Europe

Russian stocks are up 29% but still dirt cheap

There’s little love for Russia in the “West”. This isn’t surprising given the daily servings of anti-Russian coverage in the mainstream media. But it’s often the most hated investments that offer the best profit opportunities. So it has proved with Russian stocks, which are up 29% this year measured in US dollars. Despite this, they’re still cheap and offer a great opportunity.

Back on 17th March 2015 I wrote “Why I am buying Russia and selling the USA.” It analysed 16 developed and emerging stock markets using four valuation measures.

Only one market was expensive on all measures: the USA. Only one market was cheap on all measures: Russia. The conclusion seemed clear. You should sell US stocks and buy Russian ones.

A year later, on 17th March 2016, I gave an update: “Why I’m still buying Russia and selling the USA.” In the preceding year Russian stocks had gained 5.4%, including dividends and measured in US dollars, whereas US stocks had lost 1.3%. So Russia had outperformed the US by 6.7%.

Of course a profit of 5.4% in a year is nothing to write home about. Although at least it was positive, and the basic thesis was holding. Russia had outperformed the US.

Since March this year things have been much more interesting. US stocks have continued to rise to even more overpriced levels (for recent thoughts see here and here). But Russian stocks have extended a big lead. Despite this they remain dirt cheap, and I’d still favour Russia over the US, by a large margin.

Here’s a chart which shows how things have worked out since 17th March 2015. For Russian stocks I’ve used the VanEck Vectors Russia ETF (NYSE:RSX), shown in blue. For the US I’ve used the SPDR S&P 500 ETF (NYSE:SPY), shown in red.

SPY-RSX-2015-2016

RSX is up 17.8%, plus another 3.2% of dividends (net of fees), giving a total return of 21% over 17 months since March 2015. That works out as 14.4% annual equivalent, with compounding (profits on profits). Remember, this is in US dollars, so we’re comparing apples with apples.

By comparison SPY is up 6.1%, plus another 2.9% of dividends net of fees. That’s a total return of 9% over 17 months, which works out as 6.3% a year (again with compounding).

So it’s clear that Russian stocks have significantly outperformed. Of course there’s a big difference between the chart lines. Russian stocks have been much more volatile. But patient investors don’t need to worry about that. You just buy things when they’re cheap and hold on until they’re not.

Sometimes that takes a few months. Sometimes it takes many years. But either way it usually works out well in the end.

Sometimes that takes a few months. Sometimes it takes many years. But either way it usually works out well in the end.

This year the difference in performance has been even more striking. Here’s the same chart since the end of December.

SPY--RSX-2016

RSX is up 28.3% in 2016. There’s no dividend to add yet, since it pays once a year in December. SPY is up 7.1% and paid 1.1% of quarterly dividends, giving a total profit of 8.2%.

In other words, in 2016 Russian stocks have outperformed US stocks by more than 20 percentage points. That’s a huge difference.

So is it time to take Russian profits and sell? The answer is no, for the simple reason that Russian stocks remain extremely cheap. In the case of RSX there is data for 31st July. At that time the P/E was just 7.2 and the price-to-book ratio (P/B) was 1.1.

(P/B compares the market capitalisation of the company to its book value, also known as net assets or shareholders’ equity. That’s all assets less all liabilities – everything owned less everything owed – and is a good proxy for liquidation value. Stocks of companies that make a decent profit usually trade with a P/B well above 1. For a country index, anything below around 1.5 is usually bargain territory.)

For comparison, the S&P 500 currently has a P/E of 25.3 and P/B of 2.9. That means the US P/E is 3.5 times the Russian one, and the P/B is 2.5 times as big. It’s clear that Russian stocks are still extremely cheap in relative terms, despite their strong recent price performance.

Investing in Russia is likely to be a riskier prospect than the US in some respects. For example the currency, the rouble, swings around depending on commodity prices.

You might think Russian stocks deserve this much lower valuation. In a sense they do. Investing in Russia is likely to be a riskier prospect than the US in some respects. For example the currency, the rouble, swings around depending on commodity prices.

Or perhaps Russian companies are a lot less profitable than American ones? Actually the evidence points the other way, using two key measures of profitability.

First let’s look at return on equity (RoE). This is how much profit companies make in relation to their shareholders’ equity (being the same as net assets or book value). Dividing P/B by P/E is the same as E/B, which is return on equity. In the case of RSX the return on equity works out at 15.8%. In the case of the S&P 500 it works out at a lower 11.4%. By this measure Russian companies are 39% more profitable than American ones.

Another key measure is net profit margin after tax. That’s how much of top lines sales actually reach the bottom line profit. To work out this we need the P/E and the price-to-sales ratio (P/S). Net profit margin after tax is the same as E/S, which we get to by dividing P/S by P/E.

I don’t have P/S for the RSX ETF, but Star Capital provides figures for the Russian market. They put P/E at 7.5 and P/S at 0.8, which gives net margin of 10.7%. In the case of the S&P 500 the P/S is 1.9. Divide by the P/E of 25.2 and we get net profit margin after tax of 7.5%. So on this measure Russian companies are 43% more profitable.

The conclusion? Russian companies are about 40% more profitable than US ones. And yet US stocks are three times more expensive, taking a blended P/E and P/B view.

Given the still low prices and high company profitability I continue to believe Russian stocks will be the clear outperformers in the medium to long term. Do you own them yet?

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.