By Mark Fairbairn, CFA, B.Eng.
Senior Investment Analyst, International Equities
Recently, with Russia dominating headline news, I’ve been asked whether we at MD invest in that market—and if so, why? After all, isn’t Russia among the most corrupt countries in the world?
Well, yes, Russia does have significant corruption. According to Transparency International’s Corruption Perceptions Index, Russia scored a lowly 29 (where a score of zero means total corruption and 100 means no corruption).
But corruption is par for the course for many emerging market countries. For example, Mexico scores 30, only slightly better than Russia, while Brazil, China and India all score 40. By comparison, the U.S. and Canada are at the other end of the scale with scores of 74 and 82 respectively.
Political risks are high
Investing in emerging markets is challenging, and Russia is one of the more difficult places to invest in.
Corruption and political interference are part of the business environment, with companies dependent on politicians and their decisions. These risks can range from poor legal protections and limited recourse through the court systems, to corporate scandals involving bribery, to outright expropriation of corporate assets by the government.
In recent years, we have seen heightened political risks due to economic sanctions imposed on Russia by the U.S., Canada and the European Union after Russia annexed Crimea (a peninsula in the south of Ukraine) in March 2014.
Around the same time, worldwide energy prices had collapsed, plunging Russia—a petro-state—into a deep recession. Over the course of 2014, Russian equities fell around 40% in Canadian dollar terms.
Russian assets are cheap
One of the main reasons to invest in Russia is because it’s cheap, and cheap assets offer the potential for higher returns. Russian assets are cheap in part because high political risks have resulted in a risk premium being embedded in their valuation.
Think of the way that auto insurance companies charge high premiums to teenagers to offset the elevated risk of erratic driving. Financial markets do the same for Russia.
So back to the question: does MD invest in Russia? The short answer is yes.
Russian equities represent about 4% of the portfolio weighting in the MDPIM Emerging Markets Equity Pool. However, given the significant risks, we manage these investments actively, and work with experienced, specialist managers: Comgest, GMO and CIBC Asset Management.
Comgest’s investment approach is to seek high-quality growing businesses. Perhaps not surprisingly, these opportunities are limited in Russia, and therefore Comgest’s only Russian holding is Mail.ru.
Mail.ru runs Russia’s largest social network, VK, and is also active in online, desktop and mobile gaming. The strength of Mail.ru’s distribution network comes originally from its email service, where the company is also the market leader in Russia.
GMO, on the other hand, is a value investor who aims to identify undervalued companies which will produce superior long-term results. Since GMO’s stock selection is driven largely by seeking out and investing in cheap stocks, they find many more opportunities in Russia, and account for the bulk of the Russia exposure in the Pool.
Currently, GMO is mostly drawn to the Russian telecommunications sector, a particularly cheap segment. Its top Russian holding is Mobile TeleSystems, the largest mobile operator in Russia. Compared to Canadian telecom operators such as Rogers or BCE, Mobile TeleSystems trades at approximately half the valuation.
In addition to finding many cheap companies, we actively manage the currency. With the ruble trading 40% below its 2014 levels, we have overweighted the Russian currency as an added source of potential return.
Cyclically, the economy is improving
While political risks in Russia are quite high, Russia is economically less vulnerable compared with many other emerging markets, with lower levels of indebtedness in both the private and corporate sectors.
As the country emerges from its recession, its cyclical indicators have been showing significant improvement, and Russian equity returns have been very strong, up over 30% in the 12 months to March 31, 2017.1
It’s very easy to find things that are unappealing about investing in countries with a high level of political risk but those investment opportunities shouldn’t be ignored either. That said, investing in Russia should be done on an “active” basis, with a full understanding of all the risks. And that’s the approach we take with the MDPIM Emerging Markets Equity Pool.