Low valuations in Russia could lead to long-term gains

For a fund manager, investing in Eastern Europe is a little like trying to do your job with one hand tied behind your back. The MSCI Emerging Europe index consists of just five countries, which may not seem particularly narrow or restrictive when you consider the wealth of investment opportunities available in single markets such as North America or the UK. But emerging Europe is a little different.

The market in Russia, a country spanning nine time zones and home to more than 143 million people, is the largest in the index, but it consists of just 30 listed, investable companies. Hungary's market, the smallest, has only three. Yet a posse of fund managers find opportunities in this enclave of the investment world.

Russia, Turkey, Poland, Hungary and the Czech Republic might not be as sexy as Asian emerging markets or as dynamic as the African frontiers, but for long-term investors who can hold their nerve, significant rewards could be had.

Russia

Russia, the heavyweight accounting for some 55% of the MSCI index, has perhaps the most deeply rooted preconceptions to overcome.

A broker's view

Darius McDermott, director at Chelsea Financial Services: "The market is very cheap at the moment, but if you have a closer look, about 60% of it is Russian oil companies, most of which are partially state owned and at the whim of politicians. The trouble is, although these stocks have attractive valuations, I can't think of any other aspects that suggest it's a buying opportunity right now, so I'm still cautious.

We like Neptune Russia and Greater Russia or, for a more diversified play, JPM New Europe or Fidelity EMEA."

"The world seems to have given up on Russia," laments Elena Shaftan, head of Jupiter's Emerging Europe equities team. Investors fear poor corporate governance, government interference, corruption and a lack of reform. Hugo Bain, senior investment manager at Pictet, says the situation is improving, but change is not happening as quickly as investors would like.

The upshot of this lack of interest, however, is that valuations have rarely been lower. The average Russian company is trading at a price/earnings (P/E) ratio of 4.5.

Tom Wilson, manager of the Schroder Emerging Europe fund, points out that these numbers are being dragged down slightly by companies in the energy sector, which are particularly cheap, but adds that there are "compelling investment opportunities in most sectors", which may come as something of a surprise.

Russia has historically been associated with commodities and energy companies, and it is true that this is where the majority of investable companies are found. They account for 40% to 60% of the market, depending on which index you look at, says Baring Emerging Europe fund manager David Reid. But Wilson likes the consumer sectors, where consumption is robust: information technology is experiencing rapid growth as broadband penetration increases and online advertising becomes more prevalent, while telco companies are producing healthy cashflow yields and food retail is growing quickly.

Julian Mayo, director at Charlemagne, debunks some common misconceptions about Eastern Europe

Myth: Russia doesn't pay dividends

People associate Russia with poor corporate governance, but there are some really well-run companies there, some of which pay better dividend ratios than can be found in traditional emerging markets. Spurbank, rail company Global Trans and mobile phone company MTS all pay excellent dividends.

The trouble, says Bain, is that these areas are difficult to access. Russia's market is still largely illiquid and Pictet's house stance is to minimise liquidity risk, so he is particularly restricted. Bain is more interested in the likes of Gazprom, one of the world's most profitable energy companies, which bizarrely trades on a P/E of three.

Elsewhere, the likes of vodka producer Synergy - which is switching its focus to quality rather than quantity - and hypermarket operator Okey look strong. Peter Taylor, manager of the Aberdeen European Frontiers fund, also likes Sberbank, which he calls the best-run bank in Russia.

Reid says investors may be surprised to learn that the healthcare sector is also attractive; he invests in a hospital operator in the country. "Demand for high standards of care is increasing as wealth grows and people have the choice to step away from public healthcare, which may be underfunded," he explains. Reid thinks the sector will provide an exciting growth opportunity in the next couple of decades, but few investors can access it, as its companies are small, illiquid and often unlisted.

Still, there appear to be a lot of ifs, buts and maybes surrounding the country's outlook. Wilson says economic growth is quite weak but should improve, agriculture is looking better but is coming from a low base, the government is expected to ease monetary policy and automotive sales should be stronger in the latter part of the year.

But Reid warns investors have to accept such countries for what they are. "Emerging markets are very different from developed ones, and political risk in all its forms is one of their defining features."

A broker's view

Adrian Lowcock, senior investment manager at Hargreaves Lansdown: "Russia is the wild west of emerging markets: shareholders' rights are often [ignored], corporate governance is poor, many companies are controlled by oligarchs and political interference is high.

However, companies are cheap, and investors looking for value and willing to take risks find Russia attractive. The best approach is to drip feed money in to spread the risk, as [companies] could get cheaper in the short term."

The fact is that the market is volatile. In 2007, when the value of crude oil fell to around $30 a barrel, the Russian market fell by 85%. But for investors with at least a five-year time horizon and a healthy appetite for risk, Russia's lack of debt, improving governance and commitment to reform make it worth a look.

Although the index can't be described as uncorrelated, each of the countries in emerging Europe tends to thrive in slightly different conditions, which makes it a more balanced regional market than you might think. For example, Russia prospers when commodity prices soar, while Turkey's more consumer-oriented economy prefers lower commodity costs.

Emerging slowly

The long-term prospects for emerging Europe may be promising, but investing there is not going to be an easy ride. For those convinced of the story and able to sit tight for several years, now, when valuations are unlikely ever to be cheaper, is a good time to buy in. "Emerging Europe generally is the least fashionable region for investment, which makes it an interesting valuation opportunity," says Reid.

However, the volatility of the region cannot be denied. There is little continuity in the performance of emerging Europe funds: three-year total returns vary from gains of almost 21% to losses of just as much. Bain says if you believe oil prices are set to remain around $100 a barrel, Russia should be a sound investment; but there is more to these countries than that.