Professional Statement
There are several requirements for participants in the Fellowship Program. At the end, each is required to write a professional report on a topic related to his/her career, and a personal statement. The professional statement is meant to be a research article on a topic centrally related to the Fellow's work experience in Russia. Here's how mine came out.
Unfortunately, it isn't possible to import the tables and charts into the blog. (Blogger did automatically convert all my footnotes to endnotes, though.) I left some of the data in mangled form, however, since the text refers to it in some places. It may be difficult to understand without it.
Прогулка по Рынку: Observations on the Russian Stock Market
Introduction
Riding a wave of oil, favorable commodity prices for other natural resources, and some well-considered reforms, Russia’s recent macroeconomic advances have been reflected in increased bond ratings from the major rating agencies, as well as substantive improvement in the conditions for the population i.e. a declining poverty rate, real income growth, and climbing per capita GDP. While the situation certainly has room for more such dramatic improvement, the country is enjoying, and wisely exploiting, a rare confluence of favorable global conditions
Of all the potential symbols of post-Soviet Russia’s transformation into a capital-based economy, though, the country’s two thriving equity exchanges are quite possibly the most vibrant, significant, and easily quantifiable, measure of that change.
The equity market in Russia, however, is poorly understood by most investors both inside and outside the borders of the country. Translation of those positive macroeconomic trends into company performance isn’t always direct, and the capital markets on the whole suffer from a variety of characteristics typical of emerging markets.
This is an attempt to characterize many of those conditions in the marketplace, examine the main market index, and explain some factors that affect the conventional wisdom on recent market returns.
The Backdrop
The country’s economic growth has provided an excellent foundation for interest and confidence in the emerging equity market. Since passing through the disastrous crisis in 1998, GDP growth through 2005 has compounded at an impressive 6.4% per year[1]. Most projections for the near future predict a deceleration in the high growth rates of 2000 to 2004, but still remaining around a healthy 6% per year[2]. That rate challenges the government’s desire to double GDP in 10 years (a 6% growth rate implies 12 years instead), but stable inflation and projected growth in real incomes and GDP per capital should ameliorate concerns over failing to meet that aggressive timetable.
Russia’s legacy tax code was greatly rationalized in 2000, eliminating whole classes of taxes as well as lowering tax rates on businesses and individuals. Corporate tax rates, for example, fell from 35% to 24%, while a complicated personal income tax scheme was replaced with a moderate flat tax of 13%. The VAT tax was lowered, too, to 18% at that time – and recent proposals indicate that there may be a further reduction to the low teens. As a consequence of this simplification, government revenues have increased dramatically as business and individual taxpayer compliance rates have skyrocketed.
Global oil prices have also certainly been a positive tailwind for the macroeconomic conditions in the past few years, as well. Rising prices and the resulting emphasis on production increases have pushed hydrocarbons to account for more than 50% of the country’s export revenue. The windfall is being felt in every part of the growing consumer economy, but fiscal discipline on the government policy level has so far prevented any spike in the inflation rate or ruble exchange rate – the Dutch Disease, as it is known in oil circles. President Putin’s decision to allocate windfall profits to a “Stabilization Fund” dedicated to improving infrastructure for long-term economic development is a much more welcome move than allowing oil profits to simply flow into the normal, and corrupt, Russian government budgetary process. In all, Russia’s currency reserves quickly are approaching USD 200 billion, the fifth largest hard currency reserve in the world.
Russia’s debt position has improved dramatically, too, with oil revenues used for frequent and early repayment of Paris Club debt. Government debt as a percentage of GDP dropped from over 90% in 1991 to about 35% by the end of last year[3], comparing very favorably to international standards. For example, United States total government debt as a percentage of GDP is expected to reach 67.5% in fiscal year 2007[4], while the OECD member states (ex-US) had an average 47.8% debt-to-GDP ratio in 2003.[5]
Capital flight has decreased, too. In 2005, in fact, Russia posted a $300 million net inflow of capital. This represented marked improvement over the previous few years when YUKOS inspired fears drove capital outflows from USD 1.9 billion in 2003 to more than USD 8 billion in 2004[6]. While private capital flows still seem on the outbound direction, renewed confidence in Russia’s markets and companies more than made up for that; 2005 was a record-setting year for attracting foreign capital through bond issuances and direct investment in the equity market.
Concentration of the Index
Observers of the Russian stock market tend to focus on the returns to the Russian Trading System Index (RTS) as an easy proxy for general activity in Russia. This index, however, is not necessarily an appropriate measure of general economic activity or even of overall market characteristics.
Former state assets, both energy and other industries, are inheritors of the gigantism of the Soviet Union. Newer companies, at best only 15 years old, are naturally much smaller than these state and former-state assets. As a result, the index of 50 stocks is highly concentrated in the top 10 names.
The top ten stocks in the index, then, represent 75% of the value of the index. But even the composition of that top echelon is somewhat questionable. Surgutneftegas common shares and preferred alike, for example, are both included in the top 10. In addition, TransNeft – the state-controlled oil pipeline operator – is essentially a tightly politically controlled monopoly utility; its tariffs, profits and dividends are dictated by federal legislation. In fact, only 2 (NOVATEK and LUKoil) truly classify as independent entities.
