As recently as May 29 this year, The Financial Times ran an article advocating for Russia to be dropped from the list of BRIC nations, arguing, amongst other reasons, that Russians are corrupt, rude, autocratic, decreasing in population as well as political relevance, drunkards, and difficult to do business with.
Reading such an article confirmed our observation that, even though an open and highly active market for a long time, Russia remains surprisingly under-researched and misunderstood. We have been actively investing in Russia for many years and we feel many investors still overlook or avoid this attractive
investment destination due to old myths, wrong perceptions and sometimes outright bias. In this paper we would like to clarify several misinforming
generalizations and bring you up to date on the state of Russian economy, recent changes and investment opportunities.
Corruption
Several studies, including one by Daniel Treisman, a professor of political science at UCLA, have demonstrated that Russia's corruption is in line with the average corruption level of countries with the same GDP per capita and so Russia is definitely not an outlier it is broadly perceived to be, in fact it is in line with other developing countries with similar wealth levels. At the same time, Russian authorities recognize the imperative need to decrease corruption at all levels. Several important anti-corruption measures have been recently undertaken, including a comprehensive police reform and mandatory disclosure of earnings by top state officials and their family members. A campaign aimed at improving corporate governance and fighting embezzlement in state-owned companies is also gaining traction. It includes the removal of state officials from companies' BoDs, requirement to pay 25% of earnings as dividends, disclosure of end beneficiaries of suppliers and other counterparties, requirement to reduce capex and expenses and an initiative to make all big procurement tenders public and allow foreign
companies to be able to participate in them. In general, the corporate governance standards in Russia have improved dramatically since we first started investing in the country. Quality of management, transparency and disclosure are continuously improving as companies are increasingly interested in and dependent on debt and equity investors. Dividend payouts of both state and private companies are now at all-time highs and are set to increase further.
Decrease in population
After the fall of the Soviet Union, Russia indeed faced an extremely challenging demographic situation. However, over the past decade the death rates have been steadily falling and birth rates rising and as a result Russia's population decline has been recently halted. Now Russia's population is slowly growing on the back of improving economic conditions and government's effective policies to encourage births on the one hand, and higher life expectancy and declining death rates on the other. The latter is partly attributable to the lower alcohol consumption discussed below.
Drinking nation
We all associate Russia with good vodka, but most of us would be surprised to learn that Russians are not even in the top 3 drinking nations. South Koreans, Czechs, Germans, Austrians and Irish all consume more alcohol per capita than the Russians, whose actual alcohol consumption is only slightly higher than that in France, the UK and Poland. Recent and planned future increases in excise taxes on alcohol will further reduce alcohol consumption (and hence death rates) and further increase life expectancy levels, particularly among men.
Difficulties to do business with
According to the World Bank's Ease of Doing Business Survey Russia currently ranks 120th and is actually ahead of both Brazil and India. President Putin has recently announced an ambitious target to improve Russia's position in the rating to 50th place by 2015 and 20th place by 2018. In order to achieve this he
proposed several reforms we will discuss later.
We do not dismiss the fact that Russia still has many problems and sometimes sends mixed signals to the international community (the swap between the prime minister and the president certainly had a few heads turning) affecting its equity market's performance. But we know the country well enough to be able
to form our own view rather than be guided by the widespread strongly biased impressions and misconceptions. Being active investors in the country for over a decade, we have seen how much has changed over this time and we are convinced that many more improvements are yet to come. Let us look at some of the changes supporting our conviction that Russia is becoming an increasingly attractive investment case.
