Robert Amsterdam

The following is an exclusive translation of a front page article from Germany's Manager-Magazin, courtesy of our translator from www.robertamsterdam.com/deutsch.

Russian Roulette

By Arne Gottschalck

People who take their money to Russia generally invest it in oil and gas, earning huge profits as a result. However, in doing so, they are putting their trust in an economic system which is clearly becoming more closely allied to those in power in the Kremlin. The sceptics currently have the upper hand. However, they have no alternative.

Hamburg – Russia is a country with two faces. In Moscow, just a few metres separate the colourful wedding cake towers of the Kremlin basilica from the drabness of the grey blocks of flats, and the gleaming chrome of luxury automobiles from the ragged poverty of the homeless. Yet these few metres are almost impossible to bridge. The gap between rich and poor in Russia has now become so great that even President Putin, hardly known for his philanthropic views, has demanded that it be reduced by a significant increase in economic growth. This was announced in a speech made at his annual press conference in the Kremlin in front of 1,200 journalists. But is it enough simply to know that the problem exists?

No, the contradictions in Russia are also polarising investors. On the one hand, there are investors who demonise Russia. Investment company First State, for example, has significantly reduced the significance given to Russia which the country otherwise had in corresponding funds. “Several years ago, we saw increasing oil prices and Russian oil companies who used global technology”, says Glen Finegan, senior analyst at First State. “At that time, we also saw improvements in corporate governance and private oil companies which looked as though they might become the global players of tomorrow. We were focused most strongly on Russia during that period.” Eighteen months ago, investments of these funds were reduced to zero, as everything appeared to become too unstable. According to Finegan, “The Russian government began to take control of the raw materials sector… and state-controlled companies are hardly likely to bend to the wishes of private investors.”

Canadian lawyer Robert Amsterdam, who represents the interests of the jailed Mikhail Khordokovsky, among others, is familiar with this development. “Political corruption is taking hold. According to a corruption index, Russia has now descended to the same level as Swaziland. Investors have to act with extreme caution.” This is clearly what they are doing. “The increasing influence of the state on the economy is a cause for concern,” says Angelika Millendorfer, who is responsible for the Eastern Europe funds at Raiffeisen Capital Management. “The government is attempting to take control of at least one major company in the core industrial sectors, such as Rosneft in the oil sector. This could be a disadvantage for other privately owned companies.”

A problematic political situation

Take Sakhalin II as an example. This is a massive oil and gas field in Siberia which a consortium consisting of Royal Dutch Shell, Mitsui and Mitsubishi wishes to exploit. They plan to invest US$15.6 billion in the project. Yet Russia decided to withdraw a vital environmental license from the consortium in September of last year. The reason given was that Shell failed to meet environmental requirements. Russia then demanded compensation for damage caused to the environment. Gazprom offered to assist the exasperated western company by purchasing 50 percent plus one share of Sakhalin II. A decision has not yet been made. Was it justified to withdraw the license from Shell? And is Gazprom a reliable partner? “This has nothing to do with the law,” says lawyer Robert Amsterdam. It is cases like these which undermine western investors’ trust in Russia, and which are occasionally cause for despair. “If you have as much money as Shell, you can afford to be short-sighted and unprincipled. But normal investors have to be very careful.”

An indeed, many investors have grown sceptical. While umbrella funds managers were still happy to invest in Russia in 2004, for example, nowadays, they are only attracted by the wider emerging markets sector. While in 2004, the Griffin Eastern European Funds were still on the top ten list for umbrella funds managers, three years later, the same list includes only the more widely distributed JPM Emerging Markets Equity. This at least is the evidence produced by a related umbrella funds study by Fidelity. Nowadays, popularity is by no means a mark of quality or adequate inclusion in a portfolio. It is, however, a practical indication of how lucrative a specific stock exchange segment is considered to be by investment experts. Friends of Russia may nod in agreement with these arguments, but they also add a big “but”.

After all, there is a whole series of points in favour of Russia. For example, in 2006, the national economy increased by 6.9 percent, and a similar level of growth has been predicted for the current year. Inflation has in the meantime decreased to just below 9 percent. The country is the world leader in raw materials, with one-third of German gas imports coming from Russia, for example. The stock exchange itself is also doing well. More precisely, the idiosyncratic Russian stock exchange rhythm is a sign that things will again take a turn for the better soon. The Russian index, the RTX or RTS, occasionally suffers a weak period before mounting a major recovery. And 2006 was one of those weak periods.

This is also reflected in a direct comparison between Russia and Germany. Over five years, the RTX has increased by 500 percent. The Dax achieved a comparatively low growth rate of 200 percent. Calculated over a period of one year, the comparison looks very different. The Dax is in the black with 40 percent, while the RTS is at 20 percent. Sean Taylor, Investment Director at GAM, describes the shares there as being laggards, stragglers.

A growing selection

But this is not all. Until now, with its deposits of raw materials, the country has profited from the increasing prices for oil and gas. This has been almost its only source of benefit, since there were hardly any companies outside this sector. However, this situation appears to be changing, according to fund manager Angelika Millendorfer: “General Russian exposure has significantly increased in recent years, since due to a rise in IPOs and capital increases, the Russian share market is becoming more important within the context of the Eastern European and global emerging markets.” This opinion is shared by other investment companies. “The domestic economy is growing more strongly than expected, simply because national consumption is on the increase. Since Russia’s economy is now dependent essentially on domestic consumers and demand for investment, it is not sensitive to external shocks,” says Allan Conway, manager of Emerging Markets shares at Schroders.

On the one hand, the wealth from raw materials and an economy which is gradually beginning to stand firmly on its feet. On the other hand, the strong political influence on the economy, which makes investments unpredictable. Will Russian investment turn into Russian roulette? The truth is probably somewhere in between. And in times of doubt, a pragmatic approach is the most appropriate. Sean Taylor at GAM, for example, calculates that to a large extent, the political background noise has influenced share rates, and that Russian shares have in the interim become a more suitable investment than those on other emerging markets. Russia-sceptic Glen Finegan also appears to see opportunities in Russia once more. Recently, First State bought shares in Pharmstandard, a pharmaceuticals company, with the Global Emerging Markets Leaders Fund. In May, shares in Lukoil were purchased with the Global Emerging Markets Fund. At Schroders, Russia’s balance in the new Bric Funds is being increased – in contrast to India, for example. “The rate of economic growth is surprising, and on the whole, assessments are reasonable,” according to Allan Conway.

The same applies to Raiffeisen. “Three years ago, exposure of our fund in Russia was around 40 percent, but in the meantime, over 50 percent of our Eastern European share positions has already been invested in the country,” says Angelika Millendorfer. All the more so when the alternatives are so scarce. There is hardly another country in the world which can compete with the wealth from Russia’s raw materials, let alone in Eastern Europe. Only Kazakhstan is being treated as the new Russia. “With regard to raw materials, this really is true. Yet Kazakhstan has no political structures and is run by a President for life,” says Glen Finegan. “That makes it quite difficult to get a long-term perspective there.”

The only option for investors is therefore to take the Russian risk into account or to stay away completely. Eastern European funds managers have an easy choice: Their brief obliges them to put their investors’ money into Eastern Europe. And here they can hardly avoid Russia, if only because of its size. Russia itself is therefore currently very happy to present its self-confident face. “We need several financial centres and currency reserves,” Putin is claimed to have said at a meeting in St. Petersburg. It doesn’t take three guesses to find out which country and which currency he is referring to.