The RTS index is not broken down with explicit sector representation in mind. Market capitalization weighted indices in developed markets tend to define sectors, and then use the constituent market caps of index members to calculate the sector weight. Absent that system, the rapid development and intense interest in energy assets has skewed the representation to give it perhaps more of a weight than it really deserves. For example, while representing some 50% of total Russian Federation export revenues in 2006, energy related equities represent that same amount on the RTS index. Energy exports are undoubtedly the lion’s share of the macroeconomic improvement in Russia over the past few years, but it is unlikely that oil and gas alone count for more than 50% of the total economic activity of the publicly held economy in the country. Indeed, the retail sector has been growing well in excess of GDP growth, driving services higher as a percentage of GDP. Meanwhile, industry’s share as a percentage of total GDP has remained around 35%.[7]
Most significantly, this discussion of the RTS index does not include Gazprom, the energy giant controlled by the government. Its inclusion in the index in mid-March 2006, after the so-called “ring fence” prohibiting foreign ownership was removed, further altered the industry composition of the index. While rebalancing prevented drastic change to the overall concentration of the index, the oil and gas industry is much more heavily represented than before.
Still, there isn’t much else to go on when it comes to the Russian market. Despite its flaws, the RTS Index will likely remain the most visible benchmark of the equity markets for some time. It is important, however, for investors to note that the RTS Index is not necessarily a good proxy for total equity market returns that may be experienced by a diversified portfolio of holdings.
Trading Volumes and Overseas Exchanges
Trading volumes on the Russian exchanges have surged over the past few years in concert with renewed international interest in emerging markets as well as the healthy atmosphere for local issuances of new stocks. It is important, however, to see the overall trading volumes in the context of a newly developing stock market.
Most emerging market stock exchanges are relatively thinly traded compared to developed market peers. Although daily average turnover on the Russian market (including both the RTS and MICEX exchanges) now exceeds USD 1 billion (and, in fact, exceeds USD 2 billion quite regularly), the standard deviation of volumes is quite high. In March 2006, for example, daily volume averaged USD 1.8 billion. The standard deviation over that time frame was USD 656 million, nearly 1/3rd the mean. Statistically, one can expect the average daily volume of Russian stocks to range between USD 1.2 billion and USD 2.5 billion - a very wide gap - about 68% of the time.
The same top-heavy nature that plagues the RTS Index can also been seen in an analysis of security specific trading volumes. This is indicative of liquidity issues in both the overall market and in particular stocks. As can be seen in the following graphic, Gazprom represented fully 13% of the total average daily USD volume of the Russian domestically traded stock universe during the month of March.[8]
A standard expectation of emerging markets, however, is that the domestic economy is not capable of raising the necessary amounts of capital to fund growing business ventures. Companies in that position often seek to list shares on developed capital markets, where there is greater access to a larger pool of international capital. Of the 20 IPO’s of Russian companies since 2004, 13 took place overseas and 7 were released in Russia.
Within that dynamic, there has been a distinct shift to the London Stock Exchange. Prior to 2002, the exchange of choice for Russian issuers was the New York Stock Exchange. Financial scandals in the US, however, led to much more strict regulation and accounting/management requirements for US listed companies; Sarbanes-Oxley is the most frequently cited example of the new, strict regulatory environment. In addition, Russian companies find fault with some of the finer details of natural resources reserve accounting and certification.
The dynamics of international demand for Russian equities has also played a role in the shift to London as a preferred exchange. Investment bankers discovered that US investor demand for such equities only approached 50% of an issue when listing on the New York Stock Exchange. In contrast, UK and European investors usually account for just more than 50% of demand for an IPO when the listing is made in London[9]. Thus, Russian issuers are increasingly drawn to the “home market” of the investors with the greatest appetite for their equity issues.
Together, the regulatory and demand dynamics have combined to cause a major shift to London. Of the 13 foreign-market-placed IPO’s of Russian equities since 2004, 12 have been launched in London while only 1 has been floated in New York.
All of the major exchanges have initiatives to attract more mid-cap companies to the public capital markets. Most notably, the London Stock Exchange has instituted an “Alternative Investment Market” (AIM), with less stringent listing requirements. This exchange occupies a niche just outside of the fully regulated UK marketplace. The relative ease of attracting capital through listing on this exchange should attract companies that want the prestige of an overseas listing but aren’t large enough to justify the regulatory expenses.
The total Russian equity universe, then, should include volumes traded on both the domestic and overseas exchanges. In this global perspective, overseas markets account for some 36% of the average daily volume of Russian equities.
New legislation in the Russian Federation, though, may slightly change this model of raising capital. A new law requires that 30% of a new issue be placed in Russia. It’s unclear whether that “30% Rule” refers to how much of the IPO is offered inside Russia, or if it refers to how much of the issue is actually sold within the country. In either case, there may be more of a push for listing on multiple exchanges as a result (both RTS and LSE, for example). Implementation of the rule by regulators will be key to its final interpretation by the market, but serious negative consequences on the ability of Russian companies to raise capital are not expected.
In fact, many Russian-domiciled mutual funds are registered offshore at least partially for the benefit of overseas investors. These often qualify as “foreign investors” in most statistics of market trading volumes, yet they presumably have excellent access to local markets. Offering 30% of an issue domestically, then, may just be matching demand with location just as well as listing in London does for other international investors.
Liquidity and Market Capitalization
Like most emerging markets, liquidity is an issue in Russia too. Market observers have generally broken the equity universe into as many as 3 “tiers”. Neither the definition of a tier or the cut off points between them, however, is standard between brokerage houses. While some list according to market cap in USD billion increments, others classify by liquidity and trading volumes relative to outstanding shares; i.e. by the actual availability of the equity.
