Russia 2010 Worth A Tactical Look: An Investor's Guide To The Risks and Opportunities in 2010

Russia 2010
Worth A Tactical Look

An Investor’s guide to the risks and opportunities in 2010
November 2009
James Beadle
Investment Summary
Russia’s under-performance relative to its BRIC peers is justified and well-explained.

Yet, it also creates upside potential. Russia is beginning a new development phase,
which creates opportunity and makes it an attractive buy for 2010.
The potential for decisive progress is limited and many systematic problems will
remain. In the long-term Russia has some serious structural issues to contend with.
In the medium term, things look brighter. Efforts to improve the nation’s investment
climate and economic development model will increase interest in Russia, leading a
narrowing of valuation spreads in 2010. Russia is certainly not without its risks. A
second wave of financial/economic crisis would again punish Russia as commodity
prices fell. But, if such a crisis can be avoided, Russia offers very attractive risk-
adjusted potential in the coming year.
Russia 2010 – Worth A Tactical Look
About the Author

James Beadle is an investment professional with more than
eight years of experience working in and around the former
Soviet Union.
A British national, he holds and MBA from Barcelona’s EADA,

and an MSc in Financial Engineering from the International
University of Monaco.
Since first visiting Russia in 1999 he has worked in sell-side

equity research, as a consultant for the OECD, as a journalist
and as a hedge fund manager.
From 2006-09 he served as chief investment strategist for Pilgrim Asset

Management, where he co-managed $250 mln in funds and individual accounts.
As the manager of the Pilgrim Russia Investment Fund and the Pilgrim Pacific Fund
he successfully outperformed equity benchmarks and most of his peer group. He
stepped down from direct fund control in July 2008 (before the market collapsed
during the war with Georgia) when fund principals rejected his call to liquidate market
positions. The Russian market went on to fall
another 75%, bottoming in March 2009. Russia Focussed Track-Record
PRIF* Vs RTS Index
James is currently based in Vilnius, Lithuania, 160
from where he serves Russian and international 150
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clients with emerging and global market 130
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strategy. 110
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- jamesdbeadle@yahoo.co.uk 80
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RTS PRIF
* PRIF continued to trade after July 2008, when James stepped-down

as manager after making a market-wide sell recommendation.
Nothing contained herein constitutes an offer to sell or a solicitation of an offer to buy securities. Prospective investors
should review the appropriate offering memorandum and subscription documents, and consult with their own counsel
and advisors as to all matters concerning investment in
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Contents
Introduction .............................................................................................. 4
Why Russia Under-Performed In The Global Financial Crisis .................. 5
Structural Issues ................................................................................... 6
Cyclical Issues ...................................................................................... 8
What Caused The Market Turnaround? ................................................. 10
The Global Edge ................................................................................. 10
On The Russian Side .......................................................................... 11
How Is Russia Now Valued? .................................................................. 12
Outlook For 2010 & Beyond ................................................................... 13
Weaknesses Revealed ....................................................................... 13
Limited Prospects For Structural Change............................................ 13
What's Real, What's Not?.................................................................... 14
Becoming A (Guarded) Optimist.......................................................... 15
What To Buy? ........................................................................................ 15
Avoid Costly & Illiquid Funds............................................................... 16
Liquid Equity Overview........................................................................ 16
Investment Risks.................................................................................... 19
Risks On The Decline ......................................................................... 19
Risks Set To Remain .......................................................................... 19
Conclusion ............................................................................................. 20
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Introduction
Correlated to risky assets globally, Russia has been range bound in recent days.
However, the slow-down in the bull rally has yet to morph into a serious correction.
New money has become hesitant to enter the market so late in 2009, given rallies of
over 100% since the March lows. Yet, those with a longer-term horizon would do well
to begin allocating capital as Russia has a positive outlook for 2010.
Chart 1: Russia’s Recent Equity Market Surge Relative To MSCI EM Index
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RTS MSCI EM
On the credit side, Russian CDS spreads remain well bid, after a sharp recovery from
highly distressed levels in 1Q09. Bond yields have tightened enormously from highly
distressed levels and are now closer to fair value. Nonetheless, a bullish outlook for
the ruble and Russian economy imply further upside in the coming months.
Chart 2: BRIC Nation 5-Yr CDS Spreads (bps) – Russia Stands Out
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China Russia Brazil India
After a disastrous period in which Russia has suffered uniquely among its BRIC peer
group, this report takes a look at where it stands, how it got here and what are the
forward perspectives.
Without neglecting the risks, it concludes that the case for investing in Russia is
positive going into 2010. Assuming that global asset and commodity prices avert a
second major down-wave, Russia is well positioned to continue providing positive
returns in the medium term.
All liquid Russian asset classes remain heavily discounted to their BRIC peers. This
discount was previously justified by Russia’s relative disinterest in attracting
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international investors. But the crisis has changed that. Going forward Russia will
pursue new policies genuinely seeking to attract capital. This will prove the case
even if oil prices rise in 2010. For now at least, Russia’s forward-looking policy is
decoupling from its present day oil dependence.
While this political and economic chapter is unlikely to resolve Russia’s structural
problems, or to fully reverse the damage inflicted to its reputation in recent years, it
will be sufficient to attract substantial investment flows. Some discount will likely
remain, as investors will continue to demand higher returns than in other emerging
markets. This is only right – Russia remains an unstable and risky place to invest,
with serious long-term issues to resolve. Nonetheless, changing policy creates an
attractive medium term investment opportunity if the global recovery remains on
track.
Why Russia Under-Performed In The Global Financial Crisis

