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How bargain hunters should play the Russian crash

18 December 2014

Arjun Divecha explains why the bulk of GMO's Russian holdings are limited to the energy sector – and why it is considering buying more.

It’s very clear to us that the primary cause of Russia’s current troubles is a rapidly declining oil price and that what happens to the oil price will play a major role in what happens to Russia over the next few months (and years).

Coupled with Western sanctions, the declining oil price has caused a run on the currency as Russians have increasingly lost faith in the rouble and have been converting their roubles to dollars and euros.

Unlike almost all other emerging markets, Russia has an open capital account with no currency controls and so Russians are free to hold bank accounts denominated in dollars or euros and to freely move money out of the country.

As capital outflows increased in recent weeks, the Russian central bank chose (quite sensibly, in our opinion) to not spend dollars supporting the currency, but allowed it to slip, hoping that it would find a natural level.

However, the rouble kept falling in sync with the declining oil price and, as a result, two days ago the central bank decided to try and staunch the outflow by increasing interest rates from 10.5 per cent to 17 per cent, expecting that this shock treatment would cause the rouble to stop falling.

Unfortunately, they were wrong and the rouble fell precipitously (20 per cent intraday) and it appears that it stopped falling and began to recover somewhat only when the central bank intervened.

As of this writing, it’s not clear whether the central bank will change strategy and start supporting the rouble, but that seems to be a very likely possibility to us.

After all, they have $500bn in foreign reserves, a chunky rainy day fund, almost no foreign debt, and a balanced budget, so they have huge scope to intervene and continue to do so until the markets cry uncle. What’s at issue is their willingness to do so.

We suspect that there may be a change of leadership at the central bank, along with a change in policy. While analysts believe that Russia will impose selective capital controls, we are less sure, given the ineffectiveness of capital controls the last time they were tried.

For capital controls to be successful, they would need to be comprehensive rather than selective. Preventing average Russian citizens from converting roubles to dollars is widely seen as politically unviable and therefore not on the table.

Unlike previous crises in 1998 and 2008, Russia starts this one with a much healthier balance sheet and a floating currency, so if we are correct about the rouble being stabilised around these levels, the damage to GDP should be less than what we saw in those two crises.

The central bank forecasts that GDP next year will be down 4-5 per cent if oil prices stay around $60/barrel.

So, who gets hurt in this scenario? Given that at a sovereign level Russia has very low debt (and almost no foreign debt), there is almost no likelihood of the country defaulting unless it chooses to do so for political reasons (which is not that far-fetched, given sanctions on raising foreign capital).

Clearly companies that have high foreign debt are vulnerable, but this is hugely ameliorated by the fact that most companies that have foreign debt are also dollar earners, i.e., the oil and gas and metal companies.

There are estimates that the total foreign debt of Russian corporates is around $400bn and we are able to identify around $200bn on the balance sheets of the top 50 or so listed companies (of which $60bn comes from Rosneft alone).

The biggest problem for these companies is not their ability to pay (given their dollar-based revenues), but their ability to refinance foreign debt and raise new capital, given the sanctions. Thus the real problem is not one of solvency but one of liquidity.

We have a large overweight position in Russia, based on the cheapness of assets there. Given the relatively good position of the energy sector, our investments in Russia are largely focused in oil and gas companies, representing about 90 per cent of our Russian holdings.

Russian energy companies trade at valuations south of five times earnings and pay dividends north of 5 per cent.

Given that our main case is that there will not be comprehensive capital controls that limit our ability to take money out of the country, we remain comfortable holding these very cheap assets (and perhaps adding to them if they decline further).

In addition, most of our Russian assets are custodied in London and traded and settled in dollars, so while their value fluctuates with the rouble, we do not need to be buying or selling roubles to trade and settle them.

To understand why Russian energy companies are well positioned, look at the chart below. The blue line shows the price of Brent oil in dollars, and that decline, intuitively, would match the impact on the revenues of most global oil companies (assuming no change in production).

Performance of oil vs rouble since Jan 2013



Source: GMO

However, when you look at the oil price in roubles (red line) you’ll see that the decline in the rouble has almost exactly matched the decline in oil prices and so in rouble terms, the revenues of a Russian oil company (assuming no change in production) would have remained flat over the last year.

Given that most of their costs are rouble-based (and so largely unchanged), their rouble profits would also be largely unchanged. Obviously, when translated to dollars, they would be down, but stock prices have more than compensated for this decline and so we see these assets as having become more attractive.

The situation for domestic Russian companies is not quite as sanguine. Those with foreign debt and rouble revenue are likely to have a solvency problem and we could see a number of bankruptcies that would impact the financial sector.

As a result, we have chosen to largely limit our investments in Russia to the energy sector. John F. Kennedy once said: “When written in Chinese, the word ‘crisis’ is composed of two characters. One represents ‘danger,’ and the other represents ‘opportunity’.” Both are well represented in Russia today.

Arjun Divecha is the head of GMO’s emerging markets equity team. The views expressed here are his own.
 

 
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