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March 9, 2014

Russian equities – an attractive buying opportunity?

The rules for extracting outperformance in developed equity markets are now well-known and well tested. All academic studies show that the value effect leads to the biggest outperformance in the long term (1). Therefore if you want to buy something cheap, you have to find something which is not very popular. Can you think of a market which is less popular than Russia at the moment? But do the rules also apply for developing equity markets?

The Russian equity market is by far the cheapest market globally (2):

Country/Region2013 P/E
Russia4.5x
China9.2x
Brazil11.0x
Emerging Markets11.5x
Poland13.8x
Europe15.6x
USA17.4x
Prices from 7.3.2014

If valuation would be your only guiding light, then Russian equities would be a screaming buy. However, exactly the same could have been said 6 months, 1 year or 2 years ago. Still, Russian equities have continued to underperform and the 1y forward P/E multiples that investors are willing to pay has continued to contract(3):

Russian Equities

Clearly, only looking at valuation is not working in the case of Russia. The problem, particularly in Emerging Markets, is that corporate governance is the corollary of value. Companies may well trade at a discount to their intrinsic value but if management is not working for minority shareholders, or are instead working for the government, then shareholders cannot expect to see that value materialize over time. Valuation multiples that work across developed market equities can therefore not be applied to developing market equities.

Poor corporate governance and the lack of clear property rights in Russia means that we would not advocate adding Russian equities to a portfolio, despite a seemingly attractive valuation. This would only change if we see a shift in the political landscape.

If however poor corporate governance and lack of clear property rights do not put you off of investing in Russia, then you still have to decide what is the best way to gain exposure. Though we would advocate for many markets the use of ETFs, in the case of Russia indexing doesn‘t work. Around 2/3 of the MSCI Russia index are in energy and basic resources. But those sectors largely rely on global prices and are more dependant on China‘s growth model than whatever really happens in Russia. We therefore would recommend an actively managed fund that can invest off-benchmark.

Sources:
(1) Credit Suisse Global Returns Investment Yearbook 2014 (Elroy Dimson,
Paul Marsh and Mike Staunton)
(2) IBIS, MSCI, Bloomberg
(3) JPM, 1y forward PE

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