#16 - JRL 2006-179 - JRL Home
Date: Mon, 7 Aug 2006
From: James Beadle <jamesdbeadle@yahoo.co.uk>
Subject: Russian Equities A Volatile Hedge?

Yesterday’s Johnson’s List, on the eve of a US Fed interest rate decision, carried a Russia Profile piece by Pavel Erochkine of the Centre for Global Studies in London. The following points stood out as misleading, or confusing:

1. It is claimed that the equity market’s May-June correction was exclusively caused by change in perception of US interest rates. 2. It is held out that “the performance of the Russian market is inherently unpredictable.” 3. It is suggested that Rosneft shares will become the new blue-chip benchmark. 4. It is further suggested that Rosneft’s IPO will reduce capital flow to smaller companies causing them to under-perform. 5. The article is entitled “Not for the risk averse” but concludes that Russia is a wonderful hedge against commodity-driven inflation.

I would like to comment on each of these points in turn, and in doing so attempt to convey current sentiment on the Russian market, which is quite possibly at a periodic inflection point.

First, it is true that US economics contributed considerably to the RTS’s correction from an all-time high of 1765. However, it is deceptive to imply that expectations of rising US interest rates were the only cause. Like most market events, the correction was stimulated not by any single issue, but whole legion of factors, decisions and parameters.

Equities declined across the board in May-July, not only in Emerging markets. Many commodities also saw sell-offs. It is true that declines were greatest in emerging markets, but not out of proportion to increases experienced in these markets over the preceding months.

What really caused the sell off? Certainly, US rates played a role, but not in exclusion of other factors. In addition to the US, the world’s other major central banks were also in tightening mode. Japanese money supply, excessively slack for a protracted period was being reeled in hand-over-fist. Carry trades ceased to appear as attractive as they previously had, while bonds began to offer risk-free returns that rendered equities less desirable.

Stocks declined across the board as fund managers locked in profits, cut leverage and rebalanced their asset allocations to reflect expected yields on various asset classes over the second and third quarters.

Moving onto the second point, it is completely irrelevant to note that Russian equity market is unpredictable. The day the Russian equity market becomes predictable, it will cease to be an equity market. The most basic rules of finance dictate that (equity) markets must be unpredictable; otherwise they would offer a “free lunch,” which would lead to swift arbitrage pressure and eliminate any possible return.

On Rosneft’s role as a Russian benchmark. This IPO was an unusual financial event, effectively it was a cross between private and public placement, on a grand scale. The fact that strategic investors took around half the float reflects important factors: > That portfolio interest was limited by legal constraints and broader market conditions (discussed above); > That synergist drivers permitted higher valuation. Companies such as BP were able to pay at or above fair value, since their participation unlocks added commercial value in the broader Russian energy market.

What is most relevant, though, is that at least half of the float released will not trade freely as it is held by strategic partners. Add in that the company is dominantly owned by the Russian government and that the prospectus notes a risk of management not following shareholder interests, and it becomes clear that Rosneft is no typical stock. Rosneft’s share performance will never fairly reflect the broader Russian equity world, nor will it be deemed to do so, since institutional portfolio investors have largely stayed clear for legal reasons.

Meanwhile, there is limited justification to the claim that Rosneft’s existence will draw investors away from smaller stocks, but only very limited.

Certainly there is a finite pool of capital available to the Russian market, but few of the investors willing and able to buy Russia’s second and third tier companies would substitute with a blue-chip. Illiquid companies are purchased on the expectation of considerable upside. Rosneft, by contrast, is liquid and was taken to market at a very high valuation.

Finally, the comment ends with the curious twist that Russia represents a hedge against commodity driven inflation in other markets. This is true, but represents a curious contrast to the title of the article “Not For The Risk-Averse.”

Russia remains a high beta emerging market, but is already demonstrating its hedge function: Other emerging equity markets fell further and faster in the May shake-out, and have not rebounded so well.

With earnings and governance leaping forward, there remains considerable upside. Oil prices remain high, so we can expect a new round of analyst upgrades in the coming months, and the Fed is expected to hold rates (not halt them) today. Liquidity is still declining, so the rewards may not be immediate, but even so I’m fully bullish for 2H06.