As Charts 3 & 4 show, Russia suffered uniquely in the global financial crisis, as
compared to its peer group.
Although all four BRIC nations were affected by the 2008 global recession and
financial break-down, Brazil, China and India suffered equity market declines of 60-
70%, compared to Russia’s plunge of 80%. Likewise, “BIC” GDPs have largely
remained positive, while Russia is set for -6 to -7% GDP change this year.
Chart 3: BRIC Equity Markets (Relative) – Russia Lagging Over Longer-Term
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Shanghai Comp RTSI Bovespa Sensex
Chart 4: BRIC GDP Percent Change YoY – Russia Takes A Hit
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In part, such direct comparison is unfair. Although the BRIC group constitutes an
exciting investment universe and a catchy acronym, the fundamentals of these four
nations are quite different. Differing performances within the group do not
automatically reflect country-specific failings.
For example, many compare Russia to Brazil, which also enjoys an abundance of
commodities. Yet, the Brazilian market is about half as dependent on commodity
exports (around 18% of GDP this year) as Russia and its capital account is far more
tightly controlled. As a result, its internal market (including its financial sector) is far
more self-sufficient.
For its part, Russia has suffered less than many of its Eastern European nations, and
might easily point to their relative performance to defend its record. Even so, an
objective analysis would fairly criticise Russia for its failings. In fact, President Dmitry
Medvedev has recognised this publicly. Reasons for Russia’s poor economic
performance are both structural and cyclical.
Structural issues
Dependence On Commodity Exports. Russia jostles with Saudi Arabia for the titles
of number one oil producer and exporter. As such, it is hardly surprising that the
commodity bull market left its mark. As oil prices soared to $146/bbl, Russia could
hardly be expected to stand unaffected – not least if one also considers its monopoly
on gas exports to a large part of Europe (gas prices are formulaically tied to oil
prices) and its growing sales of gas to Asia.
All things considered, Russia did a reasonable job of seeking to limit the impact of
so-called Dutch disease. Rather than allowing oil export revenues to flow directly into
the economy (this would have caused far higher inflation, ruble appreciation pressure
and income disparity) the government taxed hydrocarbons heavily.
Such taxation, coupled with repeated budget surpluses, succeeded to some extent to
sterilise export revenues (as evidenced by FX and budget reserves). However, the
longevity of the bull market sharply eroded commitment to income sterilisation, and
state-spending soared as a consequence. At first, government spending was directed
to the poorer parts of the population, state-employees and pensioners. Measures to
increase payments to these groups above inflation successfully improved broader
quality of life.
As commodity prices continued to soar, so too did state spending. And yet, annual
budgets continued to close in surplus, increasing the pressure for further spending
the subsequent year. It looked like a one way trade, and for a long time it was. But,
each year, more and more revenue was diverted from the private sector to the
government, which expanded considerably.
Redistribution worked as the money flowed, rather than trickled, down, but this was a
consequence of its abundance rather than effective state policy. Russia is no
exception to the rule that the state is an ineffective manager of commercial business,
and the Russian government was dramatically expanding its reach into the economy.
Thus, when commodity prices plunged in 2H08, it was immediately clear that Russia
was dangerously exposed. The ruble came under heavy pressure (see below) and
the state swiftly had to open its coffers to sustain spending and support the struggling
private sector (also see below).
As a clarification: During the height of the bull market, several foreign-oriented

investment funds presented the argument that Russia had decoupled from oil
prices. Technically, it was true that for a while GDP growth was being driven by
consumption more than commodity exports. But these arguments glossed over
the fact that it was higher salaries paid buy the government - using hydrocarbon
taxes - that funded increased consumer demand.
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Weak Domestic Capital Market. Considering that so much money was entering the
Russian system through exports, it is perhaps surprising that the domestic capital
market was so underdeveloped. Yet, the reality is that the government’s rapid
accumulation of capital and intervention into so many economic spheres was
crowding out the public sector.
FX reserves reached close to $600 bln, but by far the majority of this was
government capital, conservatively managed in central bank affiliates. Russia had no
system for affordably lending this money domestically to finance investment and
expansion. As a result, Russian companies – showing rapid balance sheet and profit
growth – turned to international markets for low-cost funding. The global financial
market was, of course, awash with liquidity thanks to the miracles of securitisation
and Asian, Middle Eastern and Russian export-revenue recycling (the drivers of the
so-called Great Moderation).
Western banking systems enjoyed an impressively stable carry trade borrowing from
emerging market governments, only to lend back at higher rates to corporations in
those same nations. Russian companies were particularly reliant on external
financing, as their borrowing needs sharply exceeded the domestic banking system’s
capacity. Plus, with inflation stuck in double digits and the ruble steadily climbing, the
ruble was hardly an attractive borrowing currency.
When it came, the financial crisis struck the Russian commercial sector very hard by
causing a sharp reduction in capital available; falling commodity and asset prices
dramatically undermined the value of Russian collateral; and the knock-on impact in
the Russian economy further increased the perceived risk of lending there.
State Interference In The Private Sector. State

