In 2019 the Russian stock market rallied strongly as it delivered the some of the highest returns among markets across the world. The MSCI Russia Index, a tracker to measure the performance of 23 largest publicly-listed companies in the country, had risen by 44 percent around the second week of December.
According to Bloomberg, 15 of the 23 Russian members of the MSCI Index delivered total returns exceeding the expected average of 14 percent in 2019. Since the annexation of Crimea 2014, the Russian Trading System (RTS) Index surpassed the 1,400 level for the first time in June. The RTS Index has increased 46 percent since January 1 till December 25, 2019. Russian stocks outclassed their developed world and emerging market peers by quite some distance.
In comparison, the Dow, the Nasdaq and the S&P have seen new record highs in 2019 but with lower returns. The S&P 500 showed an annual gain of 27.9 percent as of December last week. Meanwhile, the Nasdaq returned 14.2 percent on average and the Dow was up more than 21.5 percent over the same period.
Even China’s stock market rose 33 percent this year, suggesting it is one of the best performing stock markets in the world. China’s market rose so much in 2019 because of high investor interest in its technology companies and relatively cheap value compared to other emerging markets. As for India, the sensex recorded a 13.7 percent growth as of December 17, 2019.
Why Russian stocks outperformed emerging markets peers
Russian investment firm TKB Investment Partners’ consensus view is that Russian equities offer strong value investment case and opportunities for increasing growth. “The trend, which started about five years ago will continue, should the global jitters and Russia sanctions topic to subside. We still trade at significant discounts to emerging market peers like Brazil, China, India and South Africa and have plenty of room to make a hefty catch up. The RTS Index reflects more than 50 percent discount to the MSCI Emerging Markets Index on FY19e P/E basis,” a spokesperson at TKB Investment Partners tells International Finance. Undervalued Russian stocks became one of the cheapest in the world — available at half the value of its emerging market peers.
The one factor that helped RTS Index outperform peers in Europe, the US and BRICS markets is the measure undertaken by the Central Bank of Russia in terms of stabilising the ruble and financial markets and de-escalation of conflict rhetoric.
“Russian market is historically very cyclical but it took RTS index about five years to restore its USD value (1,500 points) from the pre-Ukraine crisis. The strong balance sheets, high FCF yields, buybacks and solid dividend payments compared to international peers have also supported the Russian stocks in 2019,” Boris Krasnojenov, Head of Research, Senior Metals and Mining Analyst, Alfa-Bank, said in an interview with International Finance.
Another reason for its outperformance is that large capitalisation companies materially increased dividend payouts. This is especially true for companies in which the Russian government is the majority shareholder, such as Sberbank and Gazprom. Russia’s dividend yields were more than seven percent in 2019, which is twice the MSCI Emerging Markets Index dividend yield of 3.2 percent. In fact, the 44 percent return on MSCI Index includes income which came from dividend payments.
According to the TKB spokesperson, “The Central Bank of Russia’s decision to cut rate four times during the year, from 7.75 percent to 6.5 percent, coupled with a strong value case for the Russian equity market,” have subsequently led to the stock boom. That in turn made the Russian market’s dividend yield among the highest in the world at 6.7 percent, compared to just 2 percent on the S&P 500, a tracker for the biggest US-listed companies. But there were other factors that can be attributed to soaring Russian equities than just a high dividend yield.
To investors, the fact that the escalating trade war between Beijing and Washington is more intense than Russia-US face off has made the Russian stock market rather attractive. The fear of sanctions has reduced. ‘Rebound in oil prices in 2019 and no fresh EU or US sanctions,’ uplifted Russian stocks as the best global value pick for the year, Michael Guo, professor in finance at Durham University Business School tells International Finance.
Will Russian stocks remain the best value picks for 2020?
What was clear is that increasing global risk appetite and search for higher-paying assets on the back of interest rate cuts have unleashed a tidal wave in Russia’s stock market. That hugely benefits stocks that are perceived riskier and have low liquidity levels — pointing to the fact that even a measly increase in demand might raise share prices. In the base case scenario, an average of 12 percent in sustainable free cash flow yield is expected for the market over the next two years.
But in Guo’s view, “It is highly unlikely that Russian stocks will remain the best global value picks going into 2020.” This is only because the risks far outweigh the opportunities. On the geopolitical front, the uncertainty surrounding oil prices and the US-China trade war is expected to affect the Russian stock market.
Also, the sanctions regime is limiting Russia’s evolvement and has cut two percentage points off its growth as the Ministry of Finance and Central Bank of Russia has developed a hostile approach to reinforce economic safety. “Recent news about German officials finding ‘sufficient indicators’ that suggest Russia ordered the killing of Chechen rebel in Berlin, could raise fresh sanctions from the EU, which is yet another risk that could spoil the party,” Guo says.
Americans dominate Russian free float
Interestingly, North American investors accounted for more than half of the Russian free float, observed Moscow Exchange, while their representation in the European markets was only 26 percent.