This liquidity issue is no small distinction in the Russian stock exchange. Shares of some rather large companies can be somewhat hard to come by on the open market. Generally speaking, such limited float statistics are a result of concentrated holdings by state or other controlling entities.
For instance, Baltika Brewery, the largest brewer of beer in Russia, has a USD 5.5 billion market cap and represents 0.65% of the RTS index. The stock, however, traded only 11 times in the first 75 days of 2006. Despite being a bellwether consumer-products company, Baltika is a closely held joint venture with a low public float.
The effect, however, is often completely disassociated from market cap. Indeed, stocks in lower “tiers” may well be more liquid than supposedly more liquid index components. Kalina, a cosmetics manufacturer with a USD 500 million market capitalization traded on twice as many occasions during the first 3 months of 2006 as Baltika. By nearly any measure, Kalina’s trading history outdoes its much larger peer – its 99,000 shares traded equated to 1.02% of its float. Baltika’s 22,000 shares equated to only 0.02% of its float[10].
Many measures of activity, however, mistakenly focus on market capitalization as an indicator of either breadth or depth in the marketplace. This can be a very misleading statistic. For example, while the MICEX Exchange trades in excess of 80% of all Russian equity by value, it notes that the top 10 companies account for as much as 95% of the total volume. Indeed, Gazprom, at the end of its first month of trading (February 2006) on the MICEX Exchange accounted for 43% of the total volume of that exchange. Conversely, mid cap stocks only represented about 0.5% of total volume.[11]
Given the top-heavy nature of liquidity in the indices and exchanges, in many cases it seems that market cap is really representing a scarcity factor related to a particular lower tier stock. In an emerging market, whole industry sectors may be represented in the publicly traded market by a single equity with strong insider ownership and a low public float. Exposure to these sectors, then, requires fund managers to aggressively, but patiently, build positions over long periods of time.
Performance and Drivers
Against the backdrop of the improving macroeconomic situation, the major domestic equity market indices have advanced sharply. Russia has consistently ranked as one of the world’s best performing stock markets in pure price appreciation in 4 of the past 5 years[12].
Conventional wisdom, backed up by compelling evidence in the macroeconomic sphere, posits that advances in the Russian stock market are solely the function of advances in the price of oil.
However, casual observation alone brings this hypothesis into question. Oil prices have fluctuated in the past 9 months, but RTS Index returns have been quite consistently positive over the same time period (chart attached). Longer time frames only show the same experience. While the near-term oil future has advanced by 122% since January 2000, the RTS Index has increased more than 740% (chart attached).
Admittedly, examining two charts is a superficial way to seek relationships between variables. Further segmentation and regression analysis of the data, however, presents a much more nuanced – and perhaps surprising – explanation of recent oil and stock market activity.
In the case of 2005 and year-to-date (YTD) 2006 returns, the analysis returned some interesting results.
R-Squared
Time Frame SPOT 1 mo future 3 mo future 6 mo future
2005 0.42 0.46 0.44 0.45
1st half 2005
0.68 0.64 0.66 0.65
2nd half 2005
0.30 0.31 0.33 0.31
2005 – YTD 2006*
0.02 0.42 0.45 0.48
*all results are statistically significant at the 95% confidence level except the regression for 2005-YTD2006 SPOT (which barely missed hitting the significance threshold).
First, the results indicate that there is no real difference with the relationship between market returns and the length of the futures contract. One might expect a stronger relationship between near-term market returns and higher longer-term futures contracts. In this case, that would mean equity values would increase as participants in the oil market signaled their belief that oil prices were likely to increase or that stronger prices were sustainable into the future. The minor variations in r-squared values across the horizontal axis of this table, however, indicate that this is not the case.
Second, the results do not indicate a consistent relationship between oil and market returns over time. The 2005 whole-year r-squared between oil and market returns is about 0.42; at best, a moderately strong correlation of 0.65. Yet breaking the year into two 6-month periods shows a marked decrease in the correlation of the two variables over time. The r-squared for the first half of the year indicates a very strong correlation (about 0.83) explaining 68% of the variation in the independent variable (RTS Index returns). Yet the second half of the year is much weaker, explaining only 30% of the variation.
Third, perhaps not too surprisingly, keeping oil price performance in mind over the course of 2005 shows that the RTS Index returns were more correlated to larger changes in oil prices. That is, the correlation was strongest when the oil price was advancing the most, up 34% from January to June. In the second half of the year, when oil only increased 8% in price, the correlation was weakest. However, examining the coincident market returns in those periods does reveal a bit of a surprise.
Date
Oil
% change
RTS Index
% change
R-Squared*
12/31/2005
61.04
8%
1125.6
59%
0.30
6/30/2005
56.50
34%
706.4
16%
0.68
1/11/2005
42.12
607.6
*”R-squared” indicates the regression over the previous 6-month period.
Here, the data indicate that the market and oil prices were most correlated while oil prices were advancing strongly. Yet the market returns were lower in that period and higher in the second half of the year when the correlation had supposedly weakened. The conventional wisdom view of Russia as an oil economy would tend to support the idea that market returns and oil price advances were coincidental or slightly lagged at worst, when the opposite appears to be true.
Fourth, longer term annual analysis of the data is inconclusive at best (table attached). The relationship between spot and futures prices of differing lengths was much less consistent than the 2005 and 2006 data indicated. In addition, the regression analysis of year-by-year calendar returns showed that most of the correlations were in the moderately correlated range, and some relationships were actually modestly negative in some years. Oil prices had been advancing, however, in each of the years from 2002 to the present.