During his first two years in
interference began in earnest with the attack on Yukos, a
globally significant event, which represented a sea-change power, Putin was seen as a
in the Putin era. powerful, uncorrupted, pro-
During his first two years in power, Putin had a very
market reformist.
different reputation, he was seen as a powerful, uncorrupted, pro-market reformist
with a clear view of the challenges Russia faced. Benefiting from the post-default
economic recovery, he quickly began to pursue real change, and struck a pragmatic
agreement with the oligarchs that had so dominated Russia throughout the Yeltsin
era.
The “you stay out of politics, government will stay out of business” pact seems
incredible in retrospect. It is certainly true that Yukos CEO Mikhail Khodorkovsky had
political ambitions, but in hindsight, his tentative crossing of that dividing line opened
the door for the government to surge into business.
Government interference in business is invariably bad in general, but in Russia it was
negative for very particular reasons: The nature and goals of the government attack
on Yukos grossly exceeded any reasonable response to Khodorkovsky’s growing
political curiosity. They also obliterated any perception of a functioning legal system,
transferred huge assets into state control and empowered the siloviki group, from
which more, lesser publicised government attacks on business then flowed.
Not only did large parts of the Russian economy come under the inefficient control of
the state, but the Yukos affair sharply increased the risk of doing business in Russia.
Long-term private investment continues to suffer the consequences to this day.
Bureaucratic And Judicial Corruption. The government’s destruction of Yukos had
implications beyond the expansion of state interests and the soaring risks of long-
term investment. In addition to empowering the siloviki political group, it also
empowered the corrupted bureaucracy, and undermined progress toward an
effective independent judiciary. These developments were further fuelled by rapid
economic growth (without such large export capital-inflows, corruption would not
have flourished to such an extent). It became both extremely costly and extremely
difficult to conduct business in Russia - another reason why quick-profit projects
flourished at the expense of longer-term sustainable development.
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Cyclical issues
Political Events Of 2007-08. The severity of Russia’s collapse in 2008 was not
exclusively a consequence of its weak development model and over dependence on
the commodities bull market. Domestic politics in 2007 and 2008 also contributed
dramatically. In fact, no investor has any excuse for losing more than 25% in the
liquid Russian equity market in the Great Crash of 2008-09:
- Elections. The first political events of real relevance were the 2007 and 2008
elections, which constituted the Putin-Medvedev transition. Commodity markets were
soaring as these events approached, leaving government coffers flush. Even more
important, Putin was highly cautious as to how the power transition might be
smoothly managed. As a result, he was ready to spend hugely to facilitate transition,
and had the means to do so. State spending soared in the run-up to the
parliamentary elections, and remained high through the presidential vote that
followed.
Increased spending had several impacts. First, it greatly fuelled both ruble
appreciation and inflation; second it boosted public optimism – which helps to explain
the severity of the sentiment shift that followed. Third, this spending created a bulge
in economic growth, which was never sustainable and with retrospect created an
artificially challenging year-on-year base for subsequent data comparison.
Chart 4: Govt Spending (RUB Mln) – Elections Exaggerate Crisis Impact
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1400 Economic Crisis
Stimulus
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1000 Pre-election
800 spending
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- Putin’s Posture. Growth in early 2008 was not only fed by increased state-
spending. It was also fuelled by global events. The first half of the year was
characterised by a sharp increased in emerging market confidence, with an extreme
form of the “decoupling” theme quickly establishing the perception that emerging
markets could sustain growth while the US fell into recession.
Soaring commodity prices were the most obvious reflection of this investment theme.
As commodities charged higher, with oil peaking at $146/bbl in early July, Vladimir
Putin, now prime minister, became ever more bellicose. Not least, he was agitated
about the soaring costs of large-scale infrastructure
projects, such as the Sochi Winter Olympic preparations. Political events ironically
Perhaps unaware of the impact he was about to have, in provided ample opportunity to
late July he verbally assaulted an oligarch on live exit pre-financial meltdown.
television. Mechel owner Igor Zyuzin had failed to attend a
meeting about how to “control” pricing in the metals and mining sector, using the
excuse that he was sick. Putin expressed his disappointment at Zyuzin’s absence by
threatening to “send a doctor to fix his problems.” The market reacted instantly,
remembering the Litvinenko case in London, and treating this threat as a flagrant
euphemism. After months of spending millions of dollars portraying stability and
progress, Putin suddenly publicly demonstrated exactly how business is conducted in
modern Russia. The selling that followed was violent.
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Days later, the selling accelerated further, as Russia and Georgia went to war. These
two political events ironically provided ample opportunity to exit pre-financial
meltdown, at least for those nimble enough to reverse position quickly. (Several key
Russia-oriented investment funds suffered from being oversized and unable to swiftly
exit their positions as buyers disappeared.)
Side note: The sharp pre-Lehman collapse also exposed the amount of leverage
in the Russian market. The impact of this leverage would ultimately surprise
everyone, although its presence was a greater shock to outside investors.
Insiders were well aware of pockets of leverage: shares being repo-ed, IPO
funds recycled into the equity market, and such like. No one really acknowledged
this risk, but didn’t take deep analysis to figure out that this leverage was a
market-wide phenomenon.
- Ruble Devaluation. The final problem at the cyclical level kicked-in slightly later.
Throughout his presidency, Putin had repeatedly demonstrated a lack of
understanding about economic mechanisms (a weakness excellently compensated
through the employment of a strong finance team). He shocked the market, however,
when he declared that the ruble would not devalue, even as oil fell below $40/bbl.
The writing was on the wall and many fretted about the logic of a gradual
devaluation, which took several months and $200 bln of reserves.
In fact, this devaluation policy was not a complete disaster. It gave the public time to
adjust to a weakening ruble, rather than face another shock loss of savings. It also
gave the corporate sector time to prepare for FX loan payments coming due. In
reality, Russia saw very little true capital flight, most of the lost FX reserves went to
the Russian private sector, hedging and reducing its risk.
Considering that the central bank carefully controlled the rate of decline and the
liquidity of the ruble trade (contrary to public opinion, the ruble is not really “fully”
convertible – no managed currency is), this strategy never looked systematically
threatening. And, it achieved much by way of stabilising the economic adjustment.
One might remember, of course, the origin of the policies that caused such a severe
adjustment in the first place, but finally the ruble bottomed with Russia strongly net
positive over the business cycle.
There were negatives however. In addition to exporting vast quantities of
commodities, Russia is highly dependent on importing a wide range of industrial and
consumer goods. Hence, the weaker ruble sharply fed inflation. At a time when most
countries were seeing price pressure dangerously fall, Russian inflation suffered a
painful jump. This was worse than stagflation - output didn’t stagnate, it plunged and
yet prices soared. As the ruble has reversed course, so the output gap is beginning
to weigh on prices, but the damage was lasting.
Chart 5: BRIC GDP Percent Change YoY – Russia Takes A Hit
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What Caused The Market Turnaround

