Solving the great Russian investment paradox


	March 13, 2002	atimes.com

Central Asia/Russia

Solving the great Russian investment paradox
By Bob Guldin

The news about Russia's economy is overwhelmingly positive these days - but still not positive enough. As of last Friday, the Russian stock market was up 29 percent for the year - more than any other major market in the world. Economic growth was 5.5 percent last year, and a superb 8.8 percent in 2000. The yield on Russia's Eurobond dropped more than 5 percent last year, an impressive sign of investor confidence.

Despite all the good news, foreign investment in Russia remains minuscule. Less foreign direct investment (FDI) goes into Russia than into the tiny Czech Republic. Russia currently attracts less than one-half of 1 percent of the world's total FDI. In 2000, out of a global total of $1.27 trillion in FDI, Russia attracted $4.4 billion, while China drew $46 billion. Preliminary numbers for 2001 don't show much improvement.

Call it the great Russian investment paradox: a growing economy with enormous potential that foreign investors resoundingly ignore.

The reasons Russia gets little respect from international investors are well known. However, there's a growing feeling that Russian assets today are seriously undervalued, and that in the next few years, Russia may be in for a major influx of foreign capital.

After the fall of the Soviet Union in 1991, Russia developed a host of economic dysfunctions: disastrous corporate governance, unenforceable contracts and property rights, capital flight, corruption, an opaque tax code, a weak banking sector. But most of those were tied to the unpredictable and ineffective administration of Boris Yeltsin.

The Putin presidency has changed that. As Keith Bush, the research director at the US-Russia Business Council in Washington, sees it, "Putin has provided two years of political and economic stability. Stability is a very precious commodity. You may not agree with his views on the media or Chechnya, but stability attracts investors like nothing else."

In addition, Russia today boasts many features that investors love. Christof Ruhl, chief economist of the World Bank's Russia office, told the Russia Journal that these include "a growing economy, an increasingly well-defined legal framework, a large internal market, rapid growth of real income and purchasing power, a very well educated workforce, and still relatively moderate costs for natural resources and energy and labor".

Russia's state finances look increasingly good to Western business, too. Tim Seymour, the president of Troika Dialog USA in New York, deals with lots of investors interested in Russian markets. He notes that "the flat tax has been a real boon for the government. There's less dependence on oil, so that last fall, when oil prices spiked downward, tax collections were still up 7 percent." He adds that "the sovereign's ability to service their old debt and actually pre-pay the outstanding debt" boosts investor confidence.

There's good news, too, in corporate governance. Western investors were all too aware of the ways Russian corporate insiders stripped companies of their assets and ignored minority shareholder interests in the 1990s, but that has begun to change. Five large Russian corporations, including Vimpelcom, Aeroflot, Rostelecom and Sibneft, have agreed to be rated on corporate governance by Standard & Poor's. The evaluations cost them money, but are bound to improve their images in the securities markets.

When and if new investors come into Russia, they'll be joining some of the West's best-known firms who have been there for years. Western interest in Russia's oil and gas is deep and growing. ExxonMobil is putting $4 billion into offshore oil and gas fields off Sakhalin, part of a four-nation consortium. The project is expected to result in $12 billion in total capital investment, which would make it the largest FDI ever in Russia. Four oil companies, including ChevronTexaco, have put $2.5 billion into the Caspian Pipeline Consortium, which recently started pumping oil from Kazakhstan to a Russian port on the Black Sea.

Anders Aslund, a noted expert on the post-Soviet economies at the Carnegie Endowment for International Peace in Washington, believes there are big areas of the Russian economy that are ripe for Western investment. Aslund says investors should stay away from the big Russian energy firms, which are cash-heavy and don't want foreign investors, as well as "very big enterprises" from Soviet times that carry "all kinds of social and financial liabilities".

That leaves such areas as light manufacturing, consumer goods, and retail sales as promising sectors. "There's an enormous boom in big stores, retail trade, in Moscow and St Petersburg," he says, "but really only those two cities. IKEA opened its first store and had tremendous demand; it's now opening a second store in Moscow. There's a fast-rising middle class and foreign companies are tapping into that.

"The tobacco sector has been taken over by foreign companies," Aslund says, throughout the former Soviet Union. "Philip Morris is probably the biggest US investor in Russia, but obviously they don't want to talk about that because it would raise public health concerns. Philip Morris has 80 percent of the tobacco market in Kazakhstan also." The US firm R J Reynolds is a major player too. "They're both making enormous money," says Aslund. "This is the biggest and earliest success story, but it's not talked about."

One of the best areas for European corporations has been beer brewing, Aslund adds. Interbrew of Belgium has about 20 percent of the Russian market. Russia's biggest brewer, Baltika, is jointly owned by Scottish & Newcastle of Britain and Carlsberg of Denmark.

US firms McDonald's, Coca-Cola, and Procter and Gamble are all strong in Russia, Aslund notes. The Swedish mobile-phone manufacturer Ericsson tripled its sales in Russia last year, and many consumer goods companies doubled their sales, Aslund says. "And then, of course, you have the question, if we have such big sales, why don't we produce in Russia?"

Aslund is convinced that auto manufacturing is Russia's next big thing: "mass-production of relatively cheap cars, costing $8,000-$10,000 in current dollars. The question is who will produce them?" General Motors, Fiat, Renault, and Ford have all ventured into the field, though some firms, such as DaimlerChrysler and Renault, have had tough sledding. Whoever makes them, Aslund predicts domestic auto production will grow from about a million cars per year now to 1.5 million in three years - almost all of them new models.

