Emerging markets part 3: JSFC Sistema ADRs (ISIN US48122U2042) – Is a Russian company investible (1)?

This is the third installment of my little “Emerging Markets” series (part 1: Ashmore Plc, part 2: Koc Holding).

As the post got really long, I will divide it into 2 parts. Sorry for the “cliff hanger”….

Investing in Russia

Some readers may recollect that I invested into the Russian pharmaceutical company Pharmstandard last year and was very lucky to get out early before the stock subsequently lost more than 50%. My interpretation of this experience is that an actually relatively well-managed company got bullied into buying a worthless company and thereby shifting a lot of company funds to some shady people.

This should be a reminder that investing in Russia is somehow different. Although one shouldn’t be surprised too much about this. Russia is still at a very early stage in capitalism. It is only 20+ years since privatization started really kicking off. For me, the current state of Russia’s capital markets looks a little bit like the US in the 1910s and 1920s, the age of the famous “Robber Barons”. Bullying other people, “unfriendly” take overs using brute force were quite common in those times as well.

Russia itself is clearly different to any other country as well. In contrast to Turkey for instance, Russia is resource rich, on the other hand it looks like very poorly governed from the outside. Resource rich countries are always at risk to fall for the “resource curse”. This is how Wikipedia defines it:

The resource curse, also known as the paradox of plenty, refers to the paradox that countries and regions with an abundance of natural resources, specifically point-source non-renewable resources like minerals and fuels, tend to have less economic growth and worse development outcomes than countries with fewer natural resources. This is hypothesized to happen for many different reasons, including a decline in the competitiveness of other economic sectors (caused by appreciation of the real exchange rate as resource revenues enter an economy, a phenomenon known as Dutch disease), volatility of revenues from the natural resource sector due to exposure to global commodity market swings, government mismanagement of resources, or weak, ineffectual, unstable or corrupt institutions (possibly due to the easily diverted actual or anticipated revenue stream from extractive activities).

This sounds logical, although further down, Wikipedia cites some other studies which seem to contradict this to a certain extent.

So investing in Russia is clearly an adventure. But again, similar to Turkey, the problems are not a secret. The Russian stock market is currently the cheapest in the world, with a p/E of around 5x, P/B of 0,72 and a dividend yield of 4,3%. In EUR terms, the Russian stock Market lost -34,5% since the end of 2010 compared to +37% for instance for the DAX.

I have a compiled a short table, comparing performance (10 year, 5 Year, 3 Year, 1 Year) and valuation of different Emerging markets:

10 5 3 1   P/E P/B
MICEX 8,26% 18,09% -10,24% -18,12%   5,4 0,7
SENSEX 11,09% 14,26% -3,10% -5,02%   17,1 2,6
IBOV 9,33% 2,89% -20,78% -34,32%   17,1 1,1
SHCOMP 6,54% 2,38% -6,62% -14,04%   10,3 1,4
               
Turkey 8,92% 15,92% -7,31% -37,75%   8,8 1,3
Indonesia 17,87% 30,67% 2,43% -22,43%   21,3 2,6
Philipines 21,00% 32,37% 21,75% -15,48%   19,0 2,8

It is interesting to see that Russia didn’t do so bad over a 10 year horizon, but especially underperformed over the last 3 years. In contrast, the valuation level compared to other EM is really stunning. So one can assume that a lot of bad sentiment seems to be priced in.

Interestingly, I just came across this some recent study, which says that “traditional” value investing, i.e. buying contrarian and cheap, works very well in Emerging Markets, much better than small cap investing or momentum.

Fraud, quality of accounts etc.

Personally, I would not make general distinctions between EM countries, but rather on a company levels. I think fraud and fraudulent accounting is much more probable in those countries than in “developed” markets, although even in developed markets fraud might be more widespread that commonly believed. I think it is more important to look at individual companies and their track record in order to get an idea.

Another aspect is to look out for and avoid systemic fraud. I have written quite often about the so-called “German-Chinese” companies. In this case, Chinese companies sold shares abroad to raise “fresh” money mostly for old shareholders which then got transferred directly to mainland China. In many cases, if you looked at the balance sheet of those companies, there was no need to raise money at ridiculously low valuations as they were supposed to be super profitable and sitting on huge cash piles anyway. So not having a domestic listing and use foreign listings in order to help old shareholders cash out implies a high probability of fraud.

