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November 30, 2001
For foreign investors, a different bear
Experts advise caution as money heads back to Moscow
By Michael Collins, CBS.MarketWatch.com
Michael Collins is editor of Investing Across Borders and a former Moscow bureau chief for United Press International.

MOSCOW (CBS.MW) -- After three years on the "do not touch" list of most money managers, Russia is suddenly one of the world's hottest markets.

Foreign investors have taken an active interest in the past month, and Russia has been one of the world's hottest emerging markets for mutual funds this year.

Is Russia finally ready to take its new role in the world economy?

Or are Western investors setting themselves up for another disappointment?

Recent events give investors plenty of reasons to take another look:

The nation is flexing its power as an oil producer by snubbing OPEC as President Vladimir Putin chats on a Texas ranch with his new buddy President Bush.

On Thursday, Moody's upgraded Russian government foreign currency bonds to Ba3, which is still well short of investment grade but two steps higher than the previous rating.

Russia is now paying its debts on time, after its $40 billion default in August 1998.

Real structural reforms and economic stability seem to be on track. Companies are showing real profit, which was rare before 1998. GDP grew by 5.5 percent the first half of this year and government economists expect to report more than 4 percent growth for the full year -- half the 2000 growth rate but a decent figure in a weak world economy.

After a decade of capital flight, analysts say Russians are bringing money back into the country to invest in Russian companies.

The government and Moscow-based investment bankers say the country is ready for serious foreign investors. But nothing in Russia is ever simple, and whether and where to invest in the country is as complex a question as an investor is likely to face.

A hot year, but significant risk

Economists and analysts warn that Russia is one of the riskiest markets in the world. For example, although its debt rating has shown steady improvement over the last year -- to "Ba3" from Moody's and "B-minus with a positive outlook" from Standard and Poor's -- at current levels Russian bonds only look safe when compared to countries like Pakistan, Indonesia and Argentina.

Even Moscow investment bankers, who say there are some great deals to be had in Russian shares, acknowledge it's not an easy market.

"I think there's a lot of value in Russia, but at the same time it's very much a market which you need to understand quite carefully before you get involved in it," said Roland Nash, head of research for Moscow-based Renaissance Capital. "To a certain extent it's an insiders market. There's not an awful lot of transparency within the companies. There's not an awful lot of transparency within the government still.

"Unless you really know what you're doing, then you can get stung," Nash said. "There are some very good bargains, but still there are a number of ways in which you can lose your shirt."

Where to look

Nash said non-energy sectors like textiles, heavy machinery, food processing, microbiology, pulp and paper and fertilizers have all shown better growth (although are still less profitable) than the oil sector in the last two years. He said the flow of Russian investment back into the country shows that Russian managers believe in their companies' ability to adapt to new economic realities.

"Obviously just by the fact of the market economy, not all of them are going to survive," Nash said. "The best will, and the worst won't. But I think that's good. That's what competition should do."

Nash said "all companies in Russia are cheap on an international comparison basis," and he suggested that foreign investors look for companies that have recognized the need to focus on share value.

He breaks his recommendations into three tiers.

On the top level he includes Yukos (YUKOF: news, chart) in the oil and gas sector, MTS (MBT: news, chart) in telecommunications and Sun Interbrew in consumer products. His second tier includes companies that are working to convince investors they recognize the need to open themselves up, including Sibneft (SBKYY: news, chart) and Norilsk (NILSY: news, chart). On the third tier of Nash's "stock universe" are companies he describes as playing the "restructuring game," including utilities Unified Energy Systems (USERY: news, chart) and Mosenergo. Weak regulation leaves investors unprotected

Analysts point out that while there's been significant progress in macroeconomic reform, there's still a long way to go in reforming the legal system and implementing corporate governance standards, for instance, to ensure that minority investors' rights are protected.

Bill Rocco, a senior analyst for Morningstar who focuses on emerging markets, said that while many fund managers with significant positions in Russia have done well this year, to get those returns they've taken significant risks. And don't forget the huge losses in Russia funds in previous years, particularly during the devaluation and Russian market crash of 1998.

Among the several funds that invest primarily in Russia, the ING Pilgrim Russia Fund (LETRX: news, chart) is up more than 60 percent for the year and the Third Millenium Russia Fund (TMRFX: news, chart) is up more than 25 percent. Read more on Russia funds.

"There's been progress," Rocco said. "Putin is an improvement. It's not as much of a Wild West market as it was five years ago, but we're only talking about five years. It doesn't mean there's anything wrong with owning a Russian stock or two as part of a larger portfolio, but having a lot of any emerging market is risky, and having a lot of Russia is riskier than most."

Russian money returning

One of the most positive signs for foreign investors, analysts say, is the flow of Russian money back into Russian companies after a decade of capital flight.

"The portfolio and direct investment coming back into the country is more than the foreign investment coming in," said Jeffrey Valkar, director of the American Business Center on Sakhalin Island in the Russian Far East and a former economic counselor at the U.S. Embassy in Moscow. "Some of that domestic money that was parked offshore is coming back into the economy ... and it appears it's being used for capital investments."

Valkar, who works closely with both Russian and American companies in one of the hottest investment regions in Russia, said he's noticed a change in how Russian managers see their companies as well.

"Companies are now beginning to think about time lines into the future, which is very good," Valkar said. "It used to be 'two or three years, strip and sell and get out.' Now it's 'grow the company and where do we want to be in five years.' It hasn't reached Western standards where we think 10 to 15 years into the future, but it is getting better."

Valkar said that many large Russian companies seem to now recognize that they need to "legitimize themselves" with good investor relations and solid strategic plans, but he added, "The small to medium industry is still extremely risky for portfolio investors."

The oil price question

The analysts seem to agree that two things helped the Russian economy turn around after the 1998 crisis: higher oil prices and a devalued ruble that made domestic companies more competitive. Unfortunately, oil prices have been falling and the ruble is getting stronger.

Energy sales account directly account for about 16 percent of GDP and a third of government revenues. Business Week recently calculated that every $5 drop in the price of crude costs Russia about 1 percent of GDP.

"For the longer term, Russia cannot rely exclusively on energy resource revenues, but must focus on deep institutional reform of its economy," Johannes Linn, the World Bank's vice president for Europe and Central Asia, said in a recent speech.

Helena Hessel, head of research for transition economies at Standard and Poor's, said Russia has made significant strides in the last year. But she notes that the country's debt level is still high, and much depends on whether Russia is able to adapt to a slowing world economy and lower oil prices.

"What we've seen is very positive in terms of structural reform," Hessel said. "However, it goes together with an international environment which is working very much against them, and therefore we might need to be careful."

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