Russia – The ultimate frontier market

With the dream team of President Medvedev and Prime Minister Putin now firmly in control of economic policy at the Kremlin, Moscow could be one of the world’s best performing emerging markets in the next year.
Frontier markets like the GCC, Russia, sub-Saharan Africa, the Balkans, Vietnam and Eastern Europe have become the most profitable segment of emerging markets. Frontier markets are now driven by a combination of positive macro themes. These include the highest crude oil and natural gas prices in history, exceptional strength in metals from gold to copper to nickel, a capex and infrastructure cycle that will literally change the landscape of cities as varied as Moscow to Muscat, and Hanoi to Abu Dhabi in the next generation.
Moreover, as frontier markets float new companies (Serbia, Ukraine), attract FDI (Turkey, UAE, Oman), restructure command economies into the free market (Vietnam), deregulate and privatise (Egypt, Saudi Arabia), we could well witness the dawn of a compelling new investment theme. Above all, frontier markets are immune from Wall Street credit woes, though GCC or Russian borrowers in international capital markets do face higher funding costs. Above all, frontier markets are not correlated to the Dow Jones index, the emerging markets index or even each other. After all, the Omani stock market has been one of the best performing exchanges in the world in 2008 at a time when the US, European and Asian stocks corrected in a vicious bear market.

Macro revival
I emphasise that frontier markets are not without the political, forex, banking and other macro risks endemic to the emerging markets. Pakistan is up 1,000 per cent since General Musharraf’s coup d’état in 1999 but political shocks, rupee depreciations, stock exchange scandals, terrorist attacks have all created periods of exceptional volatility. The UAE market faced a 70 per cent meltdown in 2006 and a succession of broker scandals.

 Vietnam has lost no less than 60 per cent of its market cap since March 2007 after monetary tightening, a spike in inflation (rice, cement, crude oil and gas), and a botched privatisation IPO programme led to panic selling by foreign fund managers. The pegged exchange rates, easy leverage, flight capital and negative dollar interest rates have led to periodic asset bubbles in the GCC capital markets. Political violence in West Beirut triggered a sell-off in Lebanese shares and the prospects of a peace settlement in Doha led to a surge in blue chips like Solidiere and BLOM Bank. These markets are definitely not for those unable to withstand volatility.

Russia is the ultimate frontier market in 2008. Moscow could be one of the world’s best performing emerging markets in the next 12 months, with the dream team of President Medvedev and Prime Minister Putin now firmly in control of economic policy in the Kremlin. The Putin era defined one of the world’s most epic sovereign financial turnaround stories, with the Russian stock index RTS up 14-fold between 2000 and 2008. Russian GDP growth will be a record 8 per cent, buoyed by historic oil, gas and metal prices. The Russian central bank and Stabilisation Fund have accumulated US$500 billion in reserves. Russia, bankrupt after the rouble devaluation of 1998, has repaid its Paris Club and IMF loans, with external debt only 10 per cent of GDP. Capex, government spending, FDI, oligarch liquidity, bank credit growth all suggests a macroeconomic renaissance in Russia.

While inflation and Kremlin variables are a chronic problem in Russian financial markets, I believe the sheer scale of corporate growth and the rise in the rouble as foreign funds scramble into Russia will ignite a spectacular secular bull market. Russian banks were hit by the Wall Street credit meltdown because so many had borrowed long-term in the Eurobond markets. With no less than 1,200 banks (include oligarch pocket banks and even Mafiya shell banks), and two banking crises in the past decade (1998 and 2004), it is only natural that Russian banks shares plummeted as the higher cost of international bank credit led to a liquidity squeeze in the rouble money market. Moreover, Putin’s model of state capitalism, the memories of Yukos and the Shell/Sakhalin 2 fiascos and tensions with the West over Ukraine, Georgia, NATO and Gazprom gas policies mean political risk in Russia will remain tangible.

Potential returns
The Russian RTS index is cheap at 9.5 times current earnings, a massive 30 per cent discount to MSCI Emerging Markets valuation metrics. The Russian index has been mauled by the highest inflation in five years, uncertainty over the Putin succession and the Kremlin’s determination to impose oil windfall taxes. Russia’s stock market trades at a 17-20 per cent discount to Britain’s FTSE 100 Index or France’s CAC 40 Index, which offer nowhere near the high growth of 20 per cent CAGR and 20 per cent ROE metrics that Russia does. Russia is also significantly cheaper than China (even after the collapse of the Shanghai A share bubble!), India and GCC, whose price-earnings ratios are still 26X, 20X and 15X, respectively. The Russian central bank will use rouble appreciation as the key component of its anti- inflation strategy. This will stimulate offshore money into the Russian financial markets. There is a potential upside of 25-30 per cent in selected bluechip shares in Moscow.

Gazprom is the world’s third most valuable company, with a market cap of US$340 billion, just behind General Electric and China Mobile. Gazprom’s chairman is the new President of Russia. There are several catalysts that could trigger a valuation or a re-rating of Gazprom’s share price from its current US$14 to US$17-18. Gazprom trades at a forward multiple of only 6 even though EPS growth next year could be 25-28 per cent. WTO accession and the spike in North Sea crude oil means Russian domestic prices will be deregulated and Gazprom will be the natural beneficiary of a rise in domestic gas prices. Moreover, Gazprom margins will rise due to success of its recent diversification programmes into oil, coal and electricity. Gazprom’s valuation metric are leveraged to a sustained rise in crude oil and gas prices.

Gazprom has a huge number of strategic initiatives in place, from exploration of mega- gasfields in Yamal Nenets, the offshore Arctic oilfields in Shtokman, the LNG business, downstream businesses in Western Europe and the Asia pipeline business. There are no shortages of catalysts to get Gazprom shares moving, if the financial markets re-price Russia.

MTS (which trades on the New York Stock Exchange under the symbol MBT) has 33 per cent of the Russian GSM market, which has no less than 77 million customers. While its fourth quarter profit more than doubled, it missed its EBITDA and EPS expectation. The shares of MBT have fallen from its 52-week high of 102 last December to 77 now. Russia’s leading telecom trades at a modest valuation of nine times forward earnings. MBT can rise to as high as US$120 in the next 12 months.

Sberbank is the largest commercial bank in Russia, with almost 50 per cent of the national deposit base. Sberbank trades at a current valuation of only 12 times earnings, which is low for an emerging markets bank whose annual profit growth can be as high as 25 per cent till 2010. Moreover, Sberbank, as the de facto sovereign owned private bank, benefits most from the new risk averse mood in the international money markets. With its 20,000 branches, Sberbank is also a proxy for the regional growth and rising per capita income across the Russian Federation. I envisage Sberbank’s price can rise to 4.50 from its current 3.60 in the next 12 months. Investors who do not wish to pick individual stocks can buy the Templeton Russia Fund (TRF) at 60-62 on the New York Stock Exchange for an 80 target.

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