Russia 110214 Basic Political Developments

Shaftan reaffirms her commitment to Russia as rising oil price drives growth

http://www.investmentweek.co.uk/investment-week/interview/2025922/shaftan-reaffirms-commitment-russia-rising-oil-price-drives-growth

14 Feb 2011 | 08:00

Hannah Smith

Investment Week - News and analysis for investment advisors and wealth managers.

Elena Shaftan is the head of Jupiter’s emerging European team and manager of the £626m Emerging European Opportunities fund with Ingrid Kukuljan. Here she explains her fund positioning, why she does not subscribe to the ‘bigger fool’ theory, and why the Russian market is not for tourists.

What is the starting point for you in selecting stocks?

There are plenty of places you would start but you always come back with a cocktail of requirements that have to be met.

It almost does not matter which way you started, you would tend to come back to ticking the same boxes. For example, the starting point can be ‘I think this is a very exciting sector’.

Last year the Russian consumer was a very exciting sector, so let us have a look what is there. What do we think are the best opportunities? How do we define those opportunities as best? A very necessary ingredient first of all is not just a strong, dedicated management team, but a situation where the management and the majority shareholders’ interests are aligned.

All the talk about corporate governance in Russia can only be mitigated by picking stocks where you are not in conflict with the people who run the business.

You need to understand the motivation of the management and the shareholders, the dynamic between the two, and of course their ability to run the company. That is one of the important things we look at. We would never invest in a company if we had not seen them.

Equally important would be simply the quality of the business – are there high barriers to entry? Does it have high enough margins not to see them eroding if the environment changes rapidly? A strong balance sheet is incredibly important for us.

And then valuations. Seeing markets going up and down like a yo-yo over the last 15 years, the one thing I am very clear about is there is no need to overpay for anything. We are quite strict on valuations.

Does valuation also drive your sell discipline?

It is a combination of factors. We run our own models for all the stocks we look at, factoring in our own assumptions and our conversations with the management.
We talk to management every six to eight weeks, probably more than most of our competitors, and more often than many sales analysts. What we are trying to see is if there is a gap between what our model suggests and what the sell side suggests and utilise this gap.

So valuation is important on the way in and it is equally important on the way out. If we find a stock we absolutely love, but we think it is expensive, we would be selling it. But that is just one of the ingredients in the sell discipline.

We often joke that we run the portfolio like I would run my wardrobe, which means everything you have not worn for a year, you chuck. Things that do not quite work out, you need to examine the reasons why. Are the original reasons for buying it still there? Has the operating environment changed? Has the management disappointed?

Or has the stock become too expensive? Has it gone out of fashion?

I do not believe in the ‘bigger fool’ theory – if I do not want to buy it, why would someone else buy it? Why would it go up? I would rather chuck it and put the money somewhere else. That makes it a very concentrated portfolio – more concentrated than some of our competitors, with only 30 stocks.

So what is turnover like in the fund? Do the opportunities you find in the region tend to be longer-term holdings?

We do not see ourselves as traders – we do not think our strength is in daily trading. When we find good companies we buy them on the basis of their two- to three-year earnings outlook, and we will sell them if the outlook changes or the valuation changes.

So the starting point is always a long-term proposition, but of course things change, and our turnover during the crisis and coming out of the crisis was much higher because we completely changed the portfolio stance.

For example, in June 2008 we had 70% in Russia. By the end of the year we had 30% in Russia, and we completely changed the composition of the fund in terms of sectors. We had 20% in cash; we had very defensive stocks.

Six months later, by the summer of the next year, we had rotated the portfolio again to focus more on consumer stocks and reinvest the cash. So when the environment changes rapidly, we would react to it, but when we make investments in particular companies, it is based on the long-term trends.

At the moment you are fully invested. What have you been adding to recently?
We have been adding aggressively to Russia again, moving back to 70%, and remaining fully invested.

Having been very underweight oil & gas last year, which was the right thing to do because the sector underperformed, we have added to it very considerably because we took a view with an increase in the oil price and without corresponding strength in the rouble, the profitability of those companies was set to improve this year, and it is quite important because one of the reasons we did not like oil companies in the past was because any increase in the oil price would be offset by the appreciating rouble.

This time around, there is an interesting situation because the oil price is rising but the rouble is not catching up with it yet.

Secondly, the reason the oil sector did not perform well last year was there was a lot of negative news on taxation, which is a trend we feel is reversing. Also, there is overwhelming value in the sector, with some companies trading on four and a half to five and a half times earnings. So that was an area of very considerable addition weight.

We have also been adding to some of the infrastructure-related plays in Russia, having taken some of the profits in consumer names when we felt they had become too expensive. We added again to retail banks in Russia.

The view we take is this year Russia is in a good position to benefit from quite a few factors that were against it in the previous two years. The global picture for emerging markets is more supportive, with the liquidity injection China and India do not particularly want and Russia does.

