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Relative value in Russia

September 7, 2009

The Russian discount to emerging markets is still at levels not seen since the period before 9/11, and we expect this discount to narrow considerably in 2010 given the three forces of oil price stability, growth and time.

Russia is trading at a 40% discount to GEM. We show that the most appropriate metric is to compare Russia with GEM on forward P/E ratios. On 2010E P/E, Russia is trading at a 40% discount to GEM, around the level it used to trade before 9/11, and far from the average 15% discount that the market enjoyed until mid-2008.

Three forces will narrow this discount. These are growth, oil price stability and time. We show that the market discount has historically been a tradeoff between the attractions of growth and the fear of corporate governance. Next year will see the first come through, while we assume that the passage of time will serve to assuage memories of the latter.

Russia is a high-growth story. We expect EPS growth of 29% in 2010 and of 36% in 2011. The bedrock of this is the 5% domestic growth that we anticipate next year on the back of falling rates and government stimulus, but there is also volume growth from the gold and oil sectors, as well as price growth for gas and utilities.

The discount is likely to narrow after November. The market has been tracking the oil price for some 12 months, but the longer oil stays over $60/bbl, the more likely the index is to break free and start trading more in line with EM valuations. We expect the link to be broken starting from the traditional November rally, and the discount to narrow during the course of 2010.

Giving a 2010 RTS Index target of 1,500. If the discount to GEM narrows only slowly, as in the period after 1998, we believe that it can fall to 25% by end next year. This gives us a 2010 RTS Index target of 1,500, which we will adjust depending on GEM valuations and the domestic tradeoff between growth and corporate governance.

Oil and gas, banking and consumer sectors have greatest upside. Relative to EM peers and their own history, these are the three sectors where we see the greatest opportunities from the narrowing of the discount. We highlight Rosneft, Sberbank, Magnit and X5 Retail Group as stocks trading at major discounts to global peers, and enjoying strong stories of their own.

The risk remains oil. Our optimism is presaged on the assumption that the oil price remains over $60/bbl for the foreseeable future. Should it fail to do so, the market would clearly find it harder to escape the rigid link to the oil price.

 

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