Expert Corner with HSBC’s Helfer: Russia’s economic growth

Douglas Helfer, manager at HSBC GIF Russia Equity fund, talks to Modern Russia about the Russia’s economic growth as an emerging market.

Much has been made of whether Russia deserves its place in the BRICs. How do you view it in comparison with other emerging markets?

After the 2008 financial crisis and Russia’s slow recovery relative to countries such as China, India and Brazil, some have suggested that Russia does not belong in this group of large, high-growth, emerging markets. I believe that there are areas where Russia is lagging behind, areas where Russia measures up equally well and, likewise, areas where we believe Russia is better-positioned than the rest of the BRIC universe. Russia is weaker in corporate governance and its regulatory environment. We expect that over time, stability and modernization will tend to reduce the power of these negative factors. President Medvedev has made reducing corruption and strengthening the courts and legal system his top priorities. It is hoped that we will begin to get some improvements in these areas. Russia is on a par with the BRIC universe for its market size, its transparency, its general infrastructure, the general health of its population and crime levels.

From a long-term investment point of view, Russia measures up better than the other three in certain areas including the sheer size of its raw material assets. In addition, Russia’s education levels are very good, it has one of the highest literacy rates in the world including developed nations. In terms of its tendency for innovation, Russia scores higher than the other BRIC countries based on royalty payments, patents and journal articles.  In addition, Russia has a much larger middle class than the other three. Macroeconomic strength is another key variable, as, in terms of foreign exchange reserves, Russia has the third highest levels of reserves in the world. Meanwhile, its total debt to GDP at the sovereign level is one of the lowest in the world. So on balance, Russia very much deserves its place among the BRIC economies.

What are the key factors for you when considering your investment strategy for Russia?  How much emphasis do you put on undervalued assets in Russia’s traditional sectors (energy, commodities, etc.) or are there new sectors you are targeting and optimistic about?

We take a value-driven approach to the Russian equity market and put a lot of emphasis on valuation in all our work, both at the sector and the company level, so this is key to our approach. In the energy sector, one of our current favorite sectors, we like both the oil and the gas sectors due to their attractive valuations. In terms of price earnings ratios (P/E), the oil companies in the Fund are trading between 5 – 7x 2011’s earnings and at or below their book value currently. These companies are producing returns on capital of 20 percent. Gazprom, a company out of favor with many investors these days, represents even better value. It’s trading at less than 4x 2011’s earnings, at a 40 percent discount to its book value, with a return on equity of about 15 percent. We acknowledge that there have been a number of negative issues for the sector and the company in recent months. However, even having discounted these issues fully in our valuation, we believe the company represents exceptional value at this point.

Do you believe that Russia’s GDP current growth rate is likely to increase? And if so, why?

The key drivers of GDP growth in Russia all appear supportive in the medium and long term. We are firm believers in the stronger-for-longer commodity price view. We believe that oil prices and other key commodity prices should be driven by high rates of growth in Asia, particularly in China, a positive for Russian exports. From an investment point of view, the second key driver of GDP growth is fixed asset investment which grew in double digits for nearly five years before the 2008 crisis. When the crisis hit, companies stopped spending. There are now strong indicators of increasing investment on both the private and public sides.  Almost all companies we are meeting when researching investments for the fund are telling us that they’re increasing their capital expenditure plans for this year and next year. Public infrastructure spending plans are going increasing strongly in terms of fiscal stimulus during the crisis. There are also several other things driving infrastructure projects including the 2014 Winter Olympics which will be held in Sochi. We are also seeing several strong indicators that the consumer is coming back to life again and should be a key driver of growth this year and in coming years. So really all three of these key GDP drivers, exports, fixed asset investment and consumption, should support medium-term high rates of GDP growth.

What do you consider the major growth sectors for Russia in the medium and long term?

The major long-term growth sectors have low penetration levels relative to their stage of development, that is low per capita ownership of goods and services relative to countries at a similar income or wealth levels. These include retailing, everything from formal food retailing to automobile sales. The banking sector is also very under-penetrated. In Russia, total mortgages to GDP is about 3 percent. In a market like Poland it’s more like 15 percent and, in developed markets like say Spain or Holland, it’s in excess of 50 percent or 60 percent. There are many other low-penetration sectors. Insurance is another good example as is broadband connections. In Russia, total Internet access is about 42 percent of the population versus approximately 90 percent in developed Europe. Broadband penetration has been slow to roll out in Russia and it remains a very strong long- and medium-term growth story. Other sectors that currently have low penetration levels include real estate, transport and logistics.