The Russian Bear Is Back

“A ‘too-good’ deal in Russia, is, in fact, no good at all.”
— Eric Kraus, Truth and Beauty

Perhaps there is no better quote to illustrate the unique place of Russia in the investment world than this simple comment from the Financial Times: “Gazprom [the giant Russian oil and gas company] does not comprehend why its thinly veiled threats and bullying are not, as at home, seen as a normal negotiating tactic.”

What do we make of Russia? Assassinations, broken promises, corruption, frequent roughhouse tactics…these things loom large in the investor’s mind, reinforcing the idea of Russia as some sort of recurring nightmare. Then there are those flashbacks to 2004 and the whole Yukos fiasco. The government basically seized the company for back taxes in a move widely considered politically motivated (i.e., Putin didn’t like its ambitious billionaire CEO, Khodorkovsky, who was arrested and sent to rot in Siberia).

Investors lost everything — billions of dollars.

Russia seems to realize it has an image problem. I thought it was funny that various Russian news organizations/agencies published a lengthy advertising supplement recently in The Washington Post, called “Trendline Russia.” The six-page pullout section was like a mini-paper within the paper. The main point of which appears to be massaging the bruised reputation of Russia.

One headline grabbed my eye: “An Image of Future Russia: 80 Ireland-Like Regions.” And the cutaway quote: “Every Russian region, depending on its specific characteristics, can copy the breakthrough experience of Ireland or Dubai.” Heady stuff. These guys should be writing my marketing copy.

Russia’s bad reputation hasn’t yet soured investors. Even though they’ve gotten pie thrown in their faces before, investors keep coming. Foreign direct investment in Russia hit a record $27 billion through the first nine months of 2006. That’s a 43% increase from a year ago.

An Insider’s View From Moscow

Recently, I’ve been reading the comments and analysis of Eric Kraus, head of the Moscow-based Nikitsky Fund. On his fund’s site is an excellent free monthly newsletter, called Truth and Beauty (…and Russian Finance). I feel it is an insider’s on-the-ground account of what’s happening in Russia. As I love to get as close to the source as possible, Truth and Beauty has become a regular part of my reading. In his latest letter, Kraus takes to task what he calls “deeply biased Western pundits”:

“In 1997, you would have been warned of the impending collapse in oil prices, in 1998 of the catastrophic breakup of the Russian Federation — while every subsequent issue of The Economist has warned of a veritable potpourri of impending catastrophes…In the meantime, of course, oil prices quintupled, the Russian equity market has soared 30-fold, while Russian GDP has exploded to almost $1 trillion.”

Kraus points out that Russia’s growth rates over the last eight consecutive years make it the fastest growing economy in the Western Hemisphere.

Much of Russia’s success is tied to commodities, of which it is a veritable storehouse. Russia is the largest producer, or among the largest producers, of palladium, platinum, diamonds, nickel, and gold. Russia is also rich in oil and gas.

Russian oil giant Gazprom has a market capitalization of $250 billion, putting it in the weight class of international heavyweights such as Exxon and General Electric. The Russian stable also boasts other heavies such as Rosneft at $100 billion and Lukoil at $80 billion. These are just a few examples.

Russian multinationals are large and ambitious. They’ve raised billions on the London Stock Exchange. They’ve also spent billions buying up assets in emerging markets around the world — in Belarus, Ukraine, Kazakhstan, Uzbekistan, and Africa. But they are also active in more developed markets. In the U.S., for example, it was a Russian company that bought and turned around Rouge Industries, the fifth largest American steel producer and Ford supplier. It was a Russian company that paid $2.3 billion for Oregon
Steel Mills this past November.

So we see how the Russian bear is awake and has become quite the global competitor.

Russia and China — Getting Chummy

Russia’s economic wagon is lashed more and more to China and Asia. “Russia and China appear to be cozying up as never before,” The Wall Street Journal reports. In 2004, they resolved a long-standing border dispute, with Russia ceding some territory. In 2005, they carried out joint military exercises for the first time. China buys more than $1 billion worth of Russian weapons every year, making it Russia’s biggest customer. Trade between the two grew 37% in 2005.

And as China continues to scour the globe for resources, Russia figures prominently in those plans. Rosneft pledges to double its exports of oil to China and it will partner with CNOOC, the big Chinese oil company, to build an oil refinery and run gas stations in China.

Sparsely populated Russian territories bordering China are taking on waves of Chinese immigrants. By some estimates, there are over 250,000 Chinese living in Russia. This has also become something of a source of tension between the two, as small Russian towns fear becoming more and more Chinese and less and less Russian.

It’s fascinating to see all of this happen. An economically vibrant Russia certainly becomes something an investor must consider. I believe it is part of my role to analyze and report on events extraordinary and important, even though these insights may not lead to an immediate investment recommendation. I feel this is the case with Russia.

The Real Gems in Russia Are Hard to Get

As well as Russia has done, I don’t regret missing the explosive rally in Russian stocks. Surely, it is a tired and easy cliche, but investing in Russia still has the feel of playing Russian roulette. How do you account for the possibility of complete nationalization, as with Yukos? How do you account for the possibility of assets and contracts disappearing overnight?

I recently heard Bruce Berkowitz, the manager of the top-notch Fairholme Fund, speak at an investment conference. Though he may have been quoting someone else (I can’t remember), I scribbled on my notepad a quote that sticks in my mind when I think of Russia: “Anyone who accepts a small risk of losing everything will lose everything eventually.”

And then there is Douglas Adams, the great humorist. He had a great quote apropos of Vladimir Putin, Russia’s head of state: “When he heard the words ‘integrity’ and ‘moral rectitude,’ he reached for the dictionary, and when he heard the chink of ready money in large quantities, he reached for the rule book and threw it away.”

Kraus, though, is bullish on Russia. To his credit, he’s been right. But he invests in things that are hard for us to get at. “At Nikitsky,” Kraus writes, “we believe that the greatest value is to be found in privatized post-Soviet industrial assets — generally unpronounceable (e.g., Sevzapelektrosetskroy), hugely undervalued, and unknown outside a small circle of small-cap specialists.”

Short of investing in Kraus’ fund, there is no way for us to play in that sandbox. There are, however, a few backdoor plays. These are ideas that do not require an investment in a Russian company, but that benefit from some trend in Russia.

So in a world in which there seems to be many other possibilities, I see no reason to buy the popular big caps of Russia. I’ll keep watching.

Chris Mayer

January 31, 2007

The Daily Reckoning