Emerging Markets Equities

Revisiting Russia

What’s to like about Russia? It is certainly not the typical emerging market but summarily dismissing it would be a mistake.
January 2018
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What’s to like about Russia? Most emerging markets tell a simple story of strong growth, favorable demographics and rising incomes. More money means more spending which means more opportunities for those companies which are clever (or lucky) enough to be exposed to these trends.

Russia appears to have none of this. Gross domestic product per capita is currently around $8,900 USD, which is down a whopping 44% from the $16,000 USD recorded as recently as 2013. This compares very unfavorably with the likes of India or China, which saw growth of 17% and 15% respectively over the same period. The growth outlook for the Russian economy is a meager 1 to 2% and population growth is stagnant. Indeed, Russia’s population peaked as long ago as 1991 and has declined by around 5 million since then. Economically, the country is still licking its wounds from the 2014 financial crisis when the oil price plunged 60%, the ruble dropped 50% and inflation spiked to more than 15%. The central bank was, at one stage, obliged to hike interest rates by as much as 6% in one shot. By any definition, this was a bona fide economic crisis. However, the worst now seems to be over, with inflation at 4% and interest rates falling.

Russia largely operates on the exporting growth model — one that is heavily dependent on digging natural resources out of the ground and selling them to the international market. This is a highly effective model when commodity prices are high and rising but (as we have seen) is extremely fragile on the other side. Commodities constitute almost 50% of government revenues and a whopping 85% of total exports. Russia barely exports anything else, and this has changed little in the past two decades. If we strip out oil and commodities, Russia’s exports (population 143M) are less than half the dollar value of Denmark’s (population 6M). As one corporation expressed it, “…the issue with Russia is that no matter how you look at it it’s essentially a derivative on oil and commodities.”

The political environment has been equally challenging. The regime has been unashamedly authoritarian since Putin took over in 2000. Corruption is widespread and the rule of law is weak, which many of Putin’s opponents have experienced (the hard way) by serving jail time or worse. Furthermore, Russia is involved in two wars, has a number of ongoing conflicts and is subject to numerous sanctions following the annexation of the Crimean Peninsula in 2014.

When visiting Russia recently, we felt that in many ways the country was living in the past; nostalgic for the Cold War certainties in which Russia’s role and influence as a major global power was unquestioned and unassailable. Thus, Putin’s nationalist agenda resonates with much of the population. As one person said to us, “Russians are very proud and we would rather be the bad guys than be neglected.” The general view on the ground seems to be that the party (United Russia) is responsible for the economic situation (which everybody hates), but Putin himself is responsible for Russia’s aggressive foreign policy (which everybody loves). Hence, the Party’s approval ratings are a modest 50%, whereas Putin’s personal rating is more than 80%.

So is Russia relevant and, as bottom-up stock pickers, should we care? The short answer is yes. Any company that is able to do well in this challenging environment clearly merits our attention. Recently we made the pilgrimage to Krasnodar, 1300 km south of Moscow, to visit Magnit, which is Russia’s leading grocery chain. Magnit operates what are called proximity stores (a mix between convenience stores and supermarkets) and currently has a 10% market share. Like most other emerging markets, the formal retail space in Russia remains significantly underpenetrated, with traditional, “Mom ‘n Pop” type outlets continuing to dominate.

As a leading retailer, Magnit has substantial scale and negotiating power, as well as best in class logistics, which is clearly a major advantage in a country like Russia with extreme climate differences, generally poor infrastructure, and low population density beyond the Urals Mountains. As a result, Magnit has been able to invest at high returns; the payback period is about three years and return on invested capital is an impressive 25%. The management team is exceptional. The CEO, Mr. Galitsky, has built the business from scratch, treated minority shareholders fairly and has grown his business without resorting to debt. We subsequently began to build a position in this excellent retailing operation, our first foray into the Russian equity market in several years.

Russia is certainly not the typical emerging market but summarily dismissing it would be a mistake. When looking for the best ideas, keeping an open mind, a broad perspective and willingness to kick the tires in sometimes inhospitable locations is always sensible.

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