Russian equities now appear attractive, according to Coutts chief investment officer Alan Higgins and a number of other investors, as the potential for re-rating in the medium term is compelling enough to offset the risk of near-term volatility.
The ongoing conflict in Ukraine has seen Russian equities take a battering so far in 2014, as the country put itself at odds with the West by backing separatists wanting to split with Kiev and became the target of sanctions from the European Union and the US.
Over the year to date, the MSCI Russia index is down 13.20 per cent while active funds focusing on the country have had an even worse 2014, with the average Russia fund in the IMA universe falling 16.37 per cent.
The latest falls were prompted by allegations that Russia was increasing its direct involvement in the Ukrainian conflict.
In contrast, the developed market-focused MSCI World has gained 6.40 per cent, while the FTSE All Share is ahead 3.31 per cent.
The MSCI Emerging Markets index has managed to gain 10.41 per cent over the year so far.
Performance of indices year to date
Source: FE Analytics
Coutts’ Higgins (pictured) argues that these falls have brought Russian equities down to a valuation where they can be considered “attractive”.
“Russian equities have long been cheap, reflecting political risks and perceptions of corruption, but the current earnings valuation (price/earnings ratio or PE) based on forecast earnings of around 4 is low even by historical standards,” he said.
“It’s also the lowest it’s been since the credit crisis. Cyclically-adjusted PEs are lower relative to the MSCI World index than during the credit crisis. Comparing asset-based valuations, price-to-book (PB) is also low for Russia at 0.7, while MSCI World trades on a PB of 2.1 and PE of 15.”
Looking at other valuation metrics, Higgins points out that the Russian market’s average dividend yield stands at 4.8 per cent, which is historically high and compares with the MSCI World’s 2.6 per cent.
Meanwhile, Russian firms’ dividend cover is “very high in a global context”.
The CIO adds that Russian businesses remain cash rich in general while their profits appear to be stabilising.
Furthermore a more stable outlook for Russian earnings and economic growth can be garnered from recent economic data, he says.
“A major escalation of the crisis cannot be ruled out but there are significant incentives for Russia and the West to resolve their differences. Most notably, several European countries – including Germany and Italy – remain heavily dependent on Russian energy, while Russia is heavily dependent on Western capital,” Higgins said.
“We believe the potential for a re-rating of Russian equities over the next three to five years outweighs the risk of further near-term volatility. Markets historically perform well when geopolitical tensions ease.”
“Even if forward PEs – ie based on forecast earnings – were only to return to around six, which is their average since president Putin came to power, that would still represent significant upside.”
The risk for near-term volatility seems high, given the pro-Russia separatists recent moves into the control of the coastal town of Novoazovsk and their alleged plans to advance on the strategic port city of Mariupol.
In addition, there have been reports of Russian troop movements within eastern Ukraine.
Capital Economics said: “Some of the sharpest market falls have, understandably, been in Russia itself, where hopes that a diplomatic solution to the crisis might be found had triggered a rally in the stock market in the early part of this month.”
“But the latest events suggest that things are likely to get worse before they get better. In these circumstances, we expect both Russian equities and the ruble to remain weak over the rest of this year.”
Robin Geffen (pictured), manager of the three FE Crown-rated £239.9m Neptune Russia & Greater Russia fund, agrees that the valuation metrics - especially the price-to-book ratio - look encouraging.
“The price-to-book ratio of the Russian market is now just 0.7 times, only marginally above the global financial crisis lows when the Russian economy contracted by 7.8 per cent. This has taken the Russian market’s discount to emerging markets back above 50 per cent, approaching levels not seen since 2001,” he said.
“Aside from low valuations, Russia also has one of the highest dividend yields in emerging markets and one of the lowest payout ratios, providing strong support for the current dividend levels.”
Neptune Russia & Greater Russia has faced a tough 2014 with a loss of 18.59 per cent, underperforming the 13.62 per cent drop in its MSCI Russia Large Cap benchmark.
Investors have also experienced losses over one and three years, although the fund is up 11.79 per cent over five years.
Apart from 2014 to date, the fund made losses in 2011 and 2008 - the largest being in 2008, when it dropped by just over 60.69 per cent, although this was slightly better than the 63.61 per cent fall in its benchmark.
In its positive years, it made 34 per cent in both 2010 and 2007, 56.74 per cent in 2006, 66.26 per cent in 2005 and 116.03 per cent in 2009.
Performance of fund vs average fund and index year to date
Source: FE Analytics
Other open-ended funds focusing on Russia include Michael Levy's Baring Russia, Douglas Helfer’s HSBC GIF Russia Equity and Oleg Biryulyov and Sonal Tanna's JPM Russia.
Again, all have underperformed their benchmarks over the year to date.
Given the underperformance of active Russia managers, investors may be considering taking passive exposure to the country.
ETF providers such as iShares, DB X-Trackers HSBC and State Street Global Advisors have products tracking Russian equities.
Though a number of experts say now is a good entry point, State Street Global Advisors’ CIO Rick Lacaille warns that Russian equities could still be subject to further sell-offs.
“Given the potential negative impacts to the global economy if the crisis escalates and sanctions expand, investors could face significant sell-offs in Russian assets, along with knock-on effects to equity markets and debt markets,” he said.
“Russia itself would be the most impacted by the sanctions, given likely volatility in energy and natural gas markets, disruption to the Ruble, the deletion of Russia from stock and debt indices, and other effects.”
Investment trusts looking at the wider emerging Europe region include Matthias Siller’s Baring Emerging Europe and Sam Vecht and David Reid's BlackRock Emerging Europe.
Both have underperformed their MSCI Emerging Europe 10/40 benchmark over the year to date but are sitting on double-digit discounts.
Performance of trusts vs index and sector year to date
Source: FE Analytics
David Coombs, the head of multi-asset investments at Rathbone Unit Trust Management, says that though there is undoubtedly a high level of risk involved with Russian equities at the moment, current valuations are too attractive to ignore.
The FE Alpha Manager prefers to access to access single emerging market countries through investment trusts, in light of potential liquidity issues.
He has recently been buying the Baring Emerging Europe investment trust.
Coombs said: “Valuations in Russia have been cheap for some time and they deserve to be - irrespective of what’s happening in Ukraine, there are still structural issues such as corporate governance in the Russian market. ”
“Having said that, someone else once it’s great to invest in areas that others find toxic and Russia fits that.”
“You have a market that’s under the cosh from a macro perspective and from what’s going on in Ukraine [and] you have cheap valuations that are getting cheaper. On a three-year view for a medium to high-risk strategy, you have feel it’s worth a go.”
“All the news is bad - can it get worse in the short term? Of course it can but overall I think not by much.”
“Buying cheap assets is not usually stupid and usually pays off. You’re taking a risk but that risk is moderated by valuations so it feels worth taking a small position. If you’re running a medium to high-risk strategy with a five-year view, I don’t think it’s ridiculous to take advantage of this turmoil.”
Is it time to buy Russia funds or are they still too risky?
29 August 2014
Some investors have argued that Russian equities are now attractively valued, although the risk of continued volatility in the short-term remains.
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