While oil undoubtedly has been a strong factor in the improvement of the Russian economy, the data show that its effect on the equity markets is much more difficult to quantify or explain. Certainly, it is a major driver of investment returns; saying that Russia is an oil-driven environment, however, doesn’t appear to answer very many questions about how to make money in the stock market.
Significant questions, of course, are raised by the data. If oil isn’t as direct a driver of investment returns as hypothesized, then what are the other drivers of undeniably steep advances in the local market indices?
Barring a full-blown econometric model to determine the influence of multiple variables on stock market returns, observation tends to lead to a few beliefs that should be tested. Breaking the oil price into certain price bands would probably be more instructive. That is to say, RTS Index returns may well be more correlated to the persistence of oil prices at a certain level.
For example, many researchers have tried to estimate the sensitivity of the Russian economy, in the aggregate, to the price of oil. Outputs differ with respect to the amount of the increase in GDP per capita and other statistics, but directionally most of the studies agree; higher longer-term oil prices augur well for GDP expansion in Russia. Most analysts in the energy sphere also have long-term estimates for what they consider the “balanced” price of oil; keeping supply and demand considerations roughly equal, barring unforeseen risk factors from geopolitical problems. Estimates of these long-term prices are generally in the USD 30 to USD 40 range, with only the most optimistic topping out around USD 45.
Combining both factors, and the realization that oil remains stubbornly well above that long-term average price range, may then be the key to understanding market behavior. For each day that oil remains in those price ranges above the long-term estimate, long-term estimates for Russian GDP growth must also be ratcheted slightly higher.
Certainly, another variable in a more comprehensive model should be related to risk factors; In particular, country specific estimates of risk need to be examined. The Arbitrage Pricing Theory (APT) is different from other valuation models in that it tries to specifically enumerate risk of individual factors. The Capital Asset Pricing Model (CAPM), in contrast, uses only the market risk factor.
As credit rating agencies raise their opinion of Russia’s creditworthiness, spreads between Russian bonds and benchmark Western government bonds have narrowed. In addition, stability in taxation, currency, and budgetary processes have also reduced the overall risk premium for Russian stocks. Again, this seems to relate also to price bands in the oil market. As long as oil stays over USD 50, for example, Russian government tax revenues on the exports will be higher than expected by a certain factor. This further reduces risks inherent in the more comprehensive definitions of the APT.
In summary, then, it’s possible to surmise that advances in oil prices are good for the Russian economy, and by extension, the Russian stock market. The relationship, however, is not nearly as direct as many observers of the market may expect.
Capital Flows - Liquidity both Foreign and Domestic
In general over this time, emerging market indices have out-performed stock markets in the US, Europe, and Japan. This out-performance has drawn the attention of foreign investors, and capital inflows are surging into emerging market funds from pensions, institutions, and individual investors as well.
Russia is mentioned among the most fashionable and profitable markets – the BRIC. The acronym was invented by an equity strategist to highlight his preferred markets of the future – Brazil, Russia, India, and China – and the belief that the combined GDP’s of these economies could outstrip the individual GDP’s of the current dominant economies (the US and EU) by 2050.[13]
As Russia continues to post decent GDP growth and market gains, its percentage share on the MSCI Emerging Markets Index[14] is likely to continue to grow. That means that capital markets in Russia are taking a slightly larger piece of a growing pie. Indeed, in the first 3 months of 2006, emerging market inflows of $20.9 billion have already eclipsed 2005’s record setting total of $20.3 billion[15] for the entire year.
At the same time, positive current account balances and healthy oil revenues have increased the odds of ruble appreciation against the dollar. Domestic institutions now prefer to hold assets denominated in rubles – a “long” ruble position. This may well be a factor in the steep decline in Russia’s capital outflows figures over 2005, and is likely continuing into 2006, as well.
Summary
The Russian stock market, then, needs to be analyzed in the context of an emerging markets framework. This involves specialized analysis of issues such as liquidity of an individual security; the overall appropriateness of indices and other “top-down” aggregate measures; and conventional wisdom about drivers of stock market performance.
Supply and demand issues aside, though, the Russian stock market should continue to draw the attention of foreign investors as macroeconomic improvements continue. As Russia is increasingly viewed as an engine of global economic growth –a member of the BRIC countries – capital will likely be drawn here in ever growing amounts. More capital means more business expansion, which means more profits, which attracts more capital. In all, despite its emerging status, the Russian market looks like it may be setting out on a multiyear virtuous cycle of advances only marginally related to oil prices.
Endnotes
[1] Economist Country Briefing.
[2] Economist Intelligence Unit, Troika-Dialog estimate (6.2%), UFG Deutsche Bank estimate (5.9%), Russian Federation Ministry of Economics estimate (6.0%).
[3] CIA World Fact Book, Russia Country Profile 2006.
[4] US Office of Management and Budget (OMB) statistics.
[5] Organization for Economic Development and Cooperation (OECD), Statistical Database.
[6] Central Bank of the Russian Federation, Annual Statistics 2005.
[7] United Nations Economic Commission for Europe (UNECE) statistics.
[8] Renaissance Capital Evening Market Wrap; March 1st – 31st, 2006
[9] UBS Investment Bank
[10] Bloomberg.
[11] MICEX/London Stock Exchange joint conference: “Raising Capital in Russia & Abroad: Trends and Developments”, 1-2 March 2006.
[12] Bloomberg.
