Russia Forum Buzz: How Can the Valuation Gap of Russian Companies Be Overcome?

April 19, 2013


There can be little doubt, based on consensus forecasts, that Russia’s equity market is trading on substantial valuation discounts to both developed market and emerging market peer groups. A recent report from Sberbank Investment Research quantified the valuation discount to global emerging markets in the range of 25–50%. The same report also highlighted that Russia’s equity ‘risk premium’ (the excess return that investors demand for taking on relatively greater risk) is materially higher than most peer group markets and that this risk premium has widened to a nearly 10y high over the past two years. The panel will debate and attempt to explain why this valuation gap exists and outline what might be done by corporates, government and other stakeholders to close it. The panel will examine the factors that either increase or decrease appetite for domestic and international institutional investors to allocate greater funds to Russia both top-down and bottom-up. The top-down factors impacting investor sentiment and future behavior include the political outlook, macro and microeconomics, interest rates and inflation. Bottom-up factors include the financial performance of individual companies and sub-sectors, their use of cash and the effectiveness of their in-market execution and competitive strategies. Finally, corporate governance issues impact both top-down and bottom-up considerations of ‘perceived value,’ with profound implications for government policy and corporate strategy.

Anton Karamzin, the moderator, in his introduction to the session, said that Russian assets tend to trade at a substantial discount to peers. This gap varies over time and over asset classes: it is wider for equities, but more moderate in fixed income. The nature of this discount and the ways to overcome it were the main topics of discussion. The moderator asked the audience to answer several questions. The first question was whether the Russian discount is justified. The majority said that it is justified. The second question was on what are the most negative issues contributing to the valuation gap. The most popular answers were treatment of minority shareholders (36%) and adverse government influence (28%). The audience was also asked what the government could do to assist the equity market to close the valuation gap, and 62% of attendees said that attacking corruption and bureaucracy is the best answer.

Jean-Michel Six started the discussion, pointing out that Russia has a number of different features compared with other G-20 countries: the country is fully employed despite disappointing growth levels; it is moving to inflation targeting while other countries move away from this regime; and the overall macro outlook is strong, though Russia faces substantial capital outflow. The capital outflow shows that there is a deficit of trust among individuals and also between private agents and the state. The lack of capital is an important factor in Russia’s valuation gap. Another reason for the discount is government policy. Mr Six mentioned research published by the World Economic Forum (WEF) that focuses on two main scenarios for Russia, depending on the direction of the energy market: if oil prices remain high, the government has no incentive to reform and privatize; if the oil price falls, the most probable response to the macroeconomic shock will be government intervention to keep the status quo, which means no reform as well. The WEF thus concludes that Russia is in a lose-lose situation in terms of reforms, independent of the oil price movements.

Albert Ganyushin stressed that the outlook on Russian equities is established by foreign investors in the absence of a local investor base. The reason for the discount is twofold: investors are concerned about infrastructure and about the protection of minority shareholders. There has been substantial progress in infrastructure development, but companies often do not take advantage of this opportunity. Investors feel that the government could do something to protect shareholders, but see little progress in this area.

Ekaterina Novokreschenykh agrees that the protection of minority shareholders is a crucial problem. Minority investors should become a holy cow on the market, but there is no political will to solve this problem. The predictability of the rules of the game is another important issue, as well as the creation of a domestic investor base. The absence of domestic investors creates substantial volatility on the market, which is priced in and contributes to the valuation gap.

Maria Gordon stressed the difference between valuation gaps in equities and fixed income. In 1998, Russia made a principal decision not to default on foreign debt despite the fourfold devaluation of the ruble. Fast forward 15 years and Russia is one of the best places to invest in bonds. The market saw 15 years of consistent work to improve the institutional environment for the bond market. Now the valuation gap in fixed income is almost nonexistent. However, in equities, Russia tried to build institutions, willing to get quick returns, but lost its patience. For example, attempts to move to IFRS dividend payments were always undermined by companies such as Transneft. Ms Gordon also mentioned the quality of management: in Russia, mediocre managers often stay in place even despite the company’s poor performance.

Michael Calvey discussed the problem from a private equity perspective. He said that the Russian valuation gap is bad for sellers, but good for buyers and his company is entering very profitable projects in Russia that are yielding high returns. However, investors eventually will think about exiting from their projects and at this point, the discount matters. Calvey agreed with other panelists that the development of a domestic investor base may help Russia overcome the discount.

Mikhail Shamolin pointed out that the majority of Russians still possess a communist mentality and the layer of capitalist mindset is very thin. It creates expropriation risks for companies and is one of the reasons for the Russian discount. The discount on the company level depends on the management. Gazprom is dragging the whole market down, because the management is not able to find a response to the shale revolution. At the same time, companies with brilliant management teams can trade at a premium. MD Healthcare is a good example of a company with a highly committed management team that is able to place shares at very high multiples. Shamolin thinks that the government has to privatize companies to solve the problem with management. The government should not own companies, as the existence of state companies halts the process of creative destruction.