"LESS RISK, LOWER RETURN" - that was the title of one Russian investment bank's prognosis for portfolio investments in Russia in 2003. The argument that Russia had emerged from the wild fluctuations of the 1990s (and so triple-digit returns) and was approaching a fair-value equilibrium was appealing. Once again, though, that line of reasoning seems to have been completely wrong.
The leading RTS (Russian Trading System) indicator has bounced about almost as much over the first half of this year as it has always done. Rising domestic liquidity started to swell share prices before foreign investors flooded back into a stock market that was increasingly thought to have outgrown its historical volatility. The RTS rose rapidly from 360 at the start of January and by June had sailed through the psychologically important 500 mark, clawing back three-quarters of all the ground lost since the 1998 financial crisis.
The new-found enthusiasm evaporated just as quickly when in July the Kremlin turned on Russia's biggest oil company, Yukos, the poster boy for good corporate governance reform, sparking fears of large scale renationalizations. Yukos's market capitalization fell by $2 billion in a week and the market as a whole dropped by about a quarter.
Yet despite these gyrations, the basic arguments that led analysts to speculate that 2003 would be a quiet year of steady growth still hold true.
Healthy economic developments
Economic growth is steady and predictable and government finances have never looked in better shape. Russian companies are more focused on their share price than ever and rising numbers have followed Yukos's lead in increasing transparency and moving over to international accounting standards. IPOs announced over the past six months will bring more order into the equity market as companies begin to use it to raise investment capital or as a means to cash out of a successful venture. Where the analysts went wrong was to underestimate the extent of Russia's political risk ahead of parliamentary elections slated for December.
"The Yukos affair has been a nasty jolt and we have seen a mini boom-bust cycle - almost symmetrical in shape - but apart from this aberration the Russian markets have become more stable," insists James Fenkner, head of strategy at Troika Dialog. "The edge was taken off this summer as the political season is always difficult for emerging markets. Even with the recent fracas, the market is still up 38% from the start of the year, a good performance by any standard."
Most analysts agree that Russia is no longer the screaming buy that it was when the RTS was below 200 and that the market has almost reached its fair value level of about 520.
Indeed the market was rising so fast during the spring that the stock pickers found themselves in the unusual position of trying to talk the market down, rather than up. With Russia's history, analysts were afraid that over-rapid gains would inevitably lead to a nasty correction and undo what little confidence had been restored over the past 12 months.
"The liquidity flows currently driving the re-rating of Russian assets are not sustainable without [Putin's] reforms and do not provide a sound basis for valuing any asset in the medium term," Stephen Jennings, CEO of Renaissance Capital, told investors gathered at the investment bank's annual investment conference in May. Jennings was referring to the series of laws affecting nearly every walk of life that Putin has pushed through in the past four years.
Just to make sure investors got the point, Jennings went on to draw a number of unsettling parallels with the market in the months leading up to the 1998 crisis.
But there are many differences between the RTS in 1997 and 2003, the most important of which is that today it is Russian, not foreign, money driving the market, and Russian investors have begun to use the market in the traditional way - to buy and sell companies.
Roman Abramovich, the owner of oil major Sibneft, set the trend off in 2000 with the purchase of the PAZ bus factory, which he snapped up by buying the shares on the open market, paying a real, albeit low, price for them.
In May, Russia saw what may be its first ever stock-based hostile takeover bid, with an attack on oil major Surgutneftegas. After rumours began to circulate that another oil company was trying to buy up free-floating shares in preparation for a takeover bid, Surgutneftegas' shares surged 66% over the first three weeks of April as the attack gathered strength. Then, at the end of the same month, the bubble finally popped.
Russian businessmen used to see shares as little pieces of paper that granted their owner access to a company's cashflows. These days the Russian banks are setting up broker-dealer operations and the managements of leading companies are starting to look at funding expansion by selling stakes on the open market.
"What is more surprising than the fact managers are willing to give up some of the control over their companies is the fact that there are Russian investors who believe they will do just that," says Jim Nail, the head of the Pharos fund. "We are not out of the woods, but the trees are thinning."
The attraction has been the rapidly rising value of those companies that have got their corporate governance act together and are now attracting the interest of both foreign and domestic investors.
Major companies have added billions of dollars to their market caps this year. The pioneer of making money out of corporate governance was Yukos, which has added $10 billion to its net asset value since the start of the year. Other major companies, such as Norilsk Nickel, which doubled in value to $7.5 billion, have done almost as well.
Latest member of $10 billion club
Maybe the most telling example of this change in attitude was the $2 billion that Russia's leading oligarchs spent on minority stakes in state-owned utilities monopolist United Energy System's stock. Over the past six months the company's free float has fallen from over 40% to less than 10% and the market capitalization has grown to the point where UES entered the exclusive $10 billion market capitalization club alongside only Yukos and Gazprom.