EAST CAPITAL SUMMIT, Prague 8 September: Back to the future

10 years ago, Russia was still emerging from a financial crisis, a debt default and devaluation of the Ruble, but is today sitting on the world’s third largest foreign currency reserves, the state and indeed the average Russian is debt free, and the country's output of natural resources that the emerging world so desperately needs to fuel their economies is near an all-time high. 

Even so, the Russian market is trading on a price/earnings (PE) ratio of 7x, little changed from the 6x it was trading 10 years ago. Compare that with the other so-called Bric nations: the Brazil market, for example, is trading on a PE of 14x, yet its economy is just as dependent on commodities and its population is a lot less well educated and wealthy than in Russia. 

"Valuations today in Russia are the same as 10 years ago and many Eastern European markets have not really recovered from the crisis," said Peter Elam Hakansson, Chairman and Head of Portfolio Management at East Capital. "You do have to factor in the risk and volatility factor, but we think it's exaggerated right now." 

Jacob Grapengiesser, a partner of East Capital, said the dichotomy between what is happening on the ground and the perception in the minds of foreign investors marks a wide divide which will eventually be closed. And when sentiment reaches such a trend turning point, that's when the biggest gains can be made.

A sign of how that turning point might have been reached is when one looks over the past six months, the stories about Russia have definitely taken on a more positive tone. An example would be the way Russia behaved and was perceived to have behaved during the tragedy of the late Polish president's plane crash.

"The risk premiums are overstated and the market is too cheap," Grapengiesser said. "In our minds, the markets are misunderstood and risks are oversold."

East Capital’s funds have already benefited from the turning in sentiment toward the region over the decade leading up to the global economic crisis. Its Russian Fund returned 1,565% over the decade 2000-2009, the best-performing onshore regulated fund out of the roughly 94,000 other funds the average investor could have put his or her money in. Its nearest competitor returned 1,380%. Over the period, the Russian stock market was up about 780%, while an investor in the US market would have lost 26% and 5% in the European market. Elam Hakansson says, paradoxically, 2009 proved to be an excellent year for performance – its broad-based Eastern European fund outperformed the index by 23% - which is a function of East Capital's philosophy of hands-on investing rather than investing from afar. In 2009, the firm doubled the number of its local company visits. "We want to be out there seeing things for ourselves, not sitting in our offices."

One main reason why Russia and the rest of the region should be revalued is that in macro terms, overall the CEE region came out of the crisis in much better shape than Western Europe, which is heavily burdened by debt. While Russia may not match the 7-8% growth of past years, the 4-5% expected over the next few years is still considerably more than expected in Western Europe and the US.

Comparing Russia with Brazil again, Petrobras is currently carrying out a capital increase that values its oil in the ground at $8 per barrel; for Russian oil firms, it's $2.50. Not to mention of course that Petrobras' oil comes from  hard-to-get-at deepwater areas, while much of Russia's oil reserves being developed are found onshore.

"Lukoil, a well run private Russian oil firm is trading at a PE ratio of 5x, a third of that of Petrobras, and there's no good reason for that," Grapengiesser said.

As such, East Capital is predicting a shift in investment from Brazil to Russia.

Given Russia's prominence in the region, the negativity clouding investor sentiment inevitably has a spill-over effect into the other smaller markets in the region. Take Serbia, a country whose economy was marginally down last year: it is expected to grow this year, is attracting large amounts of foreign direct investment, yet its stock market is still down over 80% from its peak before the crisis. "Polish banks are trading at 2x book value, while Serbian banks are at just 0.3x book value and Russian banks 1.5x book value," Grapengiesser noted. "Serbia will get there eventually, whether in six months, one year or three years, but the trend is there."