I would however make a distinction for companies which have a local listing and subsequently seek a foreign listing without issuing a ton of new shares or old shareholders cashing out. In many of those cases, companies do so in order to raise their profile and make the company more attractive to foreigners. When they do commit fraud, at least the have to face local law enforcement, no matter how weak that might be. For the German-Chinese companies in contrast, fraud has absolutely no consequences as defrauding Non-Chinese investors is not a crime in China. It looks even that in many Chinese fraud cases, authorities support the fraudulent companies in order to avoid a bad image.

Premium/Discount for Russian ADRs

For some reason, Russian ADRs in general seem to trade in relatively wide bands against local shares. At the time of writing, Sistema ADRs trade around 8-9% higher than local shares. Interestingly, there seems to be no real rule for a premium or discount. This is a list of the most traded Russian ADRs on the London exchange:

Last Px Premium Best
GAZPROM-ADR 0.79%
LSR GROUP – GDR 1.12%
LUKOIL OAO-ADR 0.26%
MAGNIT OJSC-SPON 17.18%
MAGNITOGORSK-GDR 0.24%
MEGAFON-REGS GDR 3.94%
MMC NORILSK ADR 2.14%
NOMOS B-GDR 0.31%
NOVATEK OAO-GDR 11.54%
NOVOLIP-GDR REGS 0.47%
PHOSAGR0-GDR 0.69%
PIK GROUP-GDR -1.37%
ROSNEFT OJSC-GDR 0.35%
RUSHYDRO JSC-ADR -1.70%
SBERBANK-SP ADR 3.17%
SEVERSTAL-GDR 0.45%
SISTEMA JSFC-GDR 8.42%
SURGUTNEFTEG-ADR -0.41%
TATNEFT-ADR 2.77%
TMK-GDR REG S -0.79%
URALKALI-GDR 0.53%
VTB BANK-GDR -2.37%

So Sistema trades at the 3rd largest premium, but honestly I have no idea why this is the case. For some reason, the ADR/local share arbitrage doesn’t seem to work here. The premium compared to the valuation is not huge but still should be kept in mind.

A few thoughts on Ukraine / Crimea

I don’t want to enter any political discussions here but just a few observations from my side:

– Crimea was for long time part of the Russian Empire
– It became part of Ukraine only in 1954 without being asked
– It already has an autonomous status within Ukraine

In my opinion, neither Russia nor Europe have a big interest in escalating this issue. Europe depends on the natural gas, oil and other resources from Russia and Russia depends on the money. For me from the outside this looks rather like a defensive move from the Russians in order not to loose their access to the Black Sea. But of course I could be dead wrong and this could also be the start for a real big crisis. No one knows.

Why not invest in Ukraine ?

I have looked at a couple of Ukrainian companies as well, but with most of them I do not feel comfortable. I don’t think that agricultural businesses are very attractive and for the rest I didn’t find any company which was remotely interesting to me. Ukrainian international Government bonds could be an alternative at some point in time.

Timing considerations

Similar to Turkey, most of the people I asked have a clear opinion on Russia: It will get worse before it gets better and one should just wait a little bit when prices are cheaper and things look better and then make a “safe and cheap” investment. Interestingly, I saw this way of thinking really often but it almost always doesn’t work.

As long as a share,a sector or a market goes up, people are happily buying. As soon as something bad is happening, investors panic , sell into a crash. If they enter at all, they will buy again when prices are much higher, not when prices are low. I actually know very few people who are actually buying when things look bad and assets are cheap.

Something very similar is now happening with PIIGS stock. Two years ago, when the headlines were that the Euro zone will break within a few days, people sold stocks at absurdly low valuations just to get rid of them. Now everyone is happily jumping back into the very same stocks, although they are two or three times more expensive. Why is that so ?

I am not 100% sure but I guess much of that can be explained by the behaviour of “typical” institutional investors with a strong hierarchy. If everything goes well, of course the big boss on the top is responsible for the success. If something goes wrong and clients or analysts are calling, the safest thing to do is to get rid of the exposure as quickly as possible. In many large institutions, the number of controllers, “risk managers”, auditors etc. far outnumber the ranks of the actual risk takers. In order to justify their existence, they will show the boss that they are “on the floor” and will force people to cut risks aggressively irrespective of price level.

As a risk taker in such organisations, it is almost impossible to invest in something with bad headline news and falling prices. You buy something and the probability that it falls further is high. So you will look stupid at the end of the month and your boss and a legion of risk managers will yell at you why you are so stupid. You do this a second time and you will lose your job. So the safest thing to do is nothing, until headline news turns positive and prices are climbing, because then the chances to look good in the short term are much better and your bonus will be higher.