“According to an article in IR Magazine, as of end of June, the US institutional investors held $43.9 billion in Russian stocks from $35.3 billion at the close of 2018. The UK and Scandinavia upped their holdings to $16.5 billion and $8.1 billion respectively,” Guo says. “It is the US institutional investors that are driving the recovery in the Russian stock market.”
The US fund managers like Allianz invested billions of dollars of American investment capital into Russia’s publicly traded companies, leading to a 58 percent increase in US investment since 2015. The RTS Index has a market capitalisation of nearly $170 billion.
“On one hand foreign investors have more than 50 percent share in Russian free float. It is unlikely that material move on the market can happen without their contribution, the TKB spokesperson says. “On the other hand, since the beginning of 2019 there was around $3.6 billion net outflow from the Russian market from foreign investment funds, according to EPFR Global data presented by Financial Times.” Many global emerging markets funds with five-star ratings from Morningstar are overweight on Russia. “It is likely that this position had a positive contribution to these funds’ excess return in 2019,” he adds.
Krasnojenov points out that despite the bitter dispute between Russia and the US on global affairs — it is European investors who lost their market share while UK investors merely kept their niche. “So, given those proportions in the free float of the Russian stocks, we would assume that money managers from the US will benefit the most. The share of foreign investors in the total trading volumes on the Moscow Exchange remains around 50 percent. The high quality Russian blue-chip stocks find strong demand across overseas investors,” he explains.
Economic warning signs for investors
Russia has earned a BBB investment grade rating from Fitch, like India and China. Its spending is controlled unlike Brazil and has a Finnish-style National Wealth Fund of $124.14 billion, which was seven percent of Russian GDP at the start of 2019. “The World Bank predicts that Russian economy is set to see a growth in GDP in 2020. The current forecast indicates increase from 1.2 percent in 2019 to 1.6 percent in 2020 and to 1.8 percent in 2021,” Guo says.
Whatever the current optimism, investors are perplexed about high returns from paid out dividends in many Russian companies without the stock price moving at all. The Finance Ministry insisted that all state-owned enterprises should pay out 50 percent of their income as dividends to benefit investors. While most managements resisted the pressure, Gazprom agreed to increase dividends by 10 roubles per share, which was further hiked to 16.6 roubles per share.
After that, its total payout under international accounting standards increased from 7.5 percent of net profit to 27 percent. This has forced investors to question whether the new higher dividends will be permanent or not. Krasnojenov calls volatility of the Russian stock market the “number one enemy to the portfolio investors” for two reasons. First, “The free float is dominated by the hedge fund managers who actively trade in pairs, such as Russia vs Turkey, or Lukoil vs Sasol.” Secondly, he said “The Russian stocks are exposed to commodity price swings. We have to recognise that the oil price dynamics remains essential catalyst for the Russian equity universe.”
The economics of Russian stocks are changing. Guo adds that timing is crucial while investing in Russian stocks as the index is extremely volatile, considering how the volatility index, on average, was 31.25 in 2016, 21.63 in 2017, 24.53 in 2018, and 20.71 in 2019.
OPEC is gearing up for more cuts in 2020, however. Russia is yet to agree to further cuts. “With non-OPEC countries set to add to the oil supply in 2020, there is always the risk of further fall in oil prices, which could be damaging to Russian Stocks. With increasing uncertainty around oil prices and the threat of fresh EU sanctions looming, the level of volatility is not expected to go down anytime soon.” As well as taking into account the alliance between Russia and China, “delay in the anticipated US-China deal might impact the Russian markets,” Guo adds.
Although the trade war might potentially undermine the demand for export companies and squeeze their margins, consumer sectors and those companies benefitting from local demand should get moving rapidly in 2020. “We also recommend to pick companies which have solid dividend policy for investors including Gazprom, Lukoil, Nornickel and integrated Russia steel majors like Novolipetsk Steel and Severstal,” Krasnojenov says.
The TKB spokesperson in fact, stresses that, “it is better to pick stocks rather than sectors on the Russian equity market.” In his view, the “difference between stock performance within one sector can be tens or even hundreds of percentage points over several years. It is useful to select a good stock picker.” That said, for investors who are seeking an opinion on sectors can consider companies in oil and telecommunications. Even the metal and mining sector has performed well with marginal negative returns of 0.04 percent. More recently, Russia has started exporting natural gas to China through an 1,800 mile pipeline called the Power of Siberia headed by Gazprom, and therefore, the oil sector continues to look promising.
Defining the next big prospect
What brings optimism right now is that “Russian corporates have gone through a massive deleveraging process that obviously supports equity value growth,” Krasnojenov explains. But the deteriorating geopolitical conditions are weighing on investor sentiment — creating uncertainty around 2020. That is why a cautious approach is necessary while investing in Russian stocks in the long-term. “However, if everything goes as planned RTS Index will touch the 2,500 level of 2008 in the next five years,” Krasnojenov says.