[13] Goldman Sachs Global Economics Paper No.99; “Dreaming with BRICS: The Path to 2050”
[14] From the Morgan Stanley website:
“The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. …the index consisted of the following 26 emerging market country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey and Venezuela.”
Прогулка по Рынку: Observations on the Russian Stock Market
Introduction
Riding a wave of oil, favorable commodity prices for other natural resources, and some well-considered reforms, Russia’s recent macroeconomic advances have been reflected in increased bond ratings from the major rating agencies, as well as substantive improvement in the conditions for the population i.e. a declining poverty rate, real income growth, and climbing per capita GDP. While the situation certainly has room for more such dramatic improvement, the country is enjoying, and wisely exploiting, a rare confluence of favorable global conditions
Of all the potential symbols of post-Soviet Russia’s transformation into a capital-based economy, though, the country’s two thriving equity exchanges are quite possibly the most vibrant, significant, and easily quantifiable, measure of that change.
The equity market in Russia, however, is poorly understood by most investors both inside and outside the borders of the country. Translation of those positive macroeconomic trends into company performance isn’t always direct, and the capital markets on the whole suffer from a variety of characteristics typical of emerging markets.
This is an attempt to characterize many of those conditions in the marketplace, examine the main market index, and explain some factors that affect the conventional wisdom on recent market returns.
The Backdrop
The country’s economic growth has provided an excellent foundation for interest and confidence in the emerging equity market. Since passing through the disastrous crisis in 1998, GDP growth through 2005 has compounded at an impressive 6.4% per year[1]. Most projections for the near future predict a deceleration in the high growth rates of 2000 to 2004, but still remaining around a healthy 6% per year[2]. That rate challenges the government’s desire to double GDP in 10 years (a 6% growth rate implies 12 years instead), but stable inflation and projected growth in real incomes and GDP per capital should ameliorate concerns over failing to meet that aggressive timetable.
Russia’s legacy tax code was greatly rationalized in 2000, eliminating whole classes of taxes as well as lowering tax rates on businesses and individuals. Corporate tax rates, for example, fell from 35% to 24%, while a complicated personal income tax scheme was replaced with a moderate flat tax of 13%. The VAT tax was lowered, too, to 18% at that time – and recent proposals indicate that there may be a further reduction to the low teens. As a consequence of this simplification, government revenues have increased dramatically as business and individual taxpayer compliance rates have skyrocketed.
Global oil prices have also certainly been a positive tailwind for the macroeconomic conditions in the past few years, as well. Rising prices and the resulting emphasis on production increases have pushed hydrocarbons to account for more than 50% of the country’s export revenue. The windfall is being felt in every part of the growing consumer economy, but fiscal discipline on the government policy level has so far prevented any spike in the inflation rate or ruble exchange rate – the Dutch Disease, as it is known in oil circles. President Putin’s decision to allocate windfall profits to a “Stabilization Fund” dedicated to improving infrastructure for long-term economic development is a much more welcome move than allowing oil profits to simply flow into the normal, and corrupt, Russian government budgetary process. In all, Russia’s currency reserves quickly are approaching USD 200 billion, the fifth largest hard currency reserve in the world.
Russia’s debt position has improved dramatically, too, with oil revenues used for frequent and early repayment of Paris Club debt. Government debt as a percentage of GDP dropped from over 90% in 1991 to about 35% by the end of last year[3], comparing very favorably to international standards. For example, United States total government debt as a percentage of GDP is expected to reach 67.5% in fiscal year 2007[4], while the OECD member states (ex-US) had an average 47.8% debt-to-GDP ratio in 2003.[5]
Capital flight has decreased, too. In 2005, in fact, Russia posted a $300 million net inflow of capital. This represented marked improvement over the previous few years when YUKOS inspired fears drove capital outflows from USD 1.9 billion in 2003 to more than USD 8 billion in 2004[6]. While private capital flows still seem on the outbound direction, renewed confidence in Russia’s markets and companies more than made up for that; 2005 was a record-setting year for attracting foreign capital through bond issuances and direct investment in the equity market.
Concentration of the Index
Observers of the Russian stock market tend to focus on the returns to the Russian Trading System Index (RTS) as an easy proxy for general activity in Russia. This index, however, is not necessarily an appropriate measure of general economic activity or even of overall market characteristics.
Former state assets, both energy and other industries, are inheritors of the gigantism of the Soviet Union. Newer companies, at best only 15 years old, are naturally much smaller than these state and former-state assets. As a result, the index of 50 stocks is highly concentrated in the top 10 names.
The top ten stocks in the index, then, represent 75% of the value of the index. But even the composition of that top echelon is somewhat questionable. Surgutneftegas common shares and preferred alike, for example, are both included in the top 10. In addition, TransNeft – the state-controlled oil pipeline operator – is essentially a tightly politically controlled monopoly utility; its tariffs, profits and dividends are dictated by federal legislation. In fact, only 2 (NOVATEK and LUKoil) truly classify as independent entities.
