The Russian economy is a basket case, corporate governance is weak, the outcome of the conflict with Ukraine is less than certain, and a combination of sanctions and fear are causing capital to flee the country. Long story short, there is little evidence that the Russian market can achieve a sustained long-term growth trajectory. With that said, by conventional measures the Russian market looks relatively cheap, and volatility from geopolitical events could present short-term trading opportunities for less risk-averse investors. According to this article published on Nasdaq.com, Russia is one of the biggest bargains, second to only Greece, based on long-term Cyclically Adjusted Price-to-Earnings. The Russian market is currently trading at a P/E of about 5 to 6, and a Price to Book of only 0.65.
You would be hard pressed to find someone who is excited about the Russian economy these days. But, the key question for investors is – do low prices accurately reflect economic conditions in Russia, or has the market been oversold due to “tail” risks from the conflict with Ukraine? According to some market experts, there are clear signs of over-shooting on the downside as speculators trade on headline news. Of course, there are a number of ways the Russia-Ukraine situation could evolve, but when examining geopolitical events (and some domestic policy debates, for that matter), I subscribe to two basic analytical questions to determine the probability of a tail-risk event occurring. First, assess the key driver of the situation. Is the conflict based on religious or ideological grounds; or is it more of a power and/or economic struggle? If the answer is the former, well, good luck. If it is the latter, then it is much more likely that the main actors involved will ultimately succumb to reason over conflict. More often than not, situations in the latter category avoid serious military engagement, isolationism, large-scale trade wars, or abandonment of economic or political alliances. Instead, various domestic and international pressures tend to bring states back from the edge before any serious damage is done. The second question is to assess whether each player’s economic interests are tied to conflict or resolution. It is rare that political leaders can act in a way that overtly damages their citizens’ standard of living for a prolonged period of time. Even in Iran, strict economic sanctions have led to political change.
To be sure, this is an over-simplification, and there are examples that conflict with my general guidelines. However, this basic framework is quite useful at a macro scale. Try it out – apply these two basic questions to just about any geopolitical or policy question to assess the probabilities of various outcomes. This is the sort of calculus that some investors are making on Russia right now. For example, the Kopernik Global All-Cap Fund (KGGAX) is heavily invested in Russia on the basic premise that markets are assigning too high a probability of all-out war.
If you’re like me, and tend to agree that the risks related to Russia-Ukraine are too heavily discounted by the market, I suggest two approaches to exploiting this trading opportunity. (1) Remain diversified across sectors to avoid any one-off events driven by sanctions or other unforeseeable forces, or (2) Search for good deals on beaten-down stocks that are too systemically important for Russia and/or Europe for them to completely tank. If you go with the first strategy, I like Market Vectors TR Russia (NYSE:RSX); and otherwise, I like the oil and gas giant Gazprom (OTC:OGZPY).
Market Vectors Russia ETF
Market Vectors Russia is the most widely traded ETF investing in Russian stocks, and closely tracks the MSCI Russia Index. The fund’s expense ratio of 0.62% is about average for its Russian ETF peers, but expensive compared to other international ETFs. Top holdings include Lukoil, Gazprom, the consumer retail company Magnit, Norilisk Nickel, and Sberbank of Russia – i.e., important companies that may be hit by sanctions but will largely be backed by the oligarchs.
Using Capital Cube’s ETF analyzer, the first thing that jumps out is that many of RSX’s constituents are expected to see a drop in earnings. But, remember, this is not a growth story – it’s a speculative valuation play. In this context, it is more important to see that RSX’s holdings are largely lagging the market and undervalued.
Gazprom OAO Sponsored ADR
Gazprom, a flagship Russian company and the world’s largest natural gas producer, trades at a P/E of just 2.55 compared to an industry average of 8.33, according to Reuters. As shown by Capital Cube’s peer analysis, OGZPY’s valuation has continually dropped despite above average earnings and relatively low debt burden. While a low valuation alone is not enough to justify buying a stock, the company’s fundamentals look relatively strong on top of a nearly 6% dividend yield.
To be sure, the risks are significant – conflict with Ukraine could lead to Europe diversifying away its reliance on Russian gas; and share values could be diluted if additional shares are issued to cover capital investments related to the new gas deal with China.
Long story short, OGZPY’s valuation is very low by any measure. The stock is trading on the low-end of its 52-week range, driven down (by my estimation) by heavy discounting of geopolitical risks. Just in the past 5 days, the stock has gained over 4% as headlines of the Russia-Ukraine conflict have been more dovish. If you can stomach some volatility and do not have a particular time horizon in mind, Gazprom is a very tempting bet for 20%+ appreciation and possibly a bump in the dividend on the backside of a resolution to the Ukraine situation.
