Interview Series

WIOF Russia and CIS Performance Fund

Investment Advisor: Citadele Asset Management

(July 2012)

What is likely to change in the investment climate in Russia following the election of Vladimir Putin as president?

Although it would be naive to expect a sudden improvement, we believe that the investment climate is going to ameliorate gradually. Although there have been no major surprises in the composition of the new government in Russia, Prime Minister Dmitry Medvedev’s recent ambitious push for a privatization programme clearly points to the desire to reduce the state’s presence in the economy. At the same time, we have seen an increased number of demonstrations and discontent on the streets of Russia. Undoubtedly, on the one hand this draws foreign investors’ attention to elevated political risks, yet it also has beneficial long term effects in putting pressure on the government to accelerate democratic reforms.


The Russia and CIS region’s stock markets did well when global markets rallied at the start of the year and poorly in the recent global market downturn. Does this just demonstrate they have a high correlation with global markets or was there some other reason behind this performance?

It is a combination of both factors. The dependency of the Russian and CIS economies on the commodity environment and increased sensitivity to global appetite for risk is a well-known phenomenon. However, in May, the domestic news agenda in Russia also contributed to the stock market producing poor results. Alleged violations during the presidential election campaign contributed to elevated political risks. Furthermore, investors were not encouraged by the composition of the new government. In the Ukraine, unsupportive external news flow was combined with extremely dry liquidity on local stock markets, an absence of success on IMF negotiations and investor expectations of possible devaluation in the local currency. Also, the country’s never-ending political instability was exemplified by problems following the arrest of opposition politician Julia Tymoshenko. By contrast, internal affairs played a relatively minor role in the Central Asian region in comparison to developments on global commodity markets and demand for risk assets.


Many of the region’s markets are highly commodities-driven, meaning they can be very sensitive to fluctuations in global growth and external demand. What investment strategy do you use in the portfolio to try and deal with this?

This is certainly a significant risk for the region’s stocks, and one that we are fully aware of. While the region’s GDP growth is highly dependent on commodity prices, we have observed an increasing role played by domestic demand. According to Russian Federal State Statistics Service data for May, retail sales in the country accelerated to 6.8% y-o-y, while real wages and disposable income increased by 11.1% y-o-y and 3.6% y-o-y respectively. To benefit from the trend, alongside with the substantial exposure to the raw material segment, which naturally has a significant capitalization in the market, we have been taking more exposure to the consumer sector. The latest portfolio statistics show that we have kept almost a quarter of the portfolio in the region’s consumer oriented stocks. However, due to the structure of the region’s economies, the commodity price risk cannot be fully avoided and remains a crucial determinant of local stock market returns.


To what extent has the Eurozone crisis affected the region’s markets and have you had to alter your investment approach to deal with it?

The Eurozone crisis has significantly reduced risk appetite among international investors, which has been detrimental for emerging markets across the globe. For the CIS region it was more painful than elsewhere due to fears of a world-scale economic cool-down, which would undoubtedly put serious pressure on hard commodity prices. In anticipation of this, we made adjustments to the structure of our portfolio by significantly increasing our cash position, reducing exposure to cyclical sectors like energy and financials. Moreover, we maintained some hedging positions, holding put options on the Russian market. Yet we think that weak performance from Russian banks was mostly due to worsening sentiment on the sector rather than their fundamentals. Russian banks continue to increase loan portfolios at an impressive rate of 25-30% per year, and their exposure to the European periphery is very limited. In the long run, the privatization of the state’s stakes in Sberbank and VTB could be another supportive driver.


Russia has a very large weight in the portfolio. Is this simply because it is the largest market in the region and therefore has the most investment opportunities?

It is because Russia has the most abundant investment universe of liquid names. The capitalization of the Russian equity market is significantly higher than that of Ukraine and all of the Central Asian countries put together.

The region’s enormous wealth in fossil fuel and minerals reserves can appear very attractive to investors, but what would you recommend to an investor who was looking to put their money into a different sector or sectors?

Since everything is interlinked in the region’s economies, the prosperity of the fossil fuel and mineral reserves sectors spills over to the demand side, thereby raising domestic consumption and making certain sectors like retail attractive for investors seeking their fortunes outside of the commodity-driven universe. Real wages and retail sales volumes in Russia keep expanding, which has led to the growth of the middle-income consumer class. Similar trends are observed in Central Asian economies, and while the Ukrainian macro environment remains unstable, local food producing companies remain attractive overall.