The RTS index is not broken down with explicit sector representation in mind. Market capitalization weighted indices in developed markets tend to define sectors, and then use the constituent market caps of index members to calculate the sector weight. Absent that system, the rapid development and intense interest in energy assets has skewed the representation to give it perhaps more of a weight than it really deserves. For example, while representing some 50% of total Russian Federation export revenues in 2006, energy related equities represent that same amount on the RTS index. Energy exports are undoubtedly the lion’s share of the macroeconomic improvement in Russia over the past few years, but it is unlikely that oil and gas alone count for more than 50% of the total economic activity of the publicly held economy in the country. Indeed, the retail sector has been growing well in excess of GDP growth, driving services higher as a percentage of GDP. Meanwhile, industry’s share as a percentage of total GDP has remained around 35%.[7]
Most significantly, this discussion of the RTS index does not include Gazprom, the energy giant controlled by the government. Its inclusion in the index in mid-March 2006, after the so-called “ring fence” prohibiting foreign ownership was removed, further altered the industry composition of the index. While rebalancing prevented drastic change to the overall concentration of the index, the oil and gas industry is much more heavily represented than before.
Still, there isn’t much else to go on when it comes to the Russian market. Despite its flaws, the RTS Index will likely remain the most visible benchmark of the equity markets for some time. It is important, however, for investors to note that the RTS Index is not necessarily a good proxy for total equity market returns that may be experienced by a diversified portfolio of holdings.
Trading Volumes and Overseas Exchanges
Trading volumes on the Russian exchanges have surged over the past few years in concert with renewed international interest in emerging markets as well as the healthy atmosphere for local issuances of new stocks. It is important, however, to see the overall trading volumes in the context of a newly developing stock market.
Most emerging market stock exchanges are relatively thinly traded compared to developed market peers. Although daily average turnover on the Russian market (including both the RTS and MICEX exchanges) now exceeds USD 1 billion (and, in fact, exceeds USD 2 billion quite regularly), the standard deviation of volumes is quite high. In March 2006, for example, daily volume averaged USD 1.8 billion. The standard deviation over that time frame was USD 656 million, nearly 1/3rd the mean. Statistically, one can expect the average daily volume of Russian stocks to range between USD 1.2 billion and USD 2.5 billion - a very wide gap - about 68% of the time.
The same top-heavy nature that plagues the RTS Index can also been seen in an analysis of security specific trading volumes. This is indicative of liquidity issues in both the overall market and in particular stocks. As can be seen in the following graphic, Gazprom represented fully 13% of the total average daily USD volume of the Russian domestically traded stock universe during the month of March.[8]
A standard expectation of emerging markets, however, is that the domestic economy is not capable of raising the necessary amounts of capital to fund growing business ventures. Companies in that position often seek to list shares on developed capital markets, where there is greater access to a larger pool of international capital. Of the 20 IPO’s of Russian companies since 2004, 13 took place overseas and 7 were released in Russia.
Within that dynamic, there has been a distinct shift to the London Stock Exchange. Prior to 2002, the exchange of choice for Russian issuers was the New York Stock Exchange. Financial scandals in the US, however, led to much more strict regulation and accounting/management requirements for US listed companies; Sarbanes-Oxley is the most frequently cited example of the new, strict regulatory environment. In addition, Russian companies find fault with some of the finer details of natural resources reserve accounting and certification.
The dynamics of international demand for Russian equities has also played a role in the shift to London as a preferred exchange. Investment bankers discovered that US investor demand for such equities only approached 50% of an issue when listing on the New York Stock Exchange. In contrast, UK and European investors usually account for just more than 50% of demand for an IPO when the listing is made in London[9]. Thus, Russian issuers are increasingly drawn to the “home market” of the investors with the greatest appetite for their equity issues.
Together, the regulatory and demand dynamics have combined to cause a major shift to London. Of the 13 foreign-market-placed IPO’s of Russian equities since 2004, 12 have been launched in London while only 1 has been floated in New York.
All of the major exchanges have initiatives to attract more mid-cap companies to the public capital markets. Most notably, the London Stock Exchange has instituted an “Alternative Investment Market” (AIM), with less stringent listing requirements. This exchange occupies a niche just outside of the fully regulated UK marketplace. The relative ease of attracting capital through listing on this exchange should attract companies that want the prestige of an overseas listing but aren’t large enough to justify the regulatory expenses.
The total Russian equity universe, then, should include volumes traded on both the domestic and overseas exchanges. In this global perspective, overseas markets account for some 36% of the average daily volume of Russian equities.
New legislation in the Russian Federation, though, may slightly change this model of raising capital. A new law requires that 30% of a new issue be placed in Russia. It’s unclear whether that “30% Rule” refers to how much of the IPO is offered inside Russia, or if it refers to how much of the issue is actually sold within the country. In either case, there may be more of a push for listing on multiple exchanges as a result (both RTS and LSE, for example). Implementation of the rule by regulators will be key to its final interpretation by the market, but serious negative consequences on the ability of Russian companies to raise capital are not expected.
In fact, many Russian-domiciled mutual funds are registered offshore at least partially for the benefit of overseas investors. These often qualify as “foreign investors” in most statistics of market trading volumes, yet they presumably have excellent access to local markets. Offering 30% of an issue domestically, then, may just be matching demand with location just as well as listing in London does for other international investors.
Liquidity and Market Capitalization
Like most emerging markets, liquidity is an issue in Russia too. Market observers have generally broken the equity universe into as many as 3 “tiers”. Neither the definition of a tier or the cut off points between them, however, is standard between brokerage houses. While some list according to market cap in USD billion increments, others classify by liquidity and trading volumes relative to outstanding shares; i.e. by the actual availability of the equity.
This liquidity issue is no small distinction in the Russian stock exchange. Shares of some rather large companies can be somewhat hard to come by on the open market. Generally speaking, such limited float statistics are a result of concentrated holdings by state or other controlling entities.