The economic and financial market collapse was long and painful. Thanks largely to
the incremental ruble devaluation policy, Russian asset prices continued to decline
until March this year (the MSCI Emerging Markets Index bottomed in November
2008) and 2009 real GDP change is projected at -6 to -7%.
The Global Edge
But turnaround the market did. As one might expect from a nation that came to rely
so heavily on commodities prices, the turn was closely correlated to the oil market.
For its part, oil recovered in line with global markets. Global markets recovered
thanks to exceptional measures introduced by developed world central banks and
governments. Notably, announcements of quantitative easing by the BOE and FOMC
are closely correlated with markets bottoming.
Prices of all manner of financial assets had fallen to distressed levels (certainly
technically and in most cases fundamentally), despite the attraction of free money.
The banking system was being underwritten though – no further large-scale
bankruptcies were expected. Central banks commenced direct extraordinary policy
actions to prevent a depressionary spread of deflation. Investors took the hint and
followed suit, perhaps acting on the old maxim: “don’t fight the Fed.”
Money began to flow into all manner of risky assets, not least equities and oil. With
oil prices rising, the gradual ruble devaluation was able to halt, and prices rapidly
began to normalise.
This sharp turn in risk is not without its justification of course, largely due to the
financial conditions created. True to his word in a 2002 Federal Reserve speech, Ben
Bernanke learned the lessons of Milton Friedman’s “Monetary History of the US:”
Monetary Policy... In the 1930s, the Fed had worsened the financial crisis by
tightening policy. Bernanke had publicly acknowledged the role that tightening policy
played in the Great Depression – driving down household wealth and worsening
economic demand. His policies – and those of many other central banks – sought to
reverse the collapse of asset prices so as to reduce the pain on the consumer, and
thus far they appear to have worked.
Whether or not the financial crisis is over is open to debate, and beyond the scope of
a Russia specific report, but at this stage there can be no disputing that the Fed’s
policies have brought the US and global economies back from the edge.
...Drives Fundamentals. The fundamentals come in through the normalisation of
profits. It is certainly true on a global basis that equity earnings remain down sharply
from their peak, but they now stand at “normal” recessionary levels. In 1Q09 they
were in depression territory.
Despite its unique economic difficulties, this is also true for Russia, as the below P/E
chart demonstrates.
Chart 6: RTS Index, 2010 Earnings ($) – Valuations Plunge, Earnings Stabilise
300 3100
2600
250
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200 1600
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100 100
6/30/2007
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2/29/2008
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2/28/2009
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2010 Earnings/Share (Est) RTS
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What drove the rebound in earnings? Oil is the most obvious driver, Chart 7 below
shows how prices have recovered since 1Q09. This price dynamic has been
reflective of the broader commodities space, with China dramatically increasing
imports and fuelling sharp rebounds of a wide range of hard commodities. Russia’s
hard currency machine is back in business.
Chart 7: WTI Oil 2009 – Front Month & Average Daily Oil Prices ($/bbl)
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65
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45
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25
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Front Month YTD Avg 1Q09 Avg
On The Russian Side

But the Russian government has also contributed substantially, utilising budget
reserves and more to finance counter-cyclical spending.
True, not all this money has been well spent; much of it has gone into protecting
zombie enterprises and insider interests. But, other measures have been direct and
successful. Notably, oil taxation has been eased significantly.
Going forward, earnings can expect support more broadly. Not least, the state is
putting through large real pension increases, and inflation rates are declining sharply.
A much-anticipated second wave of banking stress has so-far been averted. (NPLs
remain very high, but banks are again beginning to lend actively.)
GDP most likely turned positive QoQ in 3Q09, as confidence returns to both
consumers and businesses.
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How Is Russia Now Valued?

Thanks in large part to such a painful sell-off, Russia has been one of the best
performing liquid markets in 2009.
Chart 8: RTS Index – Still Down, But Top-Performing Liquid Equity Market 2009
-100% -50% 0% 50% 100% 150%
China 74%
-47.9%
Russia 127%
-42.3%
Brazil 78%
-9.3%
India 75%
-19.3%
MSCI BRIC 88%
-29.1%
MSCI EM 70%
-28.0%
YTD Return Change From Peak
Determining how it is now valued is not a simple matter. Given that I am arguing a
domestic improvement vis-a-vis peers, the logical way for an international investor to
value Russia is relative to the alternatives.
Russia has always traded at a discount to its GEM peers, as it continues to do today.
There are three reasons for this:
1. Market problems. From Yukos to Shell, to TNK-BP and onto the war in Georgia,
Russia has not failed to provide domestic reasons to require high risk premiums.
2. Fundamentals. With so much of Russia’s Enterprise Value directly tied to
commodities, lower valuations can be expected. Where other emerging market
prices are buoyed by exposure to high valuation sectors, such as retail, Russia is
dominated by commodity companies, which tend to sport lower valuations.
3. Openness. The capital account is relatively open. Although the ruble is not free-
trading, it has become much easier for Russians to invest abroad. As such, local
markets are not forced higher by trapped capital, as is the case in China, Brazil
and many other emerging markets. In a sense, this makes Russia one of the
most fairly valued markets.
As the chart below shows, today is no exception to historical precedent. Russia
remains valued below its BRIC peers. This discount spread is destined to tighten,
considerably in 2010.
Chart 9: Forward P/E Spreads – BIC Premiums Near Historic Highs
4.5
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3.5
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10/10/2008
1/10/2009
4/10/2009
7/10/2009
10/10/2009
SHCOMP/RTS Bovespa/RTSI Sensex/RTSI
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Outlook For 2010 & Beyond

