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. Last Updated: 07/27/2016

Picking the Winners Beyond the Boom

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After years of enjoying the country's longest-ever growth cycle, investors in Russian markets appear to have picked the lower branches clean. Blue chips are seeing more modest growth and fairer values, and investors are having to reach beyond oil and gas -- into the financial, consumer and electricity sectors, among others -- to find the momentum they are used to. The question now is whether they still have the stomach for risk.

Now more than ever, the volatility of Russian stocks is coming from abroad. Driven more by global market mood swings than Russia's fundamentals, the benchmark RTS Index has moved hand in glove with emerging markets since November.

Analysts say this has created a new dynamic. The high oil prices that have historically been able to push Russia ahead of the pack now threaten to pull it down by slowing the global economy. "There are no domestic factors to shelter Russia from these trends," said Chris Weafer, chief strategist at Alfa Bank. "The oil price is much less influential now."

Indeed, when the global correction hit at the end of February, the buoyant price of oil did nothing to break the fall of the RTS, which sank 12.5 percent in three weeks, 3 percent more than the emerging market average.

Even though the index has recovered all the ground it lost, global appetite for risk has not. A Merrill Lynch survey of global fund managers found risk aversion at one of the highest levels in five years, meaning that a lot of market participants are still sitting on their hands.

"We see the market contraction at the end of February very much as a warning signal rather than a correction," said Roland Nash, head of research at Renaissance Capital. The signal seems to be pointing to weaker confidence around the world. For an emerging market such as Russia, which depends more than most on the more intrepid investors, this is alarming news.

On the basis of values, however, Russian equities are still cheap -- at a discount of roughly 10 percent to the emerging markets asset class. "One of the main reasons this market has moved so far is because perceptions have been so cautious and gloomy," said Al Breach, research director at UBS.

Those who can look beyond these perceptions will see the money still to be made, he said.

And Nash added that the country's domestically oriented industries could well make it a haven if the world economy went bad.

'An Economy on Steroids'

The other factor that would support its haven status is macroeconomic strength. From the windfalls of this decade, the Central Bank has been able to amass reserves worth more than $330 billion, the third-largest cash hoard in the world. The $110 billion stabilization fund has also been gleaned from export taxes on oil sold above $27 per barrel, and has only been used to pay off Russia's sovereign debt, which is now at less than 10 percent of GDP.

"We give a very high rating to Russia for managing capital inflows," said John Litwack, head of the World Bank in Russia.

Next February, when the stabilization fund is expected to reach 10 percent of GDP, a value of about $125 billion, it will be split into a reserve fund and a "fund for future generations."

As elections grow nearer, chances are that these funds will be invested domestically, with some likely to go toward the kind of pork-barrel spending the state has so far avoided. But on the whole, Litwack said, these funds promise to make for a huge source of budgetary income just from the interest.

This income will in large part go toward revamping Russia's infrastructure. Though the roads, schools and hospitals inherited from the Soviet Union have so far staved off spending, the need for new investment has now become acute, Nash said.

Federal budget spending for this year will increase 25 percent on that for 2006, reaching $206 billion, and climbing again to $275 billion in 2008, according to a three-year budget laid out by the Finance Ministry in March.

The state will also set up public-private partnerships that will allow companies to chip in on public projects with the government. The 10 that have already been chosen are expected to leverage the state's investment by 20 times, contributing up to $30 billion in private money.

Russia's national champions are also set to splurge out in coming years as greenfield projects come online and the electricity system gets revamped from top to bottom.

"The need for this spending is huge," Nash said. "But when you have an economy that's booming already, and you add steroids, it will have side affects that will be hard to absorb."

Chief among these side effects will be inflation, contained last year to 9 percent with the help of the rapid appreciation of the ruble. The success of this strategy and the apparent lack of any real alternative are likely to keep upward pressure on the ruble strong, analysts said.

Despite resistance from Russia's exporters, who suffer most from this trend, the Central Bank has said it will continue, even though this year's headline rate is already below the target of 8 percent.

Time to Diversify

So the pressure on extractive industries is almost certain to continue. Year to date, the impact has been painful for the top 10 oil and gas firms, nine of which are in the red with most showing double-digit negatives.

Rather than easing the ruble's strength or actively shifting the tax burden away from hydrocarbons, policymakers have called more loudly for other industries to take up the slack.

The growth of domestic demand could give them the chance to do so. Real wages are forecast to climb almost 13 percent this year, and while raising overhead for exporters, they will beef up Russians' buying power. The average Russian gained wealth of $8,000 last year from rising property prices alone, according to Renaissance Capital.

This translates into a population comfortable enough to leverage its income through mortgage loans and consumer credit. A Merrill Lynch study of emerging market banking found Russia had the least penetration and the most potential for growth -- with only 18 percent of Russians holding bank accounts, total loans at 9 percent of GDP, and an estimated $20 billion still "under the mattress."

"If the banks can intermediate this wealth effectively, Russian businesses are going to see a whole new client base," said Paul Tucker, managing director of emerging markets equity research at Merrill Lynch in London.

The food retail business is also widely unconsolidated, with the top five firms accounting for only 8 percent of the market, compared with an average of 60 percent in the West, a UBS study found.

But this market, like many in Russia, is represented by only a few traded companies -- three in food retail, and none so far in technology retail, which has also seen double-digit earnings growth every year this decade.

Looking for Momentum

By 2008, however, investors will have a lot more to choose from. An Alfa Bank survey found 90 companies considering an initial public offering this year, and the 40 expected to follow through should raise an impressive $30 billion.

For comparison, it took a total of 297 European IPOs to raise the same amount on the London Stock Exchange last year, according to a PricewaterhouseCoopers study.

At least one-quarter of the new emissions will come from the reform-driven electricity sector, widely viewed to be the country's most prospective and undervalued. Demand for power will grow by about 5 percent per year until 2011. Over the same period prices will be liberalized, likely making profit margins soar.

Yet taken together, all of the nonextractive industries still account for less than one-third of the market.

Oil and gas alone still hold some 60 percent, so the anticipated slowdown in the major exporters will make it tough to make money by simply betting on the indexes.

Judicious stock picking, therefore, will become essential as investors look for pockets of momentum in an economy where growth is set to stay sluggish overall.