Russia remains a compelling case for investors despite the equity market’s slow start to the year, according to Colin Croft, manager of the Jupiter Emerging European Opportunities fund.
Having previously noted this week that the structural case for investing in emerging Europe remains as strong as ever, the manager takes a closer look at Russia, which makes up 56 per cent of the fund.
The first place to look when talking about Russian equities is oil, according to the manager, which makes up roughly half of the Jupiter Emerging European Opportunities fund’s allocation to the country.
“You can’t deny that Russia is affected by the oil price – it’s their biggest export and if you look at the correlation of Russian market returns and the oil price it is pretty close.”
Performance of indices over 10yrs
Source: FE Analytics
As the above graph shows, the MSCI Russia index and S&P GSCI Brent Crude Spot index have moved in similar patterns over the last 10 years.
Croft says predicting the oil price is something that people who spend their whole lives trying to do tend to get wrong on a regular basis, but notes that he has to have an opinion in order to have the confidence to invest in the sector.
“I would say that the key issue is whether OPEC can stick to the cuts that they have agreed and so far they seem to be making reasonable progress on,” he explained. “I think this is why the oil price has been holding at around the current level.”
Brent crude currently sits around $52 per barrel after the Organization of the Petroleum Exporting Countries (OPEC) agreed to erode the surplus that has kept prices low since 2014.
Indeed, in November 2016 the group announced plans to cut production in an effort to reduce the widening surplus. However, there are other countries including the US that are not included in this deal.
“There are some swing factors in terms of some of the places like Libya or Iraq where there have been various instabilities. There are question marks over how quickly they can ramp up production or not – those are the sorts of areas that could affect it one way or the other,” Croft (pictured) said. 
However, he says it is reasonable for investors to expect the oil price remain within the $55 a barrel range - give or take $5 each way – over the medium term.
“We saw what happened last year towards the beginning of the year when it was touching $30 – it just can’t stay there because too many people go out of business,” the manager reasoned.
“There was something like 5m barrels a day of capacity that was losing money on a cash basis at that level – so I can’t see it going back to that level and staying there.
“Even if there was some kind of short-term wobble like we saw last year I would see that as a buying opportunity [for Russia] more than anything else.”
He says the current price is at a sustainable level over the medium term for the Russian oil stocks he currently holds in his portfolio.
“The outlook for Russia has improved significantly compared to last year – the oil price has rebounded from unsustainably low levels of under $30 per barrel and is currently trading at around $55 per barrel, a level that should be comfortable for Russia and is well above the $40 per barrel assumption that is baked into the Russian budget.
“If, in 2017, oil prices simply remain in the $50-$55 range that we have seen since the recent OPEC decision, that would represent a 10 - 22 per cent increase compared to 2016’s average price of $45.
“This should provide good conditions for the economy to return to growth – which could create stock picking opportunities in domestic-facing companies that have suffered from weak earnings momentum in recent years.”
However, Russia is not just an oil play, as half of the fund’s exposure to the country is outside of this sector.
“There are some of these companies that are to some extent going to be negatively correlated to the oil price because they are producing non-oil commodities where their costs are in roubles. So if the oil price goes down their costs will probably go down,” the manager said.
“I would say that Russia is not just an oil play in the same way that Saudi Arabia is because Russia has a pretty diversified industrial base.”
“They have lots of other commodities in which they are pretty big producers such as steel, iron ore, nickel and diamond mining – they have a pretty big position in all of those – and the reality is that all of those are very important.
“For example I have a small position in Alrossa, a diamond producer, and they would probably benefit if the oil price went down.”
While these non-oil commodity companies offer the fund some protection against a fall in the oil price, he notes that other areas including telecoms and domestic stocks are in some way related to the oil price, given it heavily influences the currency.
As well as this, valuations appear to favour Russian stocks, with the Russian market on a price/earnings (P/E) ratio of seven, which is in line with its 10-year average.
“That is half that of the FTSE All-Share index, which currently trades on a P/E of 14.6 and is around 20 per cent more expensive than its 10-year average,” Croft continued.
However, the Russian index has not made a good start to the year and is currently down 9.28 per cent year-to-date.
Performance fund vs indices year-to-date
Source: FE Analytics
Despite this the fund is only 93 basis points lower and is ahead of its MSCI Emerging Markets Europe benchmark by 47 basis points, in large part thanks to its non-Russia holdings.
“What’s been driving performance so far this year is the non-Russia stuff. Everyone’s been very optimistic about Russia – myself included – but actually its non-Russia that has been performing,” Croft said.
“My Romanian stocks are up 15 per cent year-to-date, which is about 3 per cent of the fund and Polish stocks and Turkish stocks are similar.”