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Russia: hidden potential or value trap?

Russian equities have way outperformed other key markets and yet remain comparatively cheap.
Christopher Bannon, Pictet Asset Management

Russian equities have continued to outperform global equities. Year-to-date, the MSCI Russia Index returned 44%, which soars past key indices in the US, Europe, the UK and Japan.

Source: FE Fundinfo. In US dollars.

The returns are even more striking when compared to the MSCI Emerging Markets Index, which is up 12.55%.

Despite the outperformance, which is also evident over the trailing three years versus the same indices, Russian equities continue to be cheap and are trading at a 50% discount to emerging markets, according to Christopher Bannon, London-based senior investment manager for Russian equities at Pictet Asset Management.

While investors may think this is a value trap, Bannon believes that the asset class does not need to be re-rated.

“Whilst Russia may have been framed as a value trap in the past, and it is true that prices remain highly discounted to other emerging markets, dividend yields have exploded,” he told FSA.

“Modest earnings growth and the compounding power of high-single-digit dividends provides for a highly appealing investment case. Russia no longer needs to re-rate to be a worthy investment in our view.”

Sanctions risks waning 

Bannon explained that Russian equities remain cheap as investors continue to price in various geopolitical risks linked to the economic sanctions imposed in 2014.

“We think the various geopolitical risks relating to US relations, Syria and Ukraine are abating. But the pricing in of these risks remains unduly high.

“We believe that sanctions have forced positive structural changes in Russia, which have improved the macro management of the economy, the quality of corporate practices and the free cash flow generating capabilities of companies.”

Because of these improvements and excess cash flows, dividend yields have also become attractive, which has also helped drive the stock market. On the average, dividend yields of Russian equities are at least 8%, versus around 3.5% across other emerging market equities.

“We expect the level of dividends is sustainable, and together with modest earnings growth, will remain drivers of the equity market for the coming years,” he said.

Bannon added that both exporters and domestically-focused companies have performed well.

Exporters have benefited this year from decent oil prices, a weaker local currency, low levels of leverage and low levels of capital expenditure spending.

Domestic firms, meanwhile, have strong earnings potential and continue to grow. Most of them have also been weighed down by geopolitical risk, which makes their valuations attractive.

For example, a Russian bank is trading at a forward price-to-earnings ratio of 5x, with a net interest margin of around 5%, a dividend yield of 10%, earnings growth of 10% and a return on equity of 20%.

“These favourable financial metrics are difficult to find in other emerging or developed markets,” he said.

For Pictet AM’s Russia-focused product, Bannon, who co-manages the fund with lead portfolio manager Hugo Bain, prefers companies that generate excess cash for shareholders and trade at a significant discount to fair value.

“We do not like to own companies going into onerous capital cycles or which are generating negative free cashflow with no prospects of turning that around,” he said.

The fund has a huge overweight in the energy sector (42% of the portfolio). Although the fund is underweight exporters, he likes Russian energy names that are highly cash generative and are paying out substantial amounts of dividends to minority investors.

There is also a bias toward domestic firms, according to Bannon.

“We believe that there are excellent and well-run businesses across financials, real estate, tech and industrials, which have been unduly beaten up by geopolitical concerns which have had no impact on fundamentals,” he said.


The Pictet Russian Equities Fund (as of 31 October 2019)

Source: FE Fundinfo. In US dollars. The fund has 38 positions with assets of $578m.


Still underinvested 

Bannon believes that investors globally remain underinvested in the Russian market.

“But our anecdotal experiences lead us to believe that this may change going forward. As investors come to terms with the remarkable valuations and strong fundamentals that the asset class offers, we would expect to see incremental allocations to Russia equities.”

In the fund industry, Russian equities continue to be a relative niche asset class, with only a few managers launching Russian-only equity products, according to Bannon.

In Hong Kong, for example, there are only six SFC-authorised Russian equities funds, which are managed by Pictet AM, HSBC Global Asset Management, BNP Paribas Asset Management, JP Morgan Asset Management, UBS Asset Management and Manulife Asset Management, according to data from FE.

The Pictet Russian Equities Fund versus its benchmark index

Source: FE Fundinfo. In US dollars.

Part of the Mark Allen Group.