But it has been a long and difficult road to get to this stage. The Russian market is closely linked to the oil price (Chart 1), so the collapse of oil from $140+ to below $40 in 2008 marked the start of almost a decade of disappointment. In that period, Russia’s influence in the emerging market (EM) world waned. At the end of 2007, its index weighting was 10.1%, fourth highest after China, South Korea and Brazil, with a market capitalization of $1.2 trillion. Today its weighting is just 3.3%. And its capitalization is less than half of what it was 10 years ago! Since mid-2017, oil has enjoyed a renaissance, currently flirting with $70 levels, with increasing confidence that $60+ is sustainable. The ruble - which is intricately linked to crude oil prices - has stabilized, having fallen 40% since oil stumbled violently in October 2014.
Past performance does not guarantee future results.
Internally, years of a stagnating economy have taken their toll. Growth in Russia is structurally challenged. Demographics play a role (the labor force is contracting at 1.5% per annum), but the main culprits are weak institutions, corruption and the lack of respect for the rule of law. These forces conspire to restrain private sector capital formation, which would ignite productivity and growth. However, these challenges also mean that those companies which do survive may often grow to be exceptional (and exceptionally managed) companies. Further, like other oligopolistic countries (most notably Mexico), limited competition underpins higher returns to capital employed.
The lean years triggered by the 2008 oil price collapse were exacerbated by sanctions imposed by the West in 2014. The past few years have been characterized by deep and persistent recession and a collapse in real incomes, which were eroded by high, currency-led inflation. Challenging fiscal conditions - which are dominated by oil taxes - coupled with sanctions were met with innovative policy. We have seen prudent monetary and fiscal policy; pension and insurance reform; and inflation brought under control. The private sector also navigated this climate successfully - deleveraging swiftly. With oil prices having stabilized at higher levels, capital formation recovering after a drought of three to four years and inflation at unparalleled low levels (real incomes slowly recovering), growth is beginning to percolate cyclically. The economy is only just emerging from recession with GDP growth of 1.8% in Q317. At 2.3% in January, inflationary pressures are benign, allowing the central bank to remain on an easing path.
Russian equities largely missed the emerging market equities rally last year. Valuations are extraordinarily inexpensive - reflective of great mistrust around growth potential, sustainability of recent crude price gains and general worries about geopolitical risks. Many companies are trading at among the lowest multiples in the world – in aggregate, the market is trading at between 6x and 7x earnings with a forward price-to-book (P/B) ratio of 0.8x and dividend yield of 5.6%. We feel that low valuations and the widening gap with other emerging market equities provide a strong case to own what we believe are exceptional companies in Russia. We have roughly 700bps of our strategy in Russia, mostly represented by a large natural gas producer, a state-owned banking and financial services company and a large food retailer.
Banking and financial services
We’re invested in what is perhaps the most privileged bank in all of the emerging markets, given this particular company’s 45% share in retail deposits, and its ROA and ROE in excess of 2% and 20%, respectively. In the past three years, with an exceptional management team and huge competitive advantages, the bank has weathered the multiple economic and political setbacks in Russia extremely well, gathering measurable share from weak competitors. It has further strengthened its balance sheet during the crisis with excess capital, and widened its competitive moat with investments in fintech. Going forward, we anticipate this company’s ability to capitalize on higher loan growth; improve efficiencies; and its propensity towards higher dividends will allow it to drive continued outperformance.
The Russia-based food retailer we’re invested in has been among the strategy’s longest-held investments, over a decade thus far. The company was negatively affected by the Russian economic malaise starting in 2014, with ongoing pressure continuing to weigh on results. During that period, it suffered through a deteriorating domestic consumer environment with no wage growth and high food inflation along with an intensifying competitive landscape. This has resulted in recent challenging operating results and declining investor confidence. While the company continues to be Russia's most profitable food retailer with a leading market share, the operating environment has become more challenging, and management has had to adjust to extraordinary adversity. Frankly, this has taken longer than anticipated, but we believe this company is capable of recovering over the next year or two with initiatives to improve its competitiveness fortuitously coincident with a recovery in the consumer landscape. The stock trades at attractive valuations while offering several growth options, including: rapid food retail consolidation; new formats under development (cosmetics and pharmacies); and the largest logistics network in the country.
Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Investments in securities of growth companies may be volatile. Emerging and developing market investments may be especially volatile. Eurozone investments may be subject to volatility and liquidity issues. Investing significantly in a particular region, industry, sector or issuer may increase volatility and risk.