So in my opinion, you can’t have it both. You don’t get super cheap prices and “improving” headline news. Either you accept low prices and bad news or “better” news and (much) higher prices.

JSFC Sistema

As the first company to analyse in Russia, I used Sistema, a major Russian conglomerate. Why so ? Three major reasons from my side:

– Sistema is a conglomerate, so it offers a broader exposure to Russia
– it seems to be a large and relatively well-connected company. So the risk of being bullied like Pharmstandard looks remote
– Shares of the company are listed widely, in the US, London and Germany

This is how Sistema describes itself on its homepage:

Incorporated in 1993, Sistema is now one of Russia’s top-10 companies by revenues and is one of the largest publicly traded diversified holding companies in the world. Sistema was ranked number 315 in the Fortune Global 500 list.

Valuation wise, Sistema looks ridiculously cheap as many Russian companies:

P/E 4,9
P/B 0,9
Div. Yield 2,6%
MArket Cap: 7,1 bn EUR
EV/EBIT ~4,1x

To be continued soon……..

25 comments

  • the risks are huge. i believe chodorkowski was wiped out because putin came into power. if the next great russian ruler has a different set of friends, these assets could be distributed differently yet again. investing in oligarchs’ companies seems to me to be a bet on putin (or like-minded) administration.

    i actually like european companies that have a meaningful portion of their business in russia. even if their assets are socialized, investors won’t be completely wiped out. valuations are getting interesting in border-region exchanges.

    • #jomppeli,

      thanks for the comment. I looked at some companies with larger operations in Russia, but I do not think that they are really cheap. Actually, one of my stocks, Vetropack, has 20% of sales in Ukraine.

      MMI

      • i’ve been looking at Tikkurila Oyj myself. probably one of the best paint companies in the world, production in ukraine and a third of revenue comes from russia. before i’ve dismissed them as i didn’t like the russian part when things were going well.

        they’re not dirt-cheap, but this thing has never been cheap since it was spun off in 2010. would love for it to drop some more though.

  • Thank you for this analysis.

    I enjoy especially the discussion about different risky markets and the institutional investing difficulties.

    During the normal life expectancy of an investor will the return of investing in risky and safe stock markets be higher than only investing in safe markets, risk adjusted?
    By safe I mean rule of law. With the existing government debt – explicit and hidden like pensions -, and loose monetary policy one could argue about the standing of e.g. USA and Germany.
    Investors with great track records concentrated on the USA. Just the USA of today may be no longer the USA of 60 years ago. Then Churchill said decades ago about Brazil “this country will always have a future” and it may never grasp it. It seems not to be easy to turn a state into a prosperous one – much more easy the other way round. Even hard for Greece with all the help it receives, or the South of Italy; in both cases more than hundred years of failure.
    I wonder whether this emerging market investing equals a timing game, where you buy something dirt cheap, you expect the news improve, then you sell to a trend buyer. In contrast to a value investment in a safe market you take the additional risk that you are expropriated in some form.
    The Credit Suisse global-investment-returns-yearbook-2014 shows the developed against emerging markets from 1900 to 2013 at 8,3% to 7,4% p.a. return.

    Will you analyze the Russian resource companies, e.g. oil?

    Strange that the Ukrainian and Russian agricultural companies almost all do not reach profit level, the advantages of the black earth seem to be huge.

  • Very interesting. Your rational is to minimize the risk of being expropriated by buying an enterprise which is there for a long time without being expropriated? Would it more convenient to buy a big basket of enterprises with similar properties? With a single enterprise there is still the risk that the most important investors loose a power struggle and the enterprise is expropriated as a mean of the struggle. (Think about Michail Chodorkowskij.)

    • I tend to agree. In this kind of countries it might be a better idea to go for a “basket” of companies instead of relying on one’s superior ability to detect a company without the risk of expropriation and fraud.
      However, any basket has to start with one company…

    • Hi Robert,

      good point. I do actually try to build up a basket across different EM countries and companies for that reason. So Sistema is only a part of my EM basket. Of cours I coul dbuy a basket for each country but I think I can add value by chosing “relatively” better companies. We will see if this is true.

      mmi

    • I’d probably go for the basket approach as well, or even cut out the work and check out some ETF’s and trackers and get exposure that way.

      I didn’t realise the Russian market was so cheap. I have an investment in Avangardco ADR’s, a Ukranian egg producer trading at a P/E of about 3-4. you come across them?