1. The Russian economy is now more resilient to external shocks than in 2008. Russian companies and banks have been actively deleveraging since then and as a result leverage ratios of Russian companies have halved since the 2008 crisis and Russian banks went from being heavily dependent on foreign wholesale funding to being net foreign creditors now. After the 2008 crisis the CB of Russia changed its official goal from exchange rate stability to gradually moving towards
inflation targeting and switching to an almost floating exchange rate regime. A more flexible exchange rate approach is beneficial to the Russian economy in the current global volatility as it can act as a shock absorber limiting the damage from the lower commodity prices and hence lower USD export revenues on the balance of payments, fiscal balance and domestic liquidity. It also protects the country's FX reserves from excessive spending to support the exchange rate
(Russia's FX reserves of USD 510bn are the world's third largest). The consumer sector is increasingly becoming one of the major drivers of Russia's economic growth on the back of rising middle class, increasing birth rates and spending-oriented society. Russian inflation is now the lowest since the fall of the Soviet Union, standing at 4% in June and the unemployment rate of 5.4% is one of the lowest in the world. This, coupled with double-digit real wages and retail
lending growth, strongly supports the consumer spending. Russia has already become the 11thlargest consumer market in the world and the second or third largest in Europe and by 2018 Russia is expected to become the largest consumer market in Europe. Russia is substantially underleveraged, with one of the world's lowest levels of government debt (10% of GDP) and household debt including mortgages (10% of GDP) so the credit cycle is still in its early days,
providing for a steady economic growth going forward.
2. The encouraging reform agenda, proposed by the recently reappointed President Putin, is aimed at the modernization of the economy and the improvement of the investment climate, something much needed for Russia in order to change its image and attract foreign investors. Better investment climate is imperative for Russia's ambitious privatization program as attractive valuations for state companies are not achievable without reforms aimed at improving their corporate governance and efficiency and liberalizing the general investment regime for local as well as foreign investors. Putin outlined five key priorities for Russia's economic development:
1) improving demographics
2) providing 25m new jobs with 50% higher productivity and real wage growth of 60-70% by 2020
3) new competitive economy with stable growth and resilience to external shocks
4) developing Siberia and the Russian Far East and
5) creation of Eurasian Economic Union by 2015 to strengthen Russia's position in the world.
In terms of the investment climate, its improvement is the new government's priority and a pre-requisite for the targeted increase in capital investment to 25% of GDP by 2015 (from <20% today) and 30% of GDP thereafter. Cost control and the increase in efficiency of state companies, discussed earlier in this report, as well as their privatization at attractive prices becomes the focus. The new privatization program envisages the state's exit from all non-resource sector companies, with the exception of natural monopolies and defense, by 2016. Proposed changes also include new simplified accounting rules for businesses, better support for SMEs, introduction of new procedures that will increase transparency of financial operations and block tax evasion via offshore structures, introduction of compulsory public discussions and audit of all investment projects with state participation, significant easing of procedures in registration, construction, taxation, customs areas and a rise by 1.3 times of the share of high technological sectors in the country's GDP. The authorities are also working on improving the financial market's infrastructure to attract more portfolio investors, with the reforms including merger of Micex and RTS exchanges, opening the local debt market to foreign investors by making local bonds Euroclearable, bringing stock settlement to internationally accepted standards of t+3 and establishing of a central depository
which will make local shares available to all global funds with the goal of subsequently lifting limits on local shares conversion to DRs thus eliminating the former's big discounts.
3. After 18 years of negotiations, Russia is finally joining the WTO, which is a milestone for Russia, benefiting the country's global reputation and general risk perception. Joining the WTO sends a strong signal that Russia is committed to making the investment environment more transparent and predictable, it will enhance FDIs into the country and help to widen its investor base. The WTO entry will facilitate access of Russian companies to the overseas markets, improve
competitiveness of Russian business, lead to productivity gains and contribute to diversifying domestic production away from natural resources. An external research suggests that WTO membership could add 1% per year to Russia's GDP over the next 5-10 years.
4. After the recent sell-off, the Russian equity market is trading at historically low multiples: below 5x forward earnings (10-year average is 8.2x) and at some 40% discount to GEMs (vs. 25% discount over the past 10 years).
The widespread misconceptions about Russia offer invaluable opportunities to knowledgeable and experienced investors ready to take advantage of the extremely attractive equity valuations before they re-rate as a result of the implementation of reforms and the improvement of the investment climate. We presented you with just some of the facts that make us believe that Russia is a compelling investment story, which should not be overlooked. As with most emerging markets, timing of entry is important but so is an extensive knowledge and experience, continuous market presence and investment approach based on unbiased research. Russia is indeed an economy of significant potential that will reward an unprejudiced and patient investor. Feel free to contact us should you be interested in discussing our views in more detail.
SG Alpha
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