For instance, Baltika Brewery, the largest brewer of beer in Russia, has a USD 5.5 billion market cap and represents 0.65% of the RTS index. The stock, however, traded only 11 times in the first 75 days of 2006. Despite being a bellwether consumer-products company, Baltika is a closely held joint venture with a low public float.
The effect, however, is often completely disassociated from market cap. Indeed, stocks in lower “tiers” may well be more liquid than supposedly more liquid index components. Kalina, a cosmetics manufacturer with a USD 500 million market capitalization traded on twice as many occasions during the first 3 months of 2006 as Baltika. By nearly any measure, Kalina’s trading history outdoes its much larger peer – its 99,000 shares traded equated to 1.02% of its float. Baltika’s 22,000 shares equated to only 0.02% of its float[10].
Many measures of activity, however, mistakenly focus on market capitalization as an indicator of either breadth or depth in the marketplace. This can be a very misleading statistic. For example, while the MICEX Exchange trades in excess of 80% of all Russian equity by value, it notes that the top 10 companies account for as much as 95% of the total volume. Indeed, Gazprom, at the end of its first month of trading (February 2006) on the MICEX Exchange accounted for 43% of the total volume of that exchange. Conversely, mid cap stocks only represented about 0.5% of total volume.[11]
Given the top-heavy nature of liquidity in the indices and exchanges, in many cases it seems that market cap is really representing a scarcity factor related to a particular lower tier stock. In an emerging market, whole industry sectors may be represented in the publicly traded market by a single equity with strong insider ownership and a low public float. Exposure to these sectors, then, requires fund managers to aggressively, but patiently, build positions over long periods of time.
Performance and Drivers
Against the backdrop of the improving macroeconomic situation, the major domestic equity market indices have advanced sharply. Russia has consistently ranked as one of the world’s best performing stock markets in pure price appreciation in 4 of the past 5 years[12].
Conventional wisdom, backed up by compelling evidence in the macroeconomic sphere, posits that advances in the Russian stock market are solely the function of advances in the price of oil.
However, casual observation alone brings this hypothesis into question. Oil prices have fluctuated in the past 9 months, but RTS Index returns have been quite consistently positive over the same time period (chart attached). Longer time frames only show the same experience. While the near-term oil future has advanced by 122% since January 2000, the RTS Index has increased more than 740% (chart attached).
Admittedly, examining two charts is a superficial way to seek relationships between variables. Further segmentation and regression analysis of the data, however, presents a much more nuanced – and perhaps surprising – explanation of recent oil and stock market activity.
In the case of 2005 and year-to-date (YTD) 2006 returns, the analysis returned some interesting results.
R-Squared
Time Frame SPOT 1 mo future 3 mo future 6 mo future
2005 0.42 0.46 0.44 0.45
1st half 2005
0.68 0.64 0.66 0.65
2nd half 2005
0.30 0.31 0.33 0.31
2005 – YTD 2006*
0.02 0.42 0.45 0.48
*all results are statistically significant at the 95% confidence level except the regression for 2005-YTD2006 SPOT (which barely missed hitting the significance threshold).
First, the results indicate that there is no real difference with the relationship between market returns and the length of the futures contract. One might expect a stronger relationship between near-term market returns and higher longer-term futures contracts. In this case, that would mean equity values would increase as participants in the oil market signaled their belief that oil prices were likely to increase or that stronger prices were sustainable into the future. The minor variations in r-squared values across the horizontal axis of this table, however, indicate that this is not the case.
Second, the results do not indicate a consistent relationship between oil and market returns over time. The 2005 whole-year r-squared between oil and market returns is about 0.42; at best, a moderately strong correlation of 0.65. Yet breaking the year into two 6-month periods shows a marked decrease in the correlation of the two variables over time. The r-squared for the first half of the year indicates a very strong correlation (about 0.83) explaining 68% of the variation in the independent variable (RTS Index returns). Yet the second half of the year is much weaker, explaining only 30% of the variation.
Third, perhaps not too surprisingly, keeping oil price performance in mind over the course of 2005 shows that the RTS Index returns were more correlated to larger changes in oil prices. That is, the correlation was strongest when the oil price was advancing the most, up 34% from January to June. In the second half of the year, when oil only increased 8% in price, the correlation was weakest. However, examining the coincident market returns in those periods does reveal a bit of a surprise.
Date
Oil
% change
RTS Index
% change
R-Squared*
12/31/2005
61.04
8%
1125.6
59%
0.30
6/30/2005
56.50
34%
706.4
16%
0.68
1/11/2005
42.12
607.6
*”R-squared” indicates the regression over the previous 6-month period.
Here, the data indicate that the market and oil prices were most correlated while oil prices were advancing strongly. Yet the market returns were lower in that period and higher in the second half of the year when the correlation had supposedly weakened. The conventional wisdom view of Russia as an oil economy would tend to support the idea that market returns and oil price advances were coincidental or slightly lagged at worst, when the opposite appears to be true.
Fourth, longer term annual analysis of the data is inconclusive at best (table attached). The relationship between spot and futures prices of differing lengths was much less consistent than the 2005 and 2006 data indicated. In addition, the regression analysis of year-by-year calendar returns showed that most of the correlations were in the moderately correlated range, and some relationships were actually modestly negative in some years. Oil prices had been advancing, however, in each of the years from 2002 to the present.
While oil undoubtedly has been a strong factor in the improvement of the Russian economy, the data show that its effect on the equity markets is much more difficult to quantify or explain. Certainly, it is a major driver of investment returns; saying that Russia is an oil-driven environment, however, doesn’t appear to answer very many questions about how to make money in the stock market.