By now, even the traditional russophiles have long
acknowledged that Russia is a global macro trade. The
Assuming a stable global
market’s collapse reflected a re-coupling to global outlook, Russia can expect to
economic drivers (sharply reversing the moderate benefit from a revitalised
progress made in defining Russia as a domestic domestic investment story.
fundamental trade). And, the recovery has been
dominated by a global resumption of risk-taking.
But, looking ahead, assuming a stable global outlook, Russia can expect to benefit
from a revitalised domestic investment story.
Weaknesses Revealed
For over ten years, Russia has been dominated by Vladimir Putin. This powerful
leader has changed greatly in that period, and he is going to change again.
There is a growing debate about how stable Russia would be without Putin, with
increasing voices calling for his departure. Yet, this argument is largely irrelevant. It is
highly unlikely that Putin will leave the Russian political scene in the coming months
or years. However, he is likely to alter his style and strategy. The financial crisis has
been a tough lesson, exposing Russia’s weaknesses and its inability to grow outside
the integrated global economy. This is a lesson that Putin will certainly learn, and
which will lead him to support President Medvedev in a campaign toward more
transparent, accountable growth and diversified economic development.
Years of soaring oil prices overwhelmed Putin’s initial political drive for reform and
liberal development. They empowered the siloviki group and led to a more
authoritarian, state-controlled economy.
Oil prices are unlikely to quickly return to their 2008 highs in the near future. But,
even if they do, Russia’s weaknesses have been exposed, and the drive for reform
has a new and clear momentum.
Limited Prospects For Structural Change

Ultimately, the chances of Russia conclusively turning Medvedev has launched a
around in the next few years are very low and this will be grassroots campaign to
partly accepted by everyone. The campaign for change
will be observable in two key forms:
introduce cultural change.
- Superficial Improvements. While Russia struggles with
fundamental peaceful change, it has long been good at superficial improvement.
Today is no exception, on the surface Russia is going to begin to look much better. In
part this is because things can hardly get worse.
But, it is also because the authorities have become so media savvy. Just as they sold
the Russian population a compelling vision of humanitarian catastrophe in South
Ossetia to garner patriotic support for the August 2008 war, so they will (more
globally) sell a vision of ‘Russia In Reform.’
- Real Change. While cynical superficial change will feed a binary debate about
whether or not Russia is really improving, the campaign for change will also bring
real improvements. It is highly unlikely that Medvedev would ever overstep his
authority, but there is certainly a degree of sincerity in desire to clean Russia up.
In fact, he appears to grasp the fact that the challenge he faces is beyond the scope
of his lifetime. Acts such as the extension of the presidential term from four to six
years severely dented his reputation, but his campaign to fight corruption and
bureaucracy undoubtedly has some integrity to it.
Many have criticised Medvedev for his weak or disingenuous interest in reform, but
the optimistic angle is that he has launched a grassroots campaign to introduce
cultural change. Yes, it starts small, but his reaching out via open media sources and
to (selective) disenfranchised elements speaks of an understanding that reform can
13
only come with time and through widespread opinion change. Thus, even as the
Kremlin brags of big, shiny and superficial progress, the incremental seeds of hope
may be slowly spreading behind the scenes, at a cultural and social level.
What’s Real, What’s Not?

Investing on small real and larger illusory change sounds dangerous. What can we
really expect? There is little doubt that both Medvedev and Putin would like to see
real progress.
The program for change is likely to have two angles – domestic improvement and
opening to investors.
Domestic Change Agenda. The domestic change agenda has in fact already
begun, but is likely to accelerate and feature high profile reports of improvements and
successes. The main goal will be to show that corruption, bureaucracy and
associated costs of doing business are on the decline. Areas of focus include:
- Streamlining business registration and regulation, especially for small businesses,
reducing the bureaucracy’s scope for interference;
- Creation of funds and resources for SMEs;
- Further allocation of resources and preferential conditions for economic
diversification through sector development, especially in technological sectors;
- Tax simplification and reduction;
- Campaign against corruption, including the prosecution of high profile graft cases
across all areas of the public sphere;
- Sales of state-owned businesses to show decline of state involvement in the
economy.
Opening to foreign investors. A concerted effort will be made to attract foreign
capital. This campaign has begun at the edges, with Putin recently meeting foreign
investors for the first time in many years. It will gain pace as Russia places its debt
on the international markets to finance its 2010 budget (with a high chance of
improving the cost of capital for the whole nation as it does).
High profile projects, including oil and gas development, will receive maximum media
attention, seeking to show a reversal of recent years when foreign companies were
pushed out. Concessions will be offered in other sectors too, as FDI provides a clear
tool for luring portfolio investment.
Foreign investors will be lured to all manner of opportunities, from sovereign debt to
FDI, to listed equity and especially to local fixed income. The weakness of the
domestic capital market is a clear learning point for the authorities. With the dollar
losing support as a single global currency and capital markets opening, indeed there
is no real reason why the ruble market cannot gain strength – as many other local
currency capital markets are likely to.
Joining The WTO. The wildcat call on the global
development front is accession to the WTO. Russia has Accession to the WTO will bring
dragged its WTO negotiations out longer than almost quantitative economic
anyone remembers. The reason is simple: joining the improvement and drive financial
WTO directly contradicts the interests of many powerful
markets up sharply.
vested interests – inefficient local businesses and the
bureaucrats that profit from supporting them.
In many ways, joining the WTO is a game-changer. It will immediately weaken many
of the barriers to more efficient development.
It is no surprise then that Russia has stalled on completing negotiations, but it
continues to express a desire to join. If a new globalist policy takes hold, Russia will
find a new impetus to address the point that it is the largest nation operating outside
this global body.
14
At present, the financial market reflects many years of broken commitments and
promises, it prices near zero probability of Russia actually joining the WTO. Even
well established market players are exhausted of wrongly predicting Russia’s
accession. But next year this could all change. When it comes, accession to the
WTO will bring quantitative economic improvement and drive financial markets up
sharply.
Becoming A (Guarded) Optimist

