Why Russian stocks are ridiculously cheap | Tradingfloor.com
• Volatility to remain for some time
• Trade dependencies make conflict a non-starter
• Positive economic outlook
By Peter Garnry
Every fund manager in the developed world is on the bandwagon grumbling about how Russian equities should be sold as political and economic risks are too high. This song has been playing out for years now and while there is some truth to that, equities can become so cheap that you have to act despite a crisis and negative news headlines.
Russian shock
As speculation about Russian military actions in Ukraine intensified and Russia’s central bank raised the key rate to seven percent, Russian equities fell 11.7 percent in the largest absolute move since the financial crisis in 2008. Volatility has been shown to cluster so we can expect volatility to remain elevated for some time. However, that is only good because it breeds opportunities.
Source: Bloomberg, Saxo Bank
Yesterday’s drop in Russian equities was just another nail in the coffin as the MSCI Russia Capped Index had underperformed world equities by 22.5 percent in 2014 alone. With today’s risk on moves across the board the under-performance has been restored.
Source: Bloomberg, Saxo Bank
Trade and wars
This analysis is about why Russian stocks are cheap and why investors should consider buying instead of selling. But before we go into valuation details, the foundation for the analysis has to be put in context. A long bet on Russian stocks hinges, obviously, on a diplomatic solution that causes little disruption to Russian companies, and an economic outlook that is not negative.
My bet is on a diplomatic solution as trade dependencies make war too costly for both sides (EU/Ukraine vs. Russia). Europe’s natural gas consumption puts USD 100 million a day into Russia’s coffers, making Europe its largest customer although imports are down to 30 percent from 45 percent in 2003. A recent Yale study shows that trade promotes peace because violence brings about substantial costs. Russia will acknowledge this just as much as Germany — the largest customer at the Russian natural gas pipeline. Therefore, oversold Russian equities bring upside opportunities in a diplomatic scenario.
The other factor supporting a long bet is a positive economic outlook. The consensus estimates for real GDP growth are 2.0 percent and 2.5 percent in 2014 and 2015, respectively. Unemployment is around 5.5 percent, much lower than in Europe, and Russia enjoys a positive current account in percentage of GDP on top of a small budget deficit of around 0.5 percent of GDP. Also OECD’s leading indicators, while not updated since September 2013, are pointing up so the Russian economy will not be entering a recession anytime soon.
Valuations signal huge wealth destruction
The MSCI Russia Index is currently trading at a 12-month forward price-to-book ratio of 0.54, which implies return on equity that is 50 percent below cost of equity. The 12-month forward price-to-earnings ratio is 3.6, which is a quarter of the developed world’s average. In other words, massive shareholder value destruction. This valuation probably made sense during the financial crisis but not this time. The world is not coming to an end.
The 12-month expected return on equity is currently 17.1 percent. So even if we estimate the cost of equity to 15 percent to reflect all the risk factors (15 percent CoE is very high in a global context) then the MSCI Russia Index should trade closer to one at the 12-month forward price-to-book ratio. This would imply an upside of 85 percent. Maybe this would be a stretch but it does give you an idea of how ridiculously cheap Russian equities are.
Russian equities, measured by the MSCI Russia Capped Index, went into a bear market yesterday based on the 120-day rolling return, collapsing to minus 23.5 percent (see chart). Normally, the market mean reverts (see financial crisis in 2008 and Europe’s crisis in 2011), and we believe that will happen again.
Instead of trying to select individual Russian stocks traded at the London Stock Exchange it is much easier to just bet on the index. The MSCI Russia Capped Index is best played through the db x-trackers MSCI Russia Capped Index UCITS ETF (ticker XMRC:xlon). The ETF has already bounced back a bit (see chart below).
Source: Bloomberg
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