Vad's Best Ideas

"All is not gold that glitters"
Old Russian Proverb

"Up to 100% mortgage with no money down"- does this sound familiar? What is the first thing that comes to your mind when reading this- Florida condos? Flip that house TV show? Or may be it's a near failure of some of the largest US lenders and Fed's bailout of Wall Street? After the shockwaves that sub prime fiasco sent throughout the world economy you probably wouldn't expect to see that slogan repeated en masse in US for quite a while, but here comes the interesting part- I was shocked to see just that last week in the airport of one of the four largest developing countries in the world- Russia.

Due to the uniqueness of my job I have been able to observe first hand the tremendous changes that happened in Russia during the last few years. I have also made handsome profits from investing in some of the companies there. But now I think that as all good things come to end eventually, this advertisement in Moscow airport might just be an indication that the end of the phenomenal run of Russian equities is not too far away.

With all the attention that China has received recently it might come as a surprise to many that most of best performing mutual funds of the past five years actually are tied to Eastern Europe. And Russia has been the major driving force behind this boom- ING Russia fund has earned the compounded annual returns of over 45% over the last 5 years.

And one might say that it has been well justified- corporate profits are growing for most companies with solid double digits, GDP is expanding in high single digits and headlines of Russian billionaires buying up the real estate in London and setting new records on Christie's auctions are more frequent than reports on new Britney's meltdowns.

But there is a scary dark side behind this boom. Russian economy is showing significant signs of the illness that has been called "Dutch decease". Its symptoms include near complete crowding out of investments in manufacturing and other productive export oriented sectors due to the unsustainable trend of the strengthening currency driven by excess petrodollars. The real estate prices in central Moscow are higher than that of 99% of the largest cities in the world and that all with GDP per capita at ¼ that of the United States.

Significant inflation pressures are becoming more visible every day (with just the headline inflation rate of 9%). Salaries growing in double digits make even some of the most promising industries like high technology uncompetitive very rapidly. Combined with near complete nationalization of the main driver of the boom- oil and gas sector and announced national champions program for many other industries, investors into the private sector companies have plenty to fear. With so much capital flowing into less productive government driven sectors and inflation inhibiting long term success of the many of the other most promising export oriented investments, it is hard to see how Russia could avoid a meltdown should oil prices decline significantly.

One might say that is all great but given that oil prices are not yet showing a significant downtrend Russia a great place to invest. I have been agreeing with that point of view until very recently. Russian companies' profits have been fueled mostly by outsized gains in the price of oil and other commodities and expansion of the consumer banking which in turn drove retail and other oriented industries to show outsized gains. Many Russian ADRs are still priced as if this double digit profit growth can continue indefinitely.

However, with real estate prices stabilizing and even declining recently, even the push of the new sub prime like credit offers might not be enough to allow Russian companies to continue growing at the same brisk pace as it did during the last 5 years.

What's more I think that this artificial commodity driven asset bubble is starting to show some signs of strain and could be up for a significant correction in the next 6-12 months. Thus I am exiting two of my existing positions in Russian equities- VIP and MBT and will look to reinvest the proceeds into something that could offer more return with less risk.

Don't get me wrong I am not trying to predict that Russian economy is going to crash and go into oblivion in the next few years. But I am definitely worried that even if the highly flexible US economy has had troubles dealing with the sub prime fallout, Russian economy might not be able to withstand a crisis of its own quite as easily, when (not if) it occurs.

Bernanke's rate cut certainly benefited Russia more than it did the US in the short term, but however shiny and promising Russian companies might look today- they are less likely to look just as good tomorrow when "the Shot Effect" of the Fed induced liquidity and inflation stimulus starts to wear off. The punch line is that in the Wall Street investment terms I would begin to slowly underweight Russian equities compared to most other emerging markets for the next 6-18 months.

Trade safe and cheers,
Vad

Please feel free to e-mail me with any comments or questions- VYazvinski@gmail.com

Comments: View Comments |  Tuesday October 9, 2007