For many years I have spoken critically and often pessimistically about the prospects
for progress in Russia. Today I remain highly sceptical of chances for success on the
path of change that the nation is about to begin. Yet, I find myself refreshingly bullish
about the Russian investment case going into 2010.
Buying Change. The first reason for this optimism is fundamental. The financial
crisis of 2008-09 has shown just how dysfunctional Russia is vis-a-vis its direct
peers. No longer is Russia clamouring to claim a seat at the table with the world’s
leading developed nations, it has come to recognise that it will take hard work just to
keep up with its economically comparable peers. Meanwhile, the shifting balance of
global power makes that peer group more influential.
The sad reality is that Russia can hardly fall further. True, the bounce puts it close to,
if not above, fair value for year-end 2009, but the prospects for improvement are real.
Russia is a buy because it must surely improve from here. Yes, it could get worse,
and yes it is a tragedy that we waited so long to get to the start line. But, conditions
are stable enough domestically and globally to bring real improvement.
Buying Optimism. With $400 bln of reserves and the world’s largest commodity
base, Russia remains a big hitter with the economic firepower to put on a good show.
A well managed PR campaign will raise its profile sharply.
The “buy optimism” argument is based on the idea Keynes once put forward
regarding who to vote for in a beauty contest. The case for buying Russia is not so
much about what change is possible, but about the fact that a great effort to change
and show improvement will influence global investor perceptions sharply - buy
because others will believe.
Russia has the desire and the resources to woo many investors. My 2010 buy call is
driven by this desire to pre-empt wider investment inflows.
What To Buy?
If the case for investing is clear, then the next obvious
Years of investing in Russia
question is what to buy? Here, I would quote Bill Browder, teach me that alpha generation
CEO of Hermitage Capital and one of Russia’s longest- rarely compensates for quarterly
running investment gurus (now long since evicted and a or monthly liquidity risk.
firm anti-Russia voice). The best way to invest in Russia is
to “keep it simple.”
For many years Bill’s Hermitage Fund recorded outstanding gains, using the axiom of
keeping it simple. True, he was helped by commodities bull markets, but credit where
due – he took focussed risk in an under-diversified portfolio and it paid off well.
Not to recommend undiversified investing, certainly some sectors will outperform
others. But, as the markets have so cruelly reminded us, systematic risk cannot be
diversified. Russia remains a highly risky place to invest. As such, its liquid
investment opportunities will remain closely correlated, especially if this macro-
development investment case plays out. And the greatest risk remains the dangers of
this change not happening.
In short, expect a rising tide to lift all ships.
15
Avoid Costly & Illiquid Funds

While there is much to be said for using local expertise, years of investing in Russia
teach me that alpha generation rarely compensates for quarterly or monthly liquidity
risk. Hedge and mutual funds do a good job of marketing their low-risk metrics, using
daily price movements (and unrealistic return distributions). They neglect to show the
redemption timed risk-adjustment, as many Russia investors have learned to their
folly.
Ultimately then, there are currently only two cost and risk efficient ways to invest in
Russian beta:
> ETFs, Futures and blue-chip “proxy” stocks;
> Managed accounts.
Liquid Equity Overview

The key take-away from this report is that Russia Risk is declining, at least
temporarily, which points to a market-wide increase in prices through a reduced cost
of equity. But as Russia begins to develop its own investment story, tied to, but less
dependent on, the price of oil, so recent high correlations will decline and stocks and
sectors will more clearly reflect individual fundamentals.
Chart 10: Crash & Recovery, Sector Comparison
300%
200%
100%
0%
-100%
Utilities
Industrial
RTS
Oil&Gas
Financials
Telecom
MetalsMining
Consumer
Retails
Correction (Inverted) Recovery
Oil & Gas. Continuing to dominate all indexes, the oil & gas sector is used by many
investors as a proxy for the entire market. As the cost of equity declines, valuations
will rise to bring the market closer to peer
averages. Assuming oil prices do not collapse 160
this will mean rising equity prices. 140
120
The sector can also expect to benefit from 100
more liberal tax conditions. Even prior to the 80
crisis, as commodity prices were soaring, 60
there was increasing clarity that high taxes 40
were destroying the E&P development. Tax 20
cuts were swiftly approved as a temporary 0
9/1/2007
16/05/2007
17/09/2007
28/01/2008
3/6/2008
3/10/2008
16/02/2009
24/06/2009
23/10/2009
stimulus to the economy early in the crisis,