One of the reason the Russian market was so unloved over the past few years was the economic performance was lacklustre.

We feel this is accelerating. Corporate governance is often talked about. We are convinced there is real momentum for reform taking place in Russia. The credit crunch was the wake-up call for the authorities when they realised how fragile and inefficient the economy is. They are really trying to take steps towards improving corporate governance and the international perception of Russia.

The oil price is picking up after it was static last year. This made the Russian market less inspiring, but this year it is catching people’s attention. Russia was such an underloved, underowned market, but now, with other emerging markets hitting problems, it is clear Russia does not have any significant structural problems, and it is trading on a significant discount to emerging markets on the whole.

What about your allocation to other markets besides Russia?

We have taken some money off the table in Turkey. It did fantastically well last year, and we felt in the short term there were headwinds as the regulator tried to take some momentum out of lending growth. While it is adjusting, the market might be a little bit unsettled, but on a longer-term view, it is an absolutely fantastic market that is going through a qualitative transformation.

Now we have a government that has been in place for eight years, coherent economic policy, inflation down, and a real structural change. Banks are still cheap, and are likely to grow their book by 20% year on year, and they are something the market will want to own. There we own a combination of banks and consumer-related stocks.

Poland had been a very stable economy, the only European economy that did not slide into recession in 2008, propped by significant EU transfers, about 3% of GDP per year, and robust domestic demand.

A theme across Russia, Turkey and Poland is they have very large domestic markets – they have relatively closed economies, so they are not dependent on what happens in Europe, for example, so the economies are driven by domestic momentum. They are also very underleveraged – households have very low debt. That is what attracts us to those three markets.

Returning to the structural issues, there is endemic corruption in Russia. How can you do due diligence to be able to invest in these markets?
All emerging markets have some degree of corruption – Russia is not for tourists. You need to do your work and understand how corruption works.

Corruption is a very big word which covers a multitude of sins. To understand the systemic risk, to understand how the government works is fairly easy in Russia, and that is why we have never been involved in any big corporate governance scandal.

There is one wonderful thing about the Russian government – they tell you what they are going to do and then they do it. You have to know who to listen to, and understand whose interests are in what sectors. What you should not do is come in as an arrogant foreign investor into a venture relying purely on his position being protected by law.

The key is understanding how the system works. I have been covering this market for 15 years. Being Russian and having contacts in Russia probably helps, and being able to find out the backgrounds of people you are dealing with. I find it easier to judge the people sitting across the table from me.

Especially in this country, there has been such an unbelievable amount of negative press on Russia, which I am sure goes back to James Bond movies. It is not easy to do business in Russia, but there is also a fair amount of exaggeration, I think.

Is there likely to be any ripple effect or contagion effect from the European sovereign debt crisis on emerging European economies?

If you looked at what happened in February 2009 when there were ripples in the European debt market, bond spreads for eastern Europe blew up really wide as well.

Since the Greek crisis began, spreads on the core eastern European markets stayed very tight – they have not budged; there have been no ripples. Why? Because the investor base recognises those economies are in much healthier shape than the southern European economies that are in trouble.

Most eastern European countries, except Hungary, have debt-to-GDP ratios below 60%, and have reasonably low budget deficit numbers, so they are not in the same position as the other European countries we are worried about.

Yes, we have seen some small ripples at some point in the past but the markets were very quick to recover. Having said that, if there is a very significant economic collapse in Europe, eastern European countries still export to Western Europe – Turkey, Poland export 30% of their GDP there, so that would slow down, but the domestic economy should not be affected.

Because China and India are suffering from inflation worries, there may be a slowdown in the flows into those economies. Could Eastern European countries stand to benefit from this?
This is why I think the region is in a good place this year. The torrent of fund flow that was going to China and India in the last year, part of it I think will be redirected to those markets, because they do not have the same problems with inflation.

What is the greatest threat to European emerging markets this year?

For Russia, the obvious risk is always a significant collapse in the oil price. If the oil price goes below $60, the Russian economy and market suffers.

To see that happening we would be talking about a very significant global shock in which most markets would not do all that well. That is always the risk one needs to bear in mind when investing in Russia. Other risks? There is always some degree of political risk for any emerging market. Both Russia and Turkey have elections coming up.

Turkey is a much better functioning democracy than Egypt. Over the past years, we have had a stand-off between the military and the government quite a few times, and all it caused was a slight ripple in the market, because both sides are interested in preserving stability.

One can never rule out some political events, but it is probably true for any other country. There is nothing in the region politically that causes me a significant worry.

In Russia, there is plenty of negative commentary about the Putin regime, understandably, but the good news about that regime is it is predictable.

What we do not have, which is the curse for any emerging market, is the sharing of assets.

After an election when the new ruling party comes and assets are back up for grabs, that is the most dangerous situation for an outside investor. The likelihood is we are not going to have that.