After rebounding following the 2008 crisis, the Russian stock market is in a limbo — indices haven’t fallen to new lows, but every new maximum is lower than the previous one. With economy slowing and political risks increasing there are no triggers for the general market to grow. Still it is possible to make money on Russian stocks, but not by index investing.

There are two major points to remember for investing in Russia: cyclicality (a selloff in the spring followed by a rally through the end of the year) and the huge difference in valuations between “good” and “bad” corporates. These factors remain key in 2014. QE tapering in US will be a signal to sell, as would be a drop in the oil price below the psychologically important level of USD 100 per barrel.

However, investors should be aware that money is still being printed, albeit in smaller quantities, and interest rates likely to remain low for longer than expected (possibly until 2017), while the global economy will continue to recover. While the US remains the principal driver for the market, economic news from China and Europe will also influence the Russian stocks.

The difference in valuations is likely to increase: expensive companies showing growth and respect for investor rights will become more expensive, and cheap companies disregarding investor rights will become even cheaper. The painfully familiar stamp “high standards of corporate governance” is becoming increasingly critical: stories like TNK-BP, Pharmstandard and Uralkali will be long remembered.

However, after the decline in the market even good stocks need a catalyst. What will light a fire under these names?

One theme is dividends. Five years ago dividend yields on Russian stocks were close to zero, but now the average is around 4%. Over two to three years, the yield could grow to 6%: private companies are seeing their businesses mature and are becoming increasingly willing to share profits with shareholders. The best options in this segment include Surgutneftegaz prefs, Lukoil, Gazprom Neft and Norilsk Nickel.

Another theme is potential economic recovery in Europe. In recent years, Russian indices have become more correlated with European stocks than the Brent oil price. The explanation is simple: in the range of USD 100-110, price fluctuations have little influence on the budget and economy. At the same time, Europe remains the largest market for Russian companies and consequently their earnings are directly dependent on conditions in neighboring markets. If you believe in growth in Europe, buy Gazprom and Severstal.

Another theme is upcoming IPOs. Although the Russian market as a whole may be considered undervalued, good consumer names are not cheap. Magnit, QIWI, and Yandex – these and many other companies in Russia’s “new economy” continue to perform well, delighting investors and occupying a more prominent position in indices and portfolios. Magnit managed to take fourth place in the MSCI Russia Index and caught up with Surgutneftegas in terms of market cap. And this isn’t the end of the story – the company will become even more expensive.

Investors should take a look at some new names: most investors in Russia missed out on QIWI, the value of which has nearly tripled. There will be plenty of these in the market to choose from: now it’s much cheaper for consumer companies to raise money in the market than borrow. First in line is retailer Lenta, with an issue planned for the first quarter of 2014.

Investors should also pay attention to consolidation in the banking sector. The CBR’s new leadership has adopted a policy to reduce the number of banks in Russia, and rightly so. The revocation of Master Bank’s license is the beginning of a trend, and the main beneficiary will be Sberbank. Indeed, Sberbank head German Gref recently pledged to investors that the bank would double its assets in the next five years.

Restructuring in the telecommunications market is another event to consider: telecom companies have long been investor favorites due to strong management and dividend income – the merger of Rostelecom’s mobile assets into Tele2 will lead to increased competition and a decline in revenue for operators.

However, the industry will remain attractive in the medium term, meaning that investors just need to find the best company. It could be any of three mobile operators – MTS, Megafon or Vimpelcom – but don’t touch state-owned Rostelecom. The best assets will be taken, leaving the company with the costs.

20 January 2014, Forbes Russia

equity, dividends

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