and will likely be extended or made
permanent.
RTS RTS Oil & Gas
16
Telecoms. The telecom sector is a mixed bag. Rampant corruption likely underlies
the rise of national fixed-line company Rostelecom and non-transparency continues
over Svyazinvest and the ownership of various equity stakes in both the public and
private spheres. Nonetheless, the success of foreign-listed Vimpelcom and MTS has
long-given the sector an investor friendly
reputation, one that even the (recently 160
resolved) acrimonious dispute between Alfa 140
Group and Telenor didn’t threaten. 120
100
Fixed-line growth is very limited, but the shift 80
to digital is well underway. Mobile 60
subscriptions are very high, forcing companies 40
20
to focus on international growth and additional 0
services. But, there remains substantial
9/1/2007
16/05/2007
17/09/2007
28/01/2008
3/6/2008
3/10/2008
16/02/2009
24/06/2009
23/10/2009
growth in the internet and entertainment.
Local fixed-line providers are best left to local
experts. But the wider telecom sector
continues to offer liquid, yield in the fixed RTS RTS Telecoms
income area.
Financials. Russia’s banks were hit very hard in the crisis, partly due to the collapse
of global funding, and partly due to the
dysfunction of the Russian economy. They
160
have rebounded well, supported by rising 140
asset prices and profitable FX business. 120
Going forward, banks will again represent 100
excellent value exposure to the growing 80
60
Russian economy. Over the nearer term, the 40
sector outlook is restricted by growing NPLs, 20
and a need to reduce the number of small 0
private banks. But medium and long term the
9/1/2007
15/05/2007
13/09/2007
23/01/2008
28/05/2008
26/09/2008
6/2/2009
15/06/2009
13/10/2009
sector has excellent potential.
RTS RTS Financials
Metals & Mining. The metals sector has been a highly volatile ride. Hit very hard in
the beginning of the crisis, metals companies have been direct beneficiaries of
China’s domestic stimulus, which has stabilised
prices and bought metals companies back from 250
the edge of bankruptcy. 200
Metals & Mining is one of the few sectors that 150
has recovered on clear fundamentals. As
highlighted in my May strategy, it was a direct 100
beneficiary of global (particularly Chinese) 50
stimulatory measures.
0
9/1/2007
15/05/2007
13/09/2007
23/01/2008
28/05/2008
26/09/2008
6/2/2009
15/06/2009
13/10/2009
Going forward, metals prices should remain

supportive, and the sector is likely to keep pace
with the broader market. As with oil and gas
companies, declining cost of equity will improve
valuations sharply. But, the period of metals led RTS RTS Metals & Mining
growth may be coming to an end.
17
Consumer Goods. The consumer goods sector was hit as hard as the financials and
metals sectors. It has also recovered impressively fast, but with less clear drivers.
Expansion continues apace, but like-for-like
sales remain heavily impacted. 160
140
Consumer goods is a high growth, high 120
valuation sector. As employment stabilises and 100
salaries begin to recover, the sector faces the 80
prospect of a steady return to its former break- 60
neck expansion rate. Rapid disinflation is also
40
20
contributing to the consumer area, after a 0
period of high inflation and falling sales sharply
9/1/2007
15/05/2007
13/09/2007
23/01/2008
28/05/2008
26/09/2008
6/2/2009
15/06/2009
13/10/2009
impacted the bottom line.
Legislation (currently passing into law) aiming
to improve competition in the sector has been
badly written, but the market is rightly RTS RTS Consumer
discounting that it will be improved and/or of
limited application in its current form.
Utilities. While heavily investing in UES in 1H08, I took the position that Russian
utilities were the last big development play, something akin to Gazprom share
restrictions being lifted several years before.
The break-up of UES was a major positive 160
development play, expected to unlock 140
120
enormous value. 100
Macro events clearly overtook this sector play, 80
but only temporarily. The utilities sector 60
remains a highly interesting domestic theme, 40
20
with great returns in several areas. Yet, the 0
turbulence of the post UES period makes this a
9/1/2007
15/05/2007
13/09/2007
23/01/2008
28/05/2008
26/09/2008
6/2/2009
15/06/2009
13/10/2009
sector more suited to local players. The risks in
utilities are very local. Utilities companies will
benefit with the beta move, but they will remain
dependent on sector specifics.
RTS RTS Utilities
Industrials. Russia’s industrials have probably been the hardest hit sector. As the
performance chart shows, the sector was riding high on domestically-focused
spending prior to the crash. However, years of easy business conditions have
distracted from drastically needed reforms.
Dominated by auto-manufacturers left over
from the soviet era, and drastically pressured 200
by foreign competitors (both importing and
producing within Russia) the outlook for this 150
sector remains difficult. The impressive
100
rebound thus far has come from beta
movement, and from state-support rather than 50
fundamental improvement.
0
The state, which is the default majority owner of
9/1/2007
15/05/2007
13/09/2007
23/01/2008
28/05/2008
26/09/2008
6/2/2009
15/06/2009
13/10/2009
many of these companies has shifted its focus

