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Putting the “R” back in “BRICs”, by Michael O`Flynn

Numerous commentators and professional prognosticators have questioned Russia’s positionas one of the world’s leading emerging economies by suggesting the letter “R” be removed from the phrase “BRICs”. This acronym, originally conceived by Goldman Sachs economist Jim O’Neil, has for over a decade placed the Russian economy and stock market on par with the fast-growing countries of Brazil, India and China. It is my contention that Russia most certainly deserves to be regarded as one of the elite EM nations, in part due to shared characteristics with its BRIC peers, and in part due to its uniqueness.

01.12.2011
Michael J. O’Flynn, Managing Director, UFG Asset Management

The most common measure of economic strength is growth in gross domestic product, or GDP. Most analysts expect Russia’s $1.8 trillion dollar GDP to grow this year by a robust 4% to 4.5%. This will roughly match Brazil while lagging India and China, which should reach 7% and 9% in 2011, respectively. More importantly, Russia is on the eve of entry to the World Trade Organization (WTO), which should help boost the country’s long-term sustainable GDP growth level going forward by at least half a percentage point toward 5%, according to UFG Asset Management estimates.

Growth could accelerate even further as the Russian government plans to embark on what could be called a “Thatcheresque” privatization scheme aimed at increasing competition and boosting economic efficiency through the sale of stakes in more than 900 companies between 2012 and 2015. Most certainly, then, when evaluating major economies on the benchmark metric of GDP, Russia’s economy deserves to remain in the BRIC grouping.

WTO accession and an ambitious privatization program, however, bring certain intangibles to the equation, notably the impact that an international rules-based trade framework and increased transparency will have on corruption. While difficult to quantify, one can easily imagine a scenario where once-hesitant global investors and multinational corporations might give Russia a second look now that it will soon join the ranks of the world’s leading trade body. The first place to look for the statistics to turn will be in foreign direct investment, or FDI, which has been embarrassingly low vis-à-vis Brazil, India and China, despite the fact that there are zero capital controls, a de facto freely floating currency, declining inflation and relatively benign levels of taxation in Russia. In fact, some ascribe. Russia’s willingness to allow Exxon Mobil to jointly develop arctic resources with Rosneft Oil earlier this year to have been a first sign that large amounts of FDI would be forthcoming in the post- WTO entry era.

Stock market returns Russia vs. others 2000-2011

At a time when western governments hinder efforts to harness nearby oil and gas reserves (USA) and nuclear energy (Germany, Japan), investment in Russia’s vast fossil fuel and mineral reserves is bound to rise under WTO. Meanwhile, the steadily gathering pace of noncommodity sector FDI, led by global multinational corporations like Ford, Pepsi, and Unilever, should continue to accelerate now that more open and equal access will be given to Russia’s wealthy consumer.

Herein lies the greatest misconception that professional investors and laymen alike have with regard to Russia: that the country is poor and only survives on its ability to export commodities. GDP per capita in Russia is expected to top $13,000 this year, slightly less than the equivalent of Brazil, India and China combined. Moscow itself is one of the wealthiest cities in continental Europe, and its ten million-plus citizenry’s high level of brand awareness sets the trend for the rest of the 140 million population. While demographic growth in Russia is stagnant, in sharp contrast to India and Brazil, the rising income of the rapidly expanding Russian middle class is becoming a powerful economic force and investment theme.

In combination with a 13% flat tax and largely unmortgaged housing stock that was widely gifted during the early years of privatization, we estimate at UFG that discretionary income in Russia is an amazingly high 75% of take-home pay. Though this wealth is obviously fueled by the trickle-down impact of elevated commodity prices, Russia is no mere petro-economy.

Of course, there are other reasons why Russia’s unique attributes demand inclusion in the phrase “BRICs”. There is little debt in Russia, with a modest amount in the corporate space (less than half of GDP) and even less in sovereign liabilities (below ten percent of GDP). This is in sharp contrast to the far-morelevered economies of India and Brazil, and on the sovereign level begs direct comparison to the leading global creditor nation, China (note Chinese corporate debt is close to 100% of GDP). Most investors believe political perceptions and the long memory of the 1998 domestic debt default are the reason why the S&P credit rating agency has kept Russia’s sovereign rating at triple-B, only a half-notch ahead of Brazil and India; China is AA- rated.

BRIC

Russia’s $525bn+ of central bank reserves are the third largest in the world and, ironically, may play a role in the European Financial Stability Facility (EFSF). While the Russian economy as an engine may not power the developed world out of its latest crisis, its balance sheet might provide the necessary backstop to avoid calamity, and certainly has the firepower to once again help its own domestic economy survive a second major global economic slowdown.

Other factors to consider when grouping the leading developing nation economies include education level and urbanization – both areas where Russia emerges as the clear leader among the BRICs. 99% of the Russian population is literate, with around 80% possessing the equivalent of a western bachelor’s degree; in India 25% are illiterate according to the latest available data from UNESCO. This should enable an eventual transition from an energy/commodity-based economy to one driven by science and technological innovation, if harnessed correctly (note the Kremlin’s major high-tech Skolkovo initiative). Urbanization has long been considered a key long term growth driver for any industrialized economy, and whether taken as is or as an ugly legacy of Stalin’s reign, three quarters of Russia’s citizens live in densely packed areas despite the country spanning 11 time zones over two continents. Again, this is a far higher level than the rest of the BRIC nations.

Finally, the one area of direct comparison for Russia that international investors should be keen to understand is in terms of stock market valuation. Russian shares, as measured by the benchmark MSCI Russia Index, trade now for around five and one-half times estimated 2011 earnings, a nearly 40% discount to the MSCI pan-emerging markets average of nine times earnings. Chinese and Brazilian publicly listed companies fetch around the EM average, while India still commands a steep premium of twelve times earnings.

There are obvious mitigating factors, including the sheer size of Russia’s heavily-taxed low-valued oil & gas producers and the lingering misconception that foreign capital is at risk in Putin’s Russia. Yet history tells us that during the past decade Russian valuations have on occasion approached and even briefly surpassed the broader EM average. Despite their currently depressed multiples, in terms of historic equity market performance from 2000 to the present Russian shares have returned almost 800% in US dollars, triple the reward given to investors in Brazil, India or China.

Russia is undervalued in comparison with GEM

Given the catalyst of WTO accession, a long-overdue debt rating upgrade on the “other side” of the current European fiscal crisis, sustained 5% GDP growth, increased FDI, the powerful spending habits of the Russian consumer, and the world’s media focus during the upcoming 2014 Sochi Olympic Games and 2018 FIFA World Cup, one can easily surmise that Russian equities are undervalued. Part of the rally to come in Russian shares will likely be due to the earnings growth rates that the aforementioned factors help create, and part will be due to multiple expansion as a sense of mainstream normalcy begins to return to the least loved BRIC.

The reports of Russia’s demise as an investment destination are grossly exaggerated; rather than toss the “R” out of “BRIC”, international investors should be more focused than ever on Russia as the most attractive major emerging market in the world.

Source: World Finance Review, December 2011




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