for Russia Right Now, Part 1

Published on January 22, 2021

One cannot write long about international and Emerging Markets investing without covering Russia.  Russia is a member of the BRICS ensemble and, back in the ‘90s, was the first home-run emerging markets trade of the modern era.  Many EM veterans cut their teeth in the ‘98 Russia default and its privatizations earlier in that decade on the equity side. Perhaps ironically, the Russian market’s lack of excitement today makes many of its companies a compelling opportunity now. 

When you ask people about Russia, top of mind are the Mueller report and the Crimea annexation.  On the investing side, Russia is not a priority either.  A Bloomberg article from earlier this week summed it up best: Investments Into Russia Slump to Lowest Level Since 1994: Chart – Bloomberg.   Russia is unloved. 

While not a prerequisite, a lack of investment and enthusiasm improves the odds to find good returns. Russia is such a case today.

Some investors buy Russian shares like Gazprom stock, for the wrong reasons, and the Russian market contains many risks.  Those issues aside, its low absolute valuations, the strong balance sheets of many of its companies and an opportunity to invest in sectors at low comps to international peers make Russia attractive.

I will take a wide-angle view in this post and cover single-name ideas in a post next week. 

In this post, we will cover:

• Mental traps of investing in Russia
• General risks
• Where is Russia in the cycle?
• My issue with Gazprom stock and the RSX ETF

Mental Traps of Investing in Russia

I believe most investors get tripped up in Russia because their expectations are too high.   Investors focus too much on relative valuations and ignore the limitations of Russia’s geopolitical situation and demographics.

The relative value trap usually takes one of two forms in Russia.  The classic example is: “Look how cheap Gazprom stock is compared with Petrobras, Equinor or Exxon”.  The other case relates to government finances and also skews towards the positive.  Russia’s government debt to GDP is one of the lowest of any economy of relevance in the world, under 20%, according to Trading Economics. 

The Russian government runs a pretty tight fiscal ship and is rewarded in the bond market for it.  However, that does not mean Russia cannot be volatile.  One need only look at the last decade to see that.

Furthermore, I would press that 1) Russian companies should never trade at western multiples, all else being equal, and 2) Russia runs a tight ship for a reason.  Russia and its company face geopolitical constraints, which force the Russian government and many of its companies to be more robust.  We’ll cover these in the general risks section, but these limit the capital inflows required to close gaps in relative pricing investors are so attracted to. 

The other more recent trap, I believe, relates to investing in growth companies in Russia.  In a classic EM strategy, investors look at tech companies in Russia and assume that they should grow like their analogous counterparts in the US or Europe.  This may be the case, but investors should take into consideration two key points. 

First, Russian demographics are terrible.  The population is relatively old, and immigration stems the tide but not in a meaningful manner.  This means there is limited adoption growth to be baked in from the native population for the future. 

This leads to the second issue: what markets can Russian growth companies expand into?  Is there scale in those markets?  I have not done the full work on this point, so I hope to be proven wrong. Still, I think political constraints mean that expansion outside of Russia will be limited for many of these companies, justifying a reduced multiple relative to peers who have most of the world.

The bottom line is that investors should invest in Russia for acceptable absolute valuations and treat any multiple expansion or rerating as gravy. 

General Risks

At the macro level, investing in Russia carries several risks deriving from geopolitics and its political economy.

Before we dive in, there is a quick touchpoint on perception and personal rules.  My governance and social criteria may be different than yours.   I am willing to invest in Russian companies and even state-owned companies.  I do not believe Vladimir Putin has any moral high ground, but I also do not think that the way Russia is run or its leader’s character should be a limiting factor in this case.  In this realm, things are not clear cut, and I am OK with investing in Russia.  Others may not be, and that is fine.

Sanctions

Now that we’ve touched on that, the most obvious risk in Russia is incremental financial sanctions.  Several investable Russian companies or their officers are currently under some form of sanctions.  Of the listed companies, including one I will mention in the next post, I believe these sanctions will be largely limited to new long-term capital.

DISCLAIMER:  SANCTIONS LAWS CAN BE IMPOSED AT YOUR HOME COUNTRY LEVEL OR BY THE US, WHICH IMPACTS THE GLOBAL SYSTEM.  THESE RULES CHANGE, AND NOT EVERYONE’S CIRCUMSTANCES ARE NECESSARILY THE SAME.  PLEASE DO YOUR OWN RESEARCH AND CONSULT YOUR FINANCIAL ADVISOR.  THIS IS NOT INVESTMENT ADVICE NOR WILL I BE HELD  LIABLE FOR ANY INVESTMENT LOSSES RESULTING FROM  DECISIONS YOU MAKE BASED ON READING THIS.

What this means is that a sanctioned company cannot typically issue new equity or debt.  It does, however, usually mean that you can purchase shares in the secondary market from another investor.  The idea is to starve such companies from fresh capital and force them to rely on domestic savings, which many Russian companies have been doing. 