from first-aid to addressing the root causes, but
there are no easy solutions. Industrials stand to
benefit if the Russian government can lure
foreign investors to actively partner them and RTS RTS Industrials
bring real change, but the fundamental
prospects remain very challenging.
18
Investment Risks
No investment – notably not even US government debt – is without risks. Russia has
long been a high risk investment environment, and this has certainly not changed.
Indeed, this report advocates allocating capital to Russia on a reform story, which it
openly expects to fall short of decisive improvement.
Risks On The Decline. Yet, the biggest risks in Russia are likely to be reduced in
the coming investment period, at least at the blue-chip investment level. Russia
cannot afford any more high profile corporate squeeze-outs or challenges of the
Yukos, Shell, TNK-BP or Mechel variety. Even the Telenor-Alfa Group battle over
mobile telecom assets has been amicably resolved.
Risks Set To Remain. The biggest risks set to remain are those pertaining to the
corrupted and over-reaching state.
> Vested Interests. Putin’s era has led to the entrenchment of many powerful
groups, both within the public and private spheres. These groups may feel
threatened by the changes being publicly announced, and may respond with
measures that increase the instability of the investment environment.
Personally, I discount this risk in the near-term, simply because Russia is unlikely to
pursue change at such a pace as to genuinely threaten any entrenched group.
Russia’s leadership will talk of impressive progress, while pursuing gradualist reform.
Inevitably this will lead to disappointment and sharp set-backs in the Russian
investment case, but such problems are further down the road. At this stage, Russia
has yet to present even superficial improvement.
> Macro Issues. Likewise, and even in the face of an ambitious and effective reform
agenda, Russia would remain highly dependent on resources for the foreseeable
future. During this period, Russia will remain cyclically exposed at the global level.
The 2010 investment case is contingent on the beliefs that the global market rally has
not excessively exceeded fair value and that the global macro recovery will remain
largely on track for the coming year.
> Systemic Problems. The final set of risks unlikely to disappear are those reform
issues that will be ignored or swept under a velvet veil of apparent progress. Russia
will continue to lack real democratic freedom, which will limit true creativity and
open competitive development, it will also pose a stability risk – although economic
growth will counter-balance this threat to some extent.
Demographics will continue to plague Russia’s long-term development objectives –
Russia remains the fastest shrinking large population in the world. While birth-death
dynamics have improved, Russia is unlikely to change its attitude to migration, as
necessary to foment sustainable demographic stabilisation.
Corruption has worsened under Putin, but it certainly as not born under him. In fact,
in large part, the surge in corruption reported largely represents a monetization of a
well-established culture of relationships and favours. This is problem will persist.
The government will continue to handle large parts of the commodities sector, and
taxes extracted from it. With this in mind, shrinking the state to an efficient size is
highly improbable within the life of this development phase.
19
Conclusion
Clearly, Russia remains a very exciting investment frontier.
It is as liquid as many developed markets; but lacks the Russia’s economic progress of
regulation and structure needed for such an open financial recent years was 100% beta.
market. Now the country is preparing to
The risks of doing business in Russia remain extremely create alpha.
high, well above the levels of 2006-07, when there was
hope for pro-cyclical improvement.
Yet, the change coming is highly significant. Russia does not acknowledge the extent
to which it caused its own financial crisis. But, it does recognise that what appeared
to be an effective development model was an illusion. Russia’s economic progress of
recent years was 100% beta.
Now the country is preparing to create alpha. Its ability to do so will fall well short of
its claims of success. It will also fall short of that needed to create a path toward
sustainable economic prosperity. But, there is plenty of upside anyway.
Russia in 2010 will become a genuine reform story, one worthy of allocation in any
global portfolio.
20
James Beadle
jamesdbeadle@yahoo.co.uk
+370 643 33238
+44 754 5281 587
21

Russia 2010 Worth A Tactical Look: An Investor's Guide To The Risks and Opportunities in 2010

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Russia 2010 Worth A Tactical Look: An Investor's Guide To The Risks and Opportunities in 2010

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Russia 2010

Worth A Tactical Look

Russia’s under-performance relative to its BRIC peers is justified and well-explained.

About the Author

A British national, he holds and MBA from Barcelona’s EADA,

Since first visiting Russia in 1999 he has worked in sell-side

From 2006-09 he served as chief investment strategist for Pilgrim Asset

* PRIF continued to trade after July 2008, when James stepped-down

Chart 1: Russia’s Recent Equity Market Surge Relative To MSCI EM Index

China Russia Brazil India

Why Russia Under-Performed In The Global Financial Crisis

Shanghai Comp RTSI Bovespa Sensex

Chart 4: BRIC GDP Percent Change YoY – Russia Takes A Hit

China Russia Brazil India

As a clarification: During the height of the bull market, several foreign-oriented

State Interference In The Private Sector. State

Chart 4: Govt Spending (RUB Mln) – Elections Exaggerate Crisis Impact

Chart 5: BRIC GDP Percent Change YoY – Russia Takes A Hit

China Russia Brazil India

What Caused The Market Turnaround

2010 Earnings/Share (Est) RTS

On The Russian Side

How Is Russia Now Valued?

-100% -50% 0% 50% 100% 150%

YTD Return Change From Peak

Chart 9: Forward P/E Spreads – BIC Premiums Near Historic Highs

SHCOMP/RTS Bovespa/RTSI Sensex/RTSI

Outlook For 2010 & Beyond

Limited Prospects For Structural Change

What’s Real, What’s Not?

Becoming A (Guarded) Optimist

Avoid Costly & Illiquid Funds

Liquid Equity Overview

Chart 10: Crash & Recovery, Sector Comparison

Correction (Inverted) Recovery

stimulus to the economy early in the crisis,

RTS RTS Oil & Gas

RTS RTS Financials

Going forward, metals prices should remain

many of these companies has shifted its focus

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