Significant questions, of course, are raised by the data. If oil isn’t as direct a driver of investment returns as hypothesized, then what are the other drivers of undeniably steep advances in the local market indices?
Barring a full-blown econometric model to determine the influence of multiple variables on stock market returns, observation tends to lead to a few beliefs that should be tested. Breaking the oil price into certain price bands would probably be more instructive. That is to say, RTS Index returns may well be more correlated to the persistence of oil prices at a certain level.
For example, many researchers have tried to estimate the sensitivity of the Russian economy, in the aggregate, to the price of oil. Outputs differ with respect to the amount of the increase in GDP per capita and other statistics, but directionally most of the studies agree; higher longer-term oil prices augur well for GDP expansion in Russia. Most analysts in the energy sphere also have long-term estimates for what they consider the “balanced” price of oil; keeping supply and demand considerations roughly equal, barring unforeseen risk factors from geopolitical problems. Estimates of these long-term prices are generally in the USD 30 to USD 40 range, with only the most optimistic topping out around USD 45.
Combining both factors, and the realization that oil remains stubbornly well above that long-term average price range, may then be the key to understanding market behavior. For each day that oil remains in those price ranges above the long-term estimate, long-term estimates for Russian GDP growth must also be ratcheted slightly higher.
Certainly, another variable in a more comprehensive model should be related to risk factors; In particular, country specific estimates of risk need to be examined. The Arbitrage Pricing Theory (APT) is different from other valuation models in that it tries to specifically enumerate risk of individual factors. The Capital Asset Pricing Model (CAPM), in contrast, uses only the market risk factor.
As credit rating agencies raise their opinion of Russia’s creditworthiness, spreads between Russian bonds and benchmark Western government bonds have narrowed. In addition, stability in taxation, currency, and budgetary processes have also reduced the overall risk premium for Russian stocks. Again, this seems to relate also to price bands in the oil market. As long as oil stays over USD 50, for example, Russian government tax revenues on the exports will be higher than expected by a certain factor. This further reduces risks inherent in the more comprehensive definitions of the APT.
In summary, then, it’s possible to surmise that advances in oil prices are good for the Russian economy, and by extension, the Russian stock market. The relationship, however, is not nearly as direct as many observers of the market may expect.
Capital Flows - Liquidity both Foreign and Domestic
In general over this time, emerging market indices have out-performed stock markets in the US, Europe, and Japan. This out-performance has drawn the attention of foreign investors, and capital inflows are surging into emerging market funds from pensions, institutions, and individual investors as well.
Russia is mentioned among the most fashionable and profitable markets – the BRIC. The acronym was invented by an equity strategist to highlight his preferred markets of the future – Brazil, Russia, India, and China – and the belief that the combined GDP’s of these economies could outstrip the individual GDP’s of the current dominant economies (the US and EU) by 2050.[13]
As Russia continues to post decent GDP growth and market gains, its percentage share on the MSCI Emerging Markets Index[14] is likely to continue to grow. That means that capital markets in Russia are taking a slightly larger piece of a growing pie. Indeed, in the first 3 months of 2006, emerging market inflows of $20.9 billion have already eclipsed 2005’s record setting total of $20.3 billion[15] for the entire year.
At the same time, positive current account balances and healthy oil revenues have increased the odds of ruble appreciation against the dollar. Domestic institutions now prefer to hold assets denominated in rubles – a “long” ruble position. This may well be a factor in the steep decline in Russia’s capital outflows figures over 2005, and is likely continuing into 2006, as well.
Summary
The Russian stock market, then, needs to be analyzed in the context of an emerging markets framework. This involves specialized analysis of issues such as liquidity of an individual security; the overall appropriateness of indices and other “top-down” aggregate measures; and conventional wisdom about drivers of stock market performance.
Supply and demand issues aside, though, the Russian stock market should continue to draw the attention of foreign investors as macroeconomic improvements continue. As Russia is increasingly viewed as an engine of global economic growth –a member of the BRIC countries – capital will likely be drawn here in ever growing amounts. More capital means more business expansion, which means more profits, which attracts more capital. In all, despite its emerging status, the Russian market looks like it may be setting out on a multiyear virtuous cycle of advances only marginally related to oil prices.
Endnotes
[1] Economist Country Briefing.
[2] Economist Intelligence Unit, Troika-Dialog estimate (6.2%), UFG Deutsche Bank estimate (5.9%), Russian Federation Ministry of Economics estimate (6.0%).
[3] CIA World Fact Book, Russia Country Profile 2006.
[4] US Office of Management and Budget (OMB) statistics.
[5] Organization for Economic Development and Cooperation (OECD), Statistical Database.
[6] Central Bank of the Russian Federation, Annual Statistics 2005.
[7] United Nations Economic Commission for Europe (UNECE) statistics.
[8] Renaissance Capital Evening Market Wrap; March 1st – 31st, 2006
[9] UBS Investment Bank
[10] Bloomberg.
[11] MICEX/London Stock Exchange joint conference: “Raising Capital in Russia & Abroad: Trends and Developments”, 1-2 March 2006.
[12] Bloomberg.
[13] Goldman Sachs Global Economics Paper No.99; “Dreaming with BRICS: The Path to 2050”
[14] From the Morgan Stanley website:
“The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. …the index consisted of the following 26 emerging market country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey and Venezuela.”
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