“BRIC, BRIC, BRIC”—Brazil-Russia-India-China—has been a cardinal rally cry for macro analysts ever since Jim O’Neill’s landmark report a decade ago. Never-the-less, when we started the Intelledgement Macro Strategy Investment Portfolio (IMSIP) at the end of 2006, while we did invest in Brazil (EWZ), India (IFN), and China (FXI) we eschewed Russia, and have continued to avoid it ever since.
There are many reasons to be cautious about investing in Russia. The main issue for us has been the weak rule of law and respect for private property exhibited by the government, as epitomized by the case of Mikhail Khodorkovsky, the former owner and CEO of Yukos. In 2003, Yukos was the biggest oil company in Russia, but after Khodorkovsky financed politicians opposed to then-president Vladimir Putin, he was arrested, tried, and jailed and his company destroyed. When the national government has no qualms about destroying a major company—and there are no institutional impediments to this sort of arbitrary action—clearly the risk for investors is heightened. And that is not the only yellow light.
Russia’s transition from communism to—as the CIA diplomatically phrases it—“a centralized semi-authoritarian state whose legitimacy is buttressed, in part, by carefully managed national elections” has been rough on the population. Generally speaking, the process of de-nationalizing government-owned enterprises favored the well-connected, and those with the most money and ruthlessness—so long as they do not oppose Putin—have thrived. But with the dissembling of the socialist welfare state and concomitant safety nets, the vast majority of the population has had tough times. Russia ranks dead last among developed nations in life expectancy (66 years compared to 78 for the USA), and 161st overall (the USA is 49th). The differential between men and women is unsettlingly high (60 years for men, 73 years for women). Russian life expectancy trails many developing nations—Brazil, China, India, Indonesia, and Malaysia among others—as well as most of the other former members of the Soviet Union. And conditions are evidently not confidence-inspiring: the country’s fertility rate (1.4 children born/woman) is 200th in the world and despite net plus immigration, the country’s population is declining (estimated -0.465% in 2010) and overall Russia ranks 222nd in the world in population growth (out of 233 countries).
Having said that, those Russians still alive are well-educated (99.4% literacy) and modernized (only 10% remain engaged in agriculture; 32% use the internet which is above average). Oligarch-domination notwithstanding, Russia’s Gini index rating (a measure of the degree of inequality in the distribution of income in a country) is 82nd in the world (the USA is 93rd).
Another factor to consider is Russia’s geopolitical weakness. Infrastructure spending has lagged in the past 20 years. And their military capacity is a pale shadow of its USSR heyday and consequently the nation remains under pressure to keep commodity-hungry—and neighboring—China well-satisfied. If the cost of buying what they need from Russia to keep their own economy humming—and maintain political stability—gets too expensive, the Chinese have the capacity to take as much of resource-rich and sparsely-populated Siberia as they desire (presuming no one besides the Russians oppose them). This, of course, would be a disaster for Russia.
The Russian economy is dominated by commodity exports—in 2009 Russia was the world’s largest exporter of natural gas, the second largest exporter of oil, and the third largest exporter of steel and primary aluminum—and thus is highly sensitive to the overall rate of economic growth. For example, the 2008 downturn hit Russia particularly hard, even though their banks had little direct exposure to toxic securities, because demand for commodities—and Russian exports—declined precipitously: the value of Russian exports fell from $472 billion in 2008 to $303 billion in 2009.
But on balance, given a world where the demand for commodities to feed the engines of growth is high, the Russians benefit from a sellers’ market. We are now ten years into the 21st Century, and stock market-wise, the big winner so far has been…Russia. The compounded annual growth rate of the RTSI Index over the last decade is +28%. Better, in other words, than India (+20%), Brazil (+16%), China (+3%), Germany (+1%), the USA (0%), or Japan (-3%). Better, in fact, than most hedge funds.
In 2007, we were concerned that in view of the difficult conditions in Russia, a downturn might engender social and political unrest. However, the Russian regime survived the 2008 downturn intact and shows no sign of losing its grip. The government is fostering investment in high tech, which demonstrates they are cognizant of their economy’s over-reliance on commodity exports. The potential exists for bargaining with commodity-hungry customers to trade supply guarantees for investment in Russia’s infrastructure, which to the extent that it facilitates lower-cost mining/drilling/transportation of commodities, would benefit both parties.
In view of these considerations, we have decided that overall, the potential benefits outweigh the risks. And the investment vehicle we have selected is the Market Vectors Russia ETF (RSX). This ETF did not even exist when we started the IMSIP at the end of 2006, but since its inception (24 Apr 07), it has an IER of +231 (meaning it has outperformed the RTSI index on a CAGR basis by 2.31% since April 2007). When you are consistently outperforming an index that is up nearly 30% on average every year for ten years, that is hard to resist. The ETF currently has a market cap of $2.1 billion and average daily volume of 2.7 million shares, both of which exceed our minimum criteria ($1 billion market cap and volume of one million shares/day).
Last in, first out. Between the end of 2007 and 2008, the Russian stock market declined 72% under the pressure of the economic downturn. We are going in here because we believe that [a] Russia is in better shape now than it appeared to us to be in 2007 and [b] commodity demand in 2011 is likely to be high. But should Eurozone default risk, geopolitical unrest in the far east, near east, or middle east, or any other macro-scale development appear to threaten short-to-medium term growth, we will not stick around for another 70% decline.
On the other hand, should there be another 70% decline, now that we have seen Russia work through one of those, we would be more likely to look to get in sooner next time.