Please find below, a breakdown of the impact of Russian politics on economic markets, received from Invesco, yesterday afternoon – 31/01/2022
Key takeaways
Russia could be on the brink of war with Ukraine
We’d like to think that the economic arguments will be enough to prevent conflict, but the Kremlin’s desire to restore friendly buffer states on its borders may yet prove their priority.
How are we exposed?
The Invesco Emerging Markets Strategy has three Russian holdings that comprise approximately 4% of the strategy.
Should we exit our Russian holdings?
We are cautious about capitulating at the moment of maximum fear. During periods of greatest fear, investors get their biggest opportunities.
Assessing risk
Investing by its nature involves taking risks. We’re all taught about the inverse correlation between risk and return, ‘nothing ventured, nothing gained’, even if the psychology of human behaviour can often make that relationship somewhat perplexing.
There have been countless examples of asset bubbles caused by irrational exuberance. This ultimately led to financial calamity for many of those involved, suggesting that risk is often heightened when greed is in abundance, rather than when investors are most fearful. We would argue that it’s often not the risks themselves that prove disastrous for investors, but how those risks are priced.
Take the example Cisco during the Dotcom bubble. In the 10 years following the year 2000, when the shares peaked at US$80 per share, Cisco grew revenue at an 8% CAGR and earnings per share at a 10% CAGR – a respectable rate. Yet, the shares were down around 70% over that period, and they trade at only US$56 today.
The fundamental risks to Cisco’s business in the first quarter of 2000 proved far, far less important to shareholders than the risk they were taking by paying such a high valuation. Cisco shares were trading on roughly 150x earnings in 2000, but trade on around 16x today.and US$.
We seek to minimise the main risk investors face – that of permanent loss of capital – by making sure we don’t overpay for stocks and by ensuring the companies we own shares in have strong balance sheets. We take this approach with companies wherever they’re listed, including in Russia.
Russia and geopolitics
It’s important to keep the context in mind – Russian equities have traded at a steep discount to emerging market peers for many years. There are a good reasons for this:
- Commodities. A predominance of commodity producers in the Russian market, which typically trade on lower multiples.
- Governance. Whether it’s fears about government expropriation (à la Yukos in 2003), or that a particular oligarch may get on the wrong side of the Kremlin – there is a governance deficit in Russia.
- Geopolitics. Russia’s foreign policy approach under Putin has become increasingly muscular, which has led to tensions with neighbours, including those in an expanded NATO. Following Russia’s annexation of Crimea, Western countries introduced a raft of sanctions, largely targeted at individuals close to the Russian President himself.
Given this context, we typically ascribe lower ‘fair’ valuation multiples for Russian stocks than we do for other countries in emerging markets. Effectively, we assume these risks will persist and so we price them into our estimates of what constitutes fair value. This means that we require higher returns from our Russian holdings than we do from holdings in other countries to account for these risks. We believe this fundamental approach to valuation helps reduce the risks associated with investing in Russia.
Take Sberbank, for example, which has delivered a median ROE since 2006 of 20.8%. This compares favourably with HDFC Bank, one of India’s highest quality private banks and a stock we have owned in the past. It has generated a median ROE of 18% over that time (the period in which HDFC Bank has been listed). While returns have been far less volatile at HDFC Bank compared with Sberbank (standard deviation of 1.6 vs. 6.6), we would highlight that Sberbank still provided a around 10% ROE in 2015 – a year of financial crisis in Russia following a more than halving in the rouble’s value vs. the US dollar.
Today, Sberbank trades on 0.9x price to book, having averaged around 1.5x over the last decade. HDFC Bank trades on 3.9x price to book today, having averaged above 4x over the last decade. In short, it feels to us that the risks associated with Sberbank are being clearly factored into the shares when compared to a similarly high-return bank in India.
Portfolio Construction
For portfolio construction, there are some key pillars that further reduce risk for the strategy. They are:
- Diversification by industry. This applies to the strategy as a whole, but also to our Russian holdings. We are keen to make sure that we have diversification across industries within Russia, so that we’re not overly exposed to sanctions that may fall hardest on one industry.
- Diversification by owner. We aim to be diversified by the type of business owners, be that government-owned companies, companies run by oligarchs, Western owned companies, or private equity firms. This again reduces the risk that any one type of controlling shareholder is targeted by sanctions.
- Strong domestic market positions. We make sure that the companies we’re invested in have strong domestic businesses that will enable them to survive even in a tough sanction regime.
- Strong balance sheets. Ensuring that contrarian ideas have the balance sheet strength to withstand temporary setbacks or ‘unknown unknowns’ is an important way to manage downside risk.
- Position sizing. By far and away, the biggest tool we have to reduce risk is to keep position sizes measured. Given how lowly valued Russian equities are relative to emerging market peers, you might expect valuation sensitive investors like us to be significantly overweight Russia. We are not. We much prefer to focus on picking stocks and analysing their business fundamentals as the potential source of alpha while minimising country factor risk.
Conclusions
It should go without saying that we see few winners from war in Ukraine, and we hope that diplomacy will prevail. Conflict would likely end up being protracted and destabilising. The economic impact of sanctions could be very severe for Russia’s economy, even after considering Russia’s strong fiscal position (large current account surplus and low government debt).
We’d like to think that the economic arguments will be enough to prevent conflict. But the Kremlin’s desire to restore friendly buffer states on its borders may yet prove their priority, for better or worse.
Regarding potential sanctions, we believe the range of potential outcomes is extremely wide. We’d like to highlight that valuations for many Russian stocks are now back at the levels of the 2014/15 financial crisis. To us, this implies that a good deal of bad news is already priced into shares.
We also feel that the lessons from previous episodes, such as the sanctions that were imposed on Rusal in 2018, will give Western countries pause before enacting sanctions that risk destabilising global commodity markets, as they did for aluminium then. Likewise, should the West choose to cut Russia off from the SWIFT payments system, it could wreak havoc for companies and countries that rely on Russian exports of gas and oil – including many in Western Europe.
Of course, we could just exit our holdings in Russia. However, we are cautious about capitulating at the moment of maximum fear. Looking back, it has been during periods of greatest fear that investors get their biggest opportunities. This experience, plus the low valuations (and high dividend yields) on offer, keeps us invested in Russia, albeit in a measured way.
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David Purcell
1st February 2022