Greater Russia: looking beyond benchmark stocks
After the presidential elections in Russia, a combination of economic growth and structural reforms creates opportunities. Investors could benefit from off-benchmark stocks in the equities market which is much more diverse than the typical benchmark index structure would suggest.
As most investors know, Russia is one of the largest commodities producers in the world and has one of the lowest costs of oil production and transportation at around USD 20 per barrel. This gives oil producers a potential profit margin of more than 500%. A cash cow for the federal budget, it is the most heavily taxed sector. When oil is around USD 120-130 per barrel, exporters need to pay 74% of revenues to the state.
What is important to remember though, is that this money is redistributed to other sectors through budget spending. For instance, state employees’ wages stimulate retail sales and therefore growth in firms focused on local demand. This means that the non-oil sectors benefit more than oil producers from an oil price rise. Domestics are in fact a leveraged play on oil and can produce substantial earnings growth. We believe it is possible to find local demand-focused firms with 10%-30% expected 2012 earnings growth.
Growing middle class
The middle class is expected to double in size in the coming decade on the back of real income growth and low personal income taxes, which should boost demand for durable goods and services. With one of the world’s lowest levels of private debt (about 10% of GDP) and a 13% flat income tax rate, many Russians have over 80% of earnings as disposable income.
Russia already has one of the most rapid wealth per capita growth figures. Since the end of the Soviet Union era, there has been a more than 20-fold growth in GDP per capita to just over USD 13 000, along with a more than 35-fold increase in average wages. Demand for durable goods is on the rise, which pushed Russia into second place in Europe (after Germany) for new car sales in 2011, and it could soon become number one.
Off-benchmark energy
Despite heavy taxes, it is worth looking into off-benchmark energy firms because of high dividend yields and expected oil production growth. In our view, one of the best examples is TNk-BP, which is one of the largest privately owned Russian oil producers. Its stock has an expected 2011 dividend yield of 10% and its projects in Yamal and East Siberia should help TNk-BP to increase production by 2% per year in the long term.
The equities market is wider than the benchmark universe. MSCI Russia has 26 stocks but there are around 1 000 stocks on the market overall, 200-250 of which are liquid enough to be included in a sizable portfolio. A best-selection strategy aims for a more concentrated portfolio with substantial off-benchmark exposure in a market trading at a 49% discount on forward-looking PE ratio to other emerging markets.
The economy is far more diverse than the structure of market indices suggests. About 70% of listed companies in the MSCI Russia index are in natural resources and most are statecontrolled entities. But these groups only account for 9.1%. of GDP.
Large parts of the economy are focused on local demand. Retail and wholesale trade, manufacturing, financial services, transportation, communication, utilities, real estate and construction together contribute around 60% of Russian GDP. This might seem puzzling as it is well-known that the Russian economy relies heavily on oil. However, oil producer profits are redistributed to other sectors of the economy via taxes. This means domestic stocks have growth even in a flat commodity price environment, and usually out-perform the oil and gas sector in periods of stable and reasonably high oil prices.
With an upward trend in oil prices, political stability after the elections and continued structural reforms as Russia prepares to join the World Trade Organization, we believe the local equities market is full of opportunities for a well-informed, discerning investor.