With a Democratically-run government in Washington, I believe risks of increased sanctions are marginally higher but less than when the last major round was imposed in 2018. Two main points mitigate further escalations. 

First, any sanctions that limit secondary (between investors) trading of Russian assets probably harm international investors more than they harm Russian companies.  This ineffectiveness has been proven in Venezuela, where sanctions have been beyond those in Russia, and whether they have achieved their objective is debatable. 

Secondly, the Russian economy is larger and more integrated with the global economy than Venezuela, especially with Europe, making the unintended consequences of further sanctions unclear.  Russia is one of the leading exporters of oil, and any attempts to further suppress its production via sanctions could have far-reaching impacts on oil prices and market structure. 

State Influence

State influence in Russia works in many direct and indirect ways.  The state is an owner of major companies such as Gazprom, Rosneft, Transneft and Sberbank and plays a major role in others’ regulation.  For those where this is direct ownership and more involved regulation, many times state interest does not align with minority holders, and other times it does. 

As many investors see it, the most obvious example is dividend policy for state entities.  Many state-owned companies globally choose to reinvest all of their profits as a way of patronage and to inject stimulus into the economy. More market-oriented ones adopt methodologies similar to private companies looking at hurdle rates, etc.  Finally, although rare, some will dividend out more than is prudent for direct cash injections into the government budget.

Russia’s goal is to aim towards frameworks based on leverage and prudent capital allocation.  A company’s dividend policy and state directives regarding dividends are a regular topic on investor conference calls in Russia.  Further profit distribution criteria from the Russian Ministry of Finance is supposedly forthcoming in 2021. 

Other financial methods of influence include taxes.  In a resource-rich country, mineral extraction tax policies are a major revenue source, and Russia actively adjusts its systems.  Finally, there is the politics of company owners and management.  Yukos is the most glaring example, but some understanding of how companies sit within a network is critical.

Now that we’ve covered the Russa-specific macro risks let’s see where Russia is broadly in the investing cycle.

Where is Russia in the Cycle?

Two facts can get us quickly to where Russia is in the cycle.  COVID-19 impacted Russia just like everyone else, and for investing purposes, Russia is mostly a resource economy.  It is the source of much of the economy’s profits, the key foreign exchange source and most of the market cap.

Based on those two points, we can say that Russia is likely somewhere between the trough and the early recovery of the economic cycle.  This is shown in the oil prices and PMI’s. 

More interestingly and perhaps on a longer-term horizon, I can show that Russia remains relatively starved for capital.  My choice of metric:  the yield curve.  Not only does Russia have positive nominal rates, but real ones too! The first chart below shows the nominal yields along the Russian yield curve while the second, recent inflation rates in Russia.

While there should be some caution as these real rates are not particularly high (particularly at the front end), if you think there is a broad global recovery, Russia is the market’s low-hanging fruit.  Its better quantitative fundamentals and higher relative yields should make it a destination for investors in a reflationary environment.  That does not mean convergence, just temporary outperformance.

Finally and more broadly, one cannot think about investing in Russia without having a view on commodities. While we can debate whether the commodity price appreciation seen in the last months is due to short-term supply constraints or the start of a longer-term MMT-fueled stimulus and infrastructure bonanza, I think either thesis still has at least a quarter to play out.  My gut tells me it is the latter, but I have lost a lot of money overstaying my welcome in commodities.  The risk that this reflation is transient rather than cycle should be in your analysis. 

My Issue with Gazprom Stock and the RSX ETF

I do not actually have much against Gazprom stock (MICEX: GAZP, LSE: OGZD, US OTC: OGZPY)  or the RSX ETF (NYSE: RSX).  I just think I can do better.  I will cover company-specific issues with Gazprom in the next post, but at a high level, I think I can outperform by selecting smaller companies more off the beaten path.

Flows into passive Russia-tracking products, like the RSX, could prove me wrong, as Gazprom is the largest weighting.  This brings us to RSX.  As of January 21, 2021, the sector weightings in RSX are as follows:

Gazprom, Lukoil, Novatek, Tatneft and Rosneft make up nearly the entire weighting in the energy space while the materials space is loaded with gold, aluminum, steel and nickel producers.  Russia is a commodity play, and I am electing to be a bit more surgical in my approach than the index weightings. 

It is also important to note that I  am getting some commodities exposure, particularly in upstream energy and metals through other countries and sources.  Finally, as you’ll see in the next post, I think my basket of shares can get some of the benefits of broader exposure to Russia while giving more exposure to the idiosyncratic underlying drivers I am looking for.

Conclusion

Russia is a market where capital is scarce.  This is evidenced by positive real yields and the investment flows highlighted in the Bloomberg article.  The risks of investing in Russia are well-identified by the market and, in my opinion, therefore, more than priced.  This backdrop creates opportunities to find leading global companies at compelling long-term valuations with global tailwinds to provide increased cash flow and earnings growth.

In the next post, I’ll go through the names I am investing in. 

To your investing adventure,

The Castaway Capitalist

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