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American observers also see the Russian stock market as an excellent buy right now. Says Bush, "It's a good time for portfolio investment because the shares are desperately undervalued. The perceived risks are more than outweighed by the perceived opportunities." Both Bush and Aslund point to the disparity in price/earnings ratios between Russian and US firms. Russian corporations often have P/E ratios of 5:1 or less, while American firms often trade at 50:1 or higher. Says Bush about Russian shares, "They're going to go up, I'm sure."

Troika Dialog USA deals primarily as a broker and investment banker for medium and large funds, and, Seymour says, it's "right in the middle of the appetite for Russia risk by institutional investors". He says the people he works with feel very comfortable investing in Russia now. "I don't see any investors who are overweight in Russia making any substantial moves out of Russian assets. They may be reallocating among sectors, or between different companies with more value, but not out of Russia."

Seymour does note that investor confidence depends heavily on the reform process led by Putin. "The risks are consolidated in one man. Putin's ability to make or break Russia is significant."

Getting down to specifics, Seymour sees both Gazprom and UES, the giant electric utility, as potential buys, though with some caveats. There's a "two-tiered trading structure" for Gazprom shares, in which foreigners are at a disadvantage, but if that comes down, Seymour believes it's worth buying. "It's about tariff improvement, corporate governance, it's about the new management team and the extent to which the government is finally taking control of one of its wealthiest assets." He concludes, "You have to own Gazprom, it's the biggest gas company in the world."

On United Energy Systems, Seymour comments, "It's the most liquid stock in the market. It's a bit of a momentum play on Russia; it's also a play on restructuring and tariffs and to what extent the government is following through on its plans for the monopolies."

Aslund, on the other hand, specifically warns non-Russians not to get into utilities, "because utilities are highly political. The more political a sector is, the less likely it is to be profitable for foreigners, because foreigners are bad at politics for obvious reasons."

There are also a couple of Russian oil companies, Seymour reports, that "have significant international strategies that would at least involve joint ventures with Western oil majors, especially for access to their distribution capacity. Yukos has been exploring partnerships with TotalFina." He also notes that West European companies such as Ruhrgas are likely to get into distribution deals or production-sharing arrangements to keep the energy flowing. "That's Germany's greatest motivation now - to keep the spigot on."

Seymour says that privatization of land ownership, when it comes to Russia, "will be a lightning rod for FDI, producing much greater allocations by Western investors". Real estate, agricultural business and pulp and paper would all benefit, he says. Seymour also likes the cellular-phone industry, "even though this isn't necessarily a sexy sector any more". He sees Vimpelcom and MTS, the two largest cell-phone companies, as growth companies because infrastructure for land lines in Russia has been lagging.

WimmBillDan, the juice and dairy company recently listed on the New York Stock Exchange "met with remarkable interest from the investment community", Seymour notes. "It was five to six times oversubcribed." This is a good sign for other consumer product companies that are selling to Russia's rising middle class, he says.

Looking at the overall Russian stock market performance, Seymour warns that investors are still cautious after the default, devaluation and market crash of 1998. Back in 1997, he says, "some people were moving into second- and third-tier stocks that were way off the radar screen, because they thought everything was a one-way ticket up. What will be different about this rally is that it will be concentrated in 10 or 15 blue-chip stocks."

Second-tier companies that may have value, like Tomsk Energo, will not "get a bid just because people haven't caught on to it yet". Seymour also sees some regional telecoms, or an automotive manufacturing firm like AvtoVaz, as having potential to "emerge out of the second tier".

"It's still a momentum play for a lot of stories," Seymour says of investing strategies for Russia. "So when you think there's going to be great restructuring clarity in the banking sector you want to buy Sberbank, even though it may not be a story that is ready yet."

Bond market: A sign of life

A relatively new and small but growing part of the Russian investment world is the corporate bond market. Ruhl explains that because of the absence of a functioning banking system, "you have a number of new smaller companies or would-be entrepreneurs who are desperate for credit". So since the crash of 1998, a bond market has emerged which is growing exponentially. He observes, "Cash-rich companies are willing to invest - that's a sign of life here."

And some of those bond purchases are coming from abroad. Most are from Cyprus, widely recognized as Russian overseas capital returning. "This is natural," Ruhl says. "Bonds are risky, but Russian investors are going to be the first to invest in them, because they know the market."

Foreign funds entering the bond market came to $31 million in 1999, $145 million in 2000, and $292 million in the first nine months of 2001. The return of Russian flight capital also produces an investment pattern that might be regarded as bizarre if one didn't know better - for the first three quarters of 2001, tiny Cyprus is by far the largest foreign investor in Russia. The top foreign sources for total investment for that period are: Cyprus $1.874 billion; US $1.226 billion; Netherlands $914 million; and Germany $845 million. Most of the Cyprus investment is going into bonds and long-term trade credits. Looking solely at foreign direct investment, Cyprus is the third-largest player, behind the US and the Netherlands.

Although overall foreign investment in Russia is still very low, Aslund says that fact may be normal at the present stage. "In general, FDI takes place late in an economic takeoff. If you take Poland, which has been the most successful post-communist conversion - the country had growth of 6 percent for years before foreign investment took off in 1997-1998. Most often FDI comes in late, after you've cleaned up" the economy.

Is Russia finally approaching that stage? All the signs are pointing upward, but the crash of 1998 still casts a shadow. As Seymour observes, "Times are good right now in Russia, and investors have short memories, but the psyche is still fragile."

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