Team Russia Leads the World

John Maynard Keynes essentially said, figure out a business
you understand and concentrate your investments in it.
Warren Buffett

Domestic consumer-linked sectors deliver most of Russia’s economic growth. While it is well known that the extractive industries of oil, gas, metals and mining, and utilities represent two thirds of the Russian equity market, it is, perhaps, less well known that the remaining consumer-related sectors, which represent two thirds of GDP, have driven more than 80% of domestic GDP growth since 2004. We demonstrate that Russia’s equity sectors directly exposed to domestic consumption should be major beneficiaries of this ongoing structural growth trend and yet are trading (in aggregate) at substantial (25-50% on P/E and EV/EBITDA) valuation discounts to EM peers despite growing more rapidly (2012-15E EPS CAGR of more than 20%). Moreover, we believe that Russia’s equity market should begin to narrow the valuation discount to EM peers over the next few years from circa 60% to as low as 10-15%, driven by above-trend earnings, cash flow and ROIC growth; corporate governance improvements; financial sector reforms; and a likely more concerted campaign against corruption.

Consumer sector valuations are anomalously depressed because of Russia’s oil risk image.
We also show that while Russia’s extractive industries remain incredibly important in terms of representing two thirds of exports and almost half of national income, they have in fact contributed little, if any, economic growth over the past eight years. Indeed, we assert that the market’s pricing of (excessive) equity risk premiums into the country’s consumer-related sectors is anomalous both intra-Russia as well as versus the other BRIC/EM markets. Simply put, Russia’s consumer-linked equity sectors, which offer superior long-term growth to the extractive industry sectors, seem to have been ascribed the same ‘Russia discount’ by the market. This, we believe, represents a mispricing of such equities and hence a buying opportunity. In identifying equity investment opportunities linked to the mega-theme of superior and sustainable consumption growth, we benchmark key Russian consumer sectors relative to relevant emerging markets, i.e. Brazil, India, China, Turkey and South Africa. ‘Top-down’ work by our co-collaborators, McKinsey, consistent with research produced by our economics team, suggests that emerging market consumption could triple to $30 trln by 2025 and, within this, Russian consumption should almost double to $3 trln. To gain exposure, our fundamental analysts highlight the most attractive sectors and stocks, from the bottom up, as follows: consumer retail (Magnit, Dixy Group and X5 Retail Group), agriculture (Kernel Holding, MHP, PhosAgro, Uralkali), financials (Sberbank, VTB and Vozrozhdenie Bank), telecoms (MegaFon and MTS), media and IT (CTC Media and Yandex), real estate (Etalon Group, LSR Group and AFI Development), and transportation/industrials (Aeroflot, Sollers and Mostotrest).

Prepared on the basis of the report “Consumer Speed Kings” by Sberbank Investment Research.