Once again, Russia is accused of disrespecting the sovereignty of its neighbors — this time after a recent border dispute with Georgia.
And once again, the world shakes its head and wonders when Vladimir Putin will just knock it off and stop acting like a schoolyard bully.
It’s reductive but mostly true to say that Russian shenanigans as of late have been borne mainly out of economic disputes in the region. Last year’s high-profile conflict in Ukraine was bred in large part by disagreement on whether to more closely associate with the European Union on trade and immigration, and the most recent border trouble in Georgia stems (yet again) from Russia’s efforts to control crucial oil and gas pipelines.
To a Western investor, then, it’s natural to think that Russia is a lost cause. After all, the World Bank estimates a 2.7% decline in Russian gross domestic product this year and an anemic 0.7% growth rate in 2016.
But a closer look at publicly traded Russian companies actually reveals some serious outperformance. While the S&P 500 SPX, +0.10% is up only about 2% this year, the Market Vectors Russia Index ETF RSX, -0.03% is actually up more than 20% in the same period!
So why have Russian investments performed so well if the economy is struggling and the Kremlin is getting the cold shoulder from many Western leaders?
And most importantly, what’s next for investors in Russian stocks this year and in 2016?
What’s ahead for Russia
To see where Russian stocks are headed, it’s important to remember where they’ve been. Because while the recent run for the RSX has been nice, the past hasn’t been so grand.
Namely, the fund is still down 50% since January 2011. And its peer, the Market Vectors Russia Small Cap ETF RSXJ, -1.01% is down 70% from its inception in April 2011. By contrast, the S&P 500 is up more than 67% since the beginning of 2011.
Still, contrarian investors looking for a value play may have a lot to like in Russia — and judging by the recent uptick in stocks here, some have already gotten wise to this trend.
According to Star Capital calculations, Russia has a cyclically adjusted price-to-earnings ratio (that’s CAPE, also known as Shiller PE) of just 4.8 — the lowest in the world, and a fraction of the 25.5 reading for the U.S. right now. Russia also has a conventional P/E ratio of 9.4, one of the lowest in the world and less than half of America’s 19.8.
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Other valuation metrics are attractive, too, with Russian stocks trading at a roughly 30% discount, per its 0.7 price-to-book ratio — tied for lowest with Greece, and well below the 2.9 price-to-book ratio of the U.S. Russian stocks also trade at a price-to-sales ratio of 0.7, compared with a price-to-sales ratio of 1.7 for U.S. stocks.
You get the picture. Basically, Russian stocks are among the cheapest in the world by almost any measure.
While growth prospects admittedly aren’t great, more normalized valuations alone could lift Russian stocks in the next year or so.
Furthermore, it’s clear that a lot of the pain in Russia over the past year has been caused by a strong dollar and weakening energy prices. The resource-rich nation is heavily dependent on oil and gas production and exports, most notably from giant Gazprom OGZPY, -0.59% Now that a bottom seems to be in for energy, with oil and gas prices stabilizing, these energy giants have found their footing. In fact, Gazprom stock is up by double digits since Jan. 1.
On a related note, the next biggest business in Russia remains other minerals and commodities, such as diamonds mined by Alrosa and iron and steel mined by Mechel MTL, -3.74% A strong dollar also has held back commodity prices, but now that the dollar index DXY, +0.31% has been at or near an 11-year high for the past few months, much of that pain seems to be priced in. As with Gazprom, Alrosa and Mechel have both staged impressive rallies year-to-date.
In other words, the negativity in commodities is priced in, the markets in Russia are trading at a bargain, and long-term investors with patience and a strong stomach may want to consider making a move while Russian stocks are still cheap.
Few options, but big potential
So what’s the trade if you want to play Russia?
For the typical U.S. investor who isn’t dabbling in Moscow-listed equities, there aren’t a whole lot of options. According to the Bank of New York Mellon ADR directory, there are only 31 Russian-headquartered stocks that list on the NYSE, the Nasdaq or domestic OTC markets.
Also worth noting is that many of those are highly illiquid issues on the pink sheets, like mining company Mechel, which trades less than 20,000 shares daily despite a listing price of just more than $1 per share. A simple market order could gobble up all available shares and move the market significantly, which is a risky proposition.
That leaves Russia ETFs as perhaps the only good option for individual investors.
The aforementioned small-cap RSXJ fund is, I believe, far too risky. Not only are Russian small-caps highly volatile, but the fund has roughly 23% of its assets tied up in just three stocks right now.
The large-cap RSX — which charges 0.61%, or $61 annually for every $10,000 invested — is a better bet. Not only is it a bit cheaper than RSXJ, but it offers exposure to the big players in Russia that are theoretically more stable than smaller companies.
Of course, this bias toward Russia’s large stocks means a bias toward energy with about 44% of the portfolio’s weight here, and another 17% in materials. So be aware of this commodity exposure.
Another option I like is the iShares MSCI Russia Capped ETF ERUS, -0.15% which is comparable on cost with a 0.62% expense ratio. But be aware that ERUS is actually more overweight in energy, with a 47% allocation of assets to this sector. Financials are about 14% and materials are about 12% of this iShares Russia ETF, however, if you want to move away from mining a bit and more toward banks.
A third option is the SPDR S&P Russia ETF RBL, +0.00% , but I’m leery of its 16% allocation in Gazprom and 13% allocation in Lukoil LUKOY, +0.74% — two big parts of its 50%-plus allocation toward the energy sector. If you really want to play Russian energy stocks this much, it almost makes sense to do so directly and not hedge with an ETF.
But whatever funds you pick, keep in mind that volatility will persist as long as Russia keeps saber rattling and energy prices remain weak.
Russia certainly is not for the faint of heart given the past few years of declines and the risk of continued shenanigans out of the Kremlin.
But given the tenfold outperformance of these ETFs in 2015, it is worth a look.