Features : A Seller’s Market

Russia

Foreign investors have developed an impressive appetite for Russian depositary receiptsand with good reason.

The past year-and-a-half has been remarkable for Russian equities. In 2005 they returned about 70%, as measured by Morgan Stanley Capital International. By mid-June this year they had jumped another 24%. Over the same period, the S&P; 500 rose a meager 4%.

Russias dramatic outperformance is partly a result of global demand for commodities. Very few other countries have as much of a concentration in natural-resource-related stocks, and we all know whats been happening with natural-resource companies for the last few years, says Christopher Sturdy, who heads the depositary receipts unit at The Bank of New York.

By natural resources he means oil and gas. The worlds largest pumper of natural gas is Russias state-run Gazprom, which has a valuation of some $200 billion. But theres more where that came from. Theres been substantial speculation that the Russian market has tremendous upside, observes Sturdy, and it may still be undervalued.

Among the Russia bulls is Newgate Capital Management, a Greenwich, Connecticut-based hedge fund that specializes in emerging markets. Recently, Newgate told clients that developing economies are home to nearly 75% of the worlds natural resources and pointed out that strong demand for those resourcesespecially petroleumpromises continued growth and keeps investors coming back for more.

For many investors the best way to buy Russian stocks is through depositary receipts (DRs). Because they are traded on the New York Stock Exchange, Nasdaq, the London Stock Exchange (LSE) and other markets, they have to meet appropriate listing requirements, so they save investors the trouble and expense of having to deal with currency exchange rates, international settlement concerns, unforeseen taxes and other possible cross-border issues.

While DRs may offer simplicity, convenience and cost-effectiveness for investors, to BNY they represent a great deal of business. The bank handles roughly two-thirds of the worlds DR offerings. Of that, Russian DRs comprise a growing though not yet dominant part, says Sturdy.

In all, there are some 126 Russian DR issues, with some companies having more than one available. Their total market value exceeds $100 billion, making Russia one of the largest DR issuers in the developing world. Most Russian DRs are listed in London, not New York, though some are on both. The perceived wisdom, Sturdy explains, is that theres a substantial differential between American and British markets in the valuations they put on different sectors. The UK is considered the place for trading shares related to natural resources like oil, while the US is deemed better for the capital-raising intentions of telecom and technology companies. Im not sure what the story is behind that, concedes Sturdy.

Another possible explanation for why the primary Russian DR market is in London, not the US, is that London is closer to where most of the Russian DR investors are based. As far as were able to determine, most Russian DR investment comes out of Europe, says Gregory Roath, vice president at B NYs London offices. Roath says it is unclear whether this is a cause or an effect. Furthermore, big US-based institutional investors tend to transact London-listed Russian DRs through a satellite office in London, further blurring the distinction between US and non-US investors.

Whatever the underlying reasons for Russian companies preference for the London exchange, the impact of this choice can be dramatic. Last year there were nearly 300,000 trades of Russian DRs via the London Stock Exchange alone, or 60% of its DR transactions, representing almost $80 billion. These figures are a significant jump from 2004s, when Russian DR transactions on the LSE numbered 255,000, with a total turnover value of $64 billion.

BRIC Block

The insatiable appetite for Russian DRs, as well as those from similarly large markets in Brazil, India and China, has led to the collective shorthand term BRIC. BRIC shares are so popular that many market-trackers are benchmarking them separately from other emerging market offerings. In June BNY launched its own BRIC index for American investors. Rebalanced quarterly, reflecting the volatility of the sector, the benchmark is made up of 74 DRs. Surprisingly, only six of them are Russian, and the aggregate valuation of those Russian DRs is just $20 billion; the other 68 issues in the index amount to $310 billion.

Russias small slice of the index pie is due partly to its small presence on US exchanges. Chinese, Brazilian and Indian companies have a bigger presence on US markets. Brazil and India in particular have accessed American capital markets with DRs for many years, especially in the telecom sector, explains Sturdy. Relative newcomer China has a preponderance of technology companies, many of which IPOed in the US, he adds.

Still, the expectation of high demand for Russian equities is fueling an ongoing market for Russian IPOs and secondary offerings. In late July, Rosneft, another large Russian energy group, floated its first DR, hoping to raise $14 billion. That appears to have been too optimistic. Its first day of restricted trading on the LSE raised $10.4 billion, making it Russia’s largest-ever IPO. But in unrestricted trading a few days later, the IPO received an even colder reception, perhaps on valuation concerns, slipping a penny from the original asking price of $7.55 a share. Its largest buyer was Gazprombank, a unit of fellow Russian energy giant Gazprom, which ponied up some $2.5 billion.

Other factors are having an impact on demand for Russian shares. In January a $125 billion Russian trade surplus sparked a drop in the countrys sovereign bond yields, making those bonds only about as attractive as US treasuries. Frustrated investors, in search of higher returns, turned to Russian stocks. Then, in April, restrictions on Gazprom were lifted to allow more foreign investors; they could at last purchase the 49% of the company that isnt government-owned. The share price shot up, though later it pulled back. Nevertheless, from the start of 2006 through mid-June Gazprom DRs advanced 30%. Since the cap was lifted, weve issued several hundred million DR shares of Gazprom, reports Roath. That alone has certainly contributed to the explosion in the number of DRs outstanding.

Understanding the Market

Casual observers of the Russian market may wonder at its complexity. For starters, most Russian stocks are quoted in US dollarseven on the primary Russian stock exchange, the RTS (Russian Trading System). The reason most often cited for this anomaly is that when the RTS opened, the volatility of the Russian ruble made it easier to track prices and value using dollars. Russias other exchange, the Moscow Interbank Currency Exchange, or MICEX, uses rubles exclusively. Some stocks are traded on both simultaneously.

As Western investors become more comfortable betting on companies in emerging markets, a never-ending slew of newcomers to Russian DRs are ponying up. At the same time, satisfied investors are coming back to expand their Russian exposure. In time well see more Russian companies coming to American capital markets, predicts Sturdy. Other major oil and gas companiesespecially those based in Europe, such as Britains BP Group, Frances Total, Repsol of Spain and Statoil of Norway, but also Chinas CNOOC (China National Offshore Oil Corp.)do trade in the US, he points out. In a sense, Russian energy companies are bucking the trend.

Russia also boasts a number of homegrown high-tech companies that have not yet addressed Western capital markets, says Sturdy, calling it one of the most technologically savvy and highly educated engineering communities in the world. He expects Russian technology companies to follow their Chinese counterparts and offer ADRs, though when he cannot say.

What does seem certain, however, is that the flow of Russian DRs in general will continue to grow.

Ben Mattlin