“You have to ask the question: what is Russia good at?” says Bill Browder, the CEO of Hermitage Capital Management, Russia’s largest public equity fund. “It seems that Russia is good at producing raw materials and has traditionally been very bad at making everything else,” he concludes.
It is a simple philosophy for picking Russian stocks but one that has propelled Hermitage to the top of the league tables of investment fund returns over the past five years.
Starting with $25 million, the fund is up 446% since it was set up in 1996 – including losses incurred during the 1998 financial crisis – and is now by far the single biggest equity investment manager in Russia, with $750 million of assets under management.
But it has not been plain sailing and Browder has been forced to become “a proactive investor”, as he calls himself, in a constant battle against the corporate misdeeds and shareholder abuses that plague Russia. He is one of the most outspoken portfolio investors, who on several occasions has launched public attacks on such companies as Gazprom and Unified Energy Systems, accusing management of questionable practices and insider dealing.
Browder may not be popular but he is extremely pragmatic. It is a tactic that seems to work. “Russia is one of the only countries in the world where highlighting shareholder rights abuses can actually push the stock up,” he says.
Browder started his career in 1992 as an investment banker with Salomon Brothers. He travelled around Russia advising companies that were privatizing. After banging his head against the wall trying to sell advisory services to unreceptive Russian managements, he eventually started snapping up privatization vouchers that could later be turned into company shares.
“In 1992 we were hired to advise on the privatization of a trawler fleet in Murmansk. They had 100 ships that cost $20 million each new. Yet the management had the right to buy a 51% stake in the company for $2.5 million. I quickly realized that you couldn’t make money working as an investment banker – the real money was to be made as an investor,” says Browder.
Salomon Brothers eventually bought into Browder’s arguments and the firm went on to become one of the largest investors in Russian stocks in 1994. That was also the year that the Russian stock market went up 624%, making Salomon a whopping $100 million return. “I went from complete obscurity to becoming one of the most popular people on the trading floor.” says Browder.
The massive gains piqued Salomon’s customers’ curiosity about Russia. Men like John Templeton, the founder of Templeton Asset Management, and Edmond Safra, the Chairman of Republic National Bank, wanted to know what was going on and how they could get involved. Salomon wheeled out Browder to make presentations and he was asked in nearly every meeting whether he could manage their money in Russia. When he went back to the management of Salomon Brothers to propose this new business, there was lots of enthusiasm for launching a Russian fund but all sorts of infighting.
“There were lots of heated discussions about who was going to get the credit for this interesting new business, but I didn’t hear my own name mentioned in any of the discussions so I decided to pick up and leave to do it on my own,” says Browder. “I went back to Safra and he agreed to put up the seed capital for the fund.”
The Hermitage Fund was launched with $25 million in seed capital in the run-up to Boris Yeltsin’s re-election in April 1996, when the ailing president’s approval ratings were close to zero.
But as the summer vote came closer Yeltsin’s approval ratings began to climb – thanks to an oligarch-backed PR campaign – and the stock market responded. In Hermitage’s first operational month the value of its portfolio went up 40%, then by another 35% in the second month.
“All of Safra’s client’s began to ring him: ‘Why are you keeping this to yourself?’ they asked. They wanted in,” says Browder.
The fund snowballed. By the end of the first year Hermitage had $125 million under management and by the end of the second year, with Yeltsin safely reinstalled, Russia boomed and the fund was up by 228%.
It was the start of a heady ride capped by the collapse of the financial system in August 1998. The crisis knocked the stuffing out of Hermitage along with everyone else. In the space of just a few weeks after August 17 1998 the value of the portfolio fell from $1.1 billion to $165 million.
“Some left. Many went bust. And the institutional investors wrote Russia off,” says Browder, remarkably calmly for a man who lost a little under a billion dollars in the space of six months. Committed to Russia, Browder wasn’t in any hurry to leave and began to pick through the pieces looking for new opportunities.
The financial crisis is arguably the best thing that ever happened to the economy. Strong oil exports and the government’s lack of political will to push through change had left the rouble overvalued. Domestic industry was smothered by high costs and unable to compete with relatively cheap imports. With no income, companies avoided paying taxes, driving up the budget deficit to a whopping 8% of GDP. The deficit was funded by the now notorious sovereign treasury bills, the GKOs. The collapse of international oil prices to about $10 a barrel at the start of 1998 knocked the feet out from under investors’ confidence and the whole house of cards came tumbling down.
The fruits of devaluation
But after devaluation the situation was turned on its head. The rouble was cheap and imports had disappeared. Oil companies, in particular, found their costs cut to a quarter while they were still earning hard currency. Fantastically profitable, oil companies poured investment into their oil assets for the first time and domestic industry scrambled to fill the hole left by departing foreign competition. Vladimir Putin’s election as president in March 2000 and the promise of political stability only added impetus to Russia’s rapid recovery.
“In the depths of the ditch, we saw that the economics of these companies made great sense. The only unknown was if they were going to steal from you,” says Browder.
Browder says he follows two principles in choosing investments. The first is “to align your interests with the bad guys”; the second is “make sure that Russian government cares about what is going on”.
He says: “Putin is a policeman with no sympathy for the oligarchs, unlike Yeltsin. He won’t let them steal from the state any more and we believe it.”
And the bet seems to have paid off. Putin has delivered on reform promises and Browder points out that for bond traders Russia is already rated as less risky than many of the more traditional emerging markets.
But everyone is still waiting for the stock market to take off convincingly again. Foreign direct investment remains mired at about $4 billion a year – one of the lowest levels in per capita terms in eastern Europe. And the palpable progress that Putin has brought has yet to feed through to the leading RTS index, which is still languishing at about two-thirds of its pre-crisis high.
Bonds have been recovering and Russia is now only two notches below the sought-after investment grade. Standard&Poor’s rates Russia as BB-. Analysts say that Russia’s oil companies are now trading at a premium to their emerging-market peers on an earnings basis but all Russia’s assets remain hugely undervalued by most conventional comparisons.
“When will the next boom come? Maybe when Russia is upgraded to investment grade,” says Browder. “There are some very stupid people out there, which creates opportunity. It is a combination of prejudice and ignorance.”
A self-confessed Russia apologist, Browder argues that the pain of the crisis drove away most of the best talent and the country remains under a cloud of ignorance and investors’ misconceptions. The effect of the crisis on investment sentiment is still palpable five years on, slowing down recovery. But those on the ground fervently believe that the sheer economics of Russia’s recovery will change attitudes eventually.
“The Russian risk is compensated by the low prices and the prices are depressed because of pessimism,” says Browder. “But after the recent progress, Russia is well on its way from horrible to bad, and that is where the big money gets made.”