      • #sidekick,

        thanks for the comment. Yes, I have looked at Avangardco, but I don’t really like the Agricultural businesses. Buying ETFs is also a posiibility, but it is less fun…..

        mmi

  • Hi MMI,

    great description of the functioning of large corporation investments. Having the opportunity to make some observations on my own from time to time, I can 100% confirm your analysis.
    In turn, this is a chance for us individual investors to make a cut, so I hope all stays as it is with the big boys ­čśë .

    I’m looking forward to more analysis on Russia, it is certainly an interesting market these days.
    Carry on with your research, even if you will probably start to feel the heat blowing in your face if you start playing the “political distressed country” investor. As you said, it is quite difficult to buy at the bottom, so in most times you WILL have a rollercoaster ride, and A LOT of people coming up with (often very reasonable) contra arguments or even “Schadenfreude”. Just like in the big corporate, only on a smaller scale…
    But no pain, no gain…(?)

    Good luck!

    Woodpecker

    • Hi Woodpecker,

      thanks for the “motivation”. Actually it is qquite fun to look at such companies, that is the main motivation in my research. If you only do it for money, it is not a hobby anymore. At the moment I enjoy reading annual reports of “crazy” comanies…..

      mmi

  • Have you lookd at Vimpelcom?
    Its Russia + Ukrain + Italy + …
    and you in the same boat as Michail Fridman

  • In Russia, you have no legal certainty, in many cases no enforceable property rights, and the least trusted politicians. Unlike U.S. in the 1910s and 1920s where there was mainly a lack of governmental regulation (monopoly abuse, market manipulation).

    Therefore, Russians transfer large parts of their newly acquired assets abroad, while foreign investors keep adequate distance.

    • #Welju,
      this is a good point. I would argue this is pretty much the same in most African and Asian countries as well, especially China. In contrast to China, in Russia you are at least free to transfer money in and out and exchange Rubel into other currencies. In China you are not even allowed to do this and don’t forget: China is officially still communist. Nevertheless, people are prepared to pay much higher multiples for companies in those countires.

      And speaking of legal certainty: Greek bond haircut anyone ? Local law bonds in any country are no safe bet either as we have seen in this case. And subordinated bonds of banks neither.

      MMi

  • Have you looked at London-listed Dragon Ukrainian Properties and Development? Looks to me as a very interesting special situation: huge discount to NAV, net cash, new policy to monetise assets and new management agreement, good shareholders register.

  • Don’t know whether you have seen the recent tv-report on Arte on current Russian practice to force expropriation: http://www.arte.tv/guide/de/046917-000/enteignung-auf-russisch which I believe is very reliable and not biassed. If so you would never ever invest a penny into any Russian stock. This is even worse than the “German-Chines” fraud companies ….

    • hi,

      thanks for the comment and the risk. Yes, this is clearly one of the biggest risks in Russia and I hope I made this clear in the very beginning with my experience at Pharmstandard. Don’t forget, the US in the 1920ties and 1930ties looked very similar, the strongest wil take everything. Investing in small caps doesn’t make a lot of sense. Alos one should stay away from Non Russian companies with significant Russian assets (Stada for instance…).

      mmi

  • My experience:
    I bought shares of potash producer Uralkali after they cancelled joint venture with Belarussia. I figured out that as the lowest cost producer they can beat other market participants. Now the world leaders threaten Russia with trade bans/embargoes so even if they are lowest cost producers they might have problems selling their product.

    • Thanks for the comment. Yes, there are a lot of risks. on the other, hand, trade embargoes will hit a lot of German companies (and households) as well. No Mercedes Benz for the Oligarchs anymore….and rising heating bills along with rising electricity bills will not win a lot of elections.

      Howver, Uralkali was not really cheap back then compared to the rest of Russia.

  • P.S. A PE of 5 (=earnings yield 20%) and a dividend yield of 4.3% according to your information, means a payout ratio of less than 22%. All but two stocks of the DAX have a higher ratio (and one only lightly below), if the following statistic is correct:
    http://www.topyields.nl/Top-dividend-yields-of-DAX30.php

  • TL;DR,
    but just one comment: Why do almost all of the russian stocks have such a low dividend yield, while having a ridiculously low PE-ratio? Why is the payout ratio so low? That is something which makes me suspicious. See:
    http://www.topyields.nl/Top-dividend-yields-of-MICEX.php

    Okay, there are a few stocks with dividend yields of 8% or more, like Moesk with a PE of 2.8, but you find that in Europe, too, but rather in stocks like Orange, RWE or E.On, where the payout ratio already is near 100%.

    • Good question. One reason is that unlike in the rest of the world, there are/were big opportunities to invest in Russia if you are a Russian company. I will come to that in the second part….

      MMI

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