Kazakhstan is seen as a ‘frontier’ economy with accompanying high risk but high potential returns by many investors. Is this a fair view of the country or are there relatively ‘safe’ investments to be made there where risk is low?

That depends on the definition of safe investments. Frontier market equities are relatively risky as an asset class, but it is clear that currently they offer much more appealing upside potential than, for example, investment grade fixed-income holdings. However, despite the fact that many of the region’s names are small-cap growth stocks, there are several nationally important companies like KazMunaiGas E&P, Kazakhmys and Bank Halyk which form the back-bone of the local economy and are important corporate tax payers. These companies, coupled with some other foreign players, like Uranium One, are relatively safe value plays, which form the core of our portfolio holdings in the region.


Kazakhstan’s president has said that the country needs to diversify its economy away from reliance on natural resources and focus on becoming a regional trade hub utilizing its geographical proximity to China. What investment opportunities does this offer?

First of all, it should offer some interesting opportunities in the transportation and to some extent construction industries, including investment projects for the construction of new international railway lines. Kazakhstan is uniquely positioned as a bridge between Russia and Europe and Central Asia and the Middle East. Kazakhstan already possesses developed railway infrastructure in the western and northern parts of the country, while the government sees transportation infrastructure development through public-private partnership mechanisms as an important element of the Kazkakhstan-2030 national development strategy. This is also very important in the context of the customs union with Russia and Belarus. We have already seen concrete steps taken in developing this, including the recent decision to form a joint venture between Transcontainer and Kaztransserviss, which would be a key player in the regional container transportation market. A massive privatization programme is also planned for the coming years. While the official purpose of the programme is so citizens can benefit from large national companies and promote the country’s idle local equity market, investors like our Fund can benefit in the longer-term. For example, among the companies slated for privatisation are: Air Astana, KEGOC, KazTransOil, KazTransGas, shipping company Kazmortransflot, Samruk-Energo, national rail monopoly Kazakhstan Temir Zholy, KazMunaiGas and uranium miner Kazatomprom.


What key reforms do you think need to be undertaken in the Fund’s focus markets to improve the investment environment?

One of the important things is an improvement in enforcement of laws, including property rights. Investors would also like more predictable regulations and tax policies, as well as liberalization of the markets. The Russian government is already pushing for a reduction of the state’s influence on the economy, which is obviously a step in the right direction. Moreover, the president has declared his intention to move Russia from 120th place in the World Bank’s Doing Business rating to 20th by 2018. It is an ambitious target, yet clearly illustrates authorities’ intention to work on the investment climate. For Central Asia, a key issue is democratization and a stable political environment. At the same time, we consider Ukraine the most politically vulnerable and unpredictable among the Fund’s target regions, although we expect more clarity after the parliamentary elections, which are due in October.


What do you see as the prospects for the region’s markets for the next six months?

A lot will depend on the global demand for risk. As long as there are no signs of relief or at least a resolution of the Eurozone debt crisis seems remote, and Chinese macroeconomic statistics continue to weaken, imported volatility will most likely dominate over fundamentals. However, we think that much of the uncertainty is already priced-in and valuations look very attractive. On the domestic front, for the Russian market we expect to see further steps in implementing the privatization programme, which may be an important driver for local equities. Also, ratification of WTO membership is expected to come during the year and this could improve the country’s attractiveness as an investment destination. Another issue is the willingness of state companies to increase dividend payout ratios, the latest positive example of which was the doubling of planned dividends by Rosneft, the nation’s biggest oil producer, which is likely to lift the payout to 25% of 2011 IFRS profit. Along with that, we expect certain steps in the way of improvement in corporate governance practices at state-controlled companies which are likely to come with the privatization programme. In Central Asia, we believe Kazakhstan and Mongolia’s macroeconomic indicators should remain stable, which should re-enforce investor interest in those economies. We are more cautious with regard to the Ukraine, where pre-elections there will be elevated political risks while the country remains under harsh debt pressure. The post-election months are likely to be economically and socially challenging.

IMPORTANT NOTE: This report has been prepared for information only, and it does not represent an offer to purchase or subscribe to shares. World Investment Opportunities Funds (“WIOF”) is registered on the official list of collective investment undertakings pursuant to part I of the Luxembourg law of 20th December 2002 on collective investment undertakings as an open-ended investment company. WIOF believes that the information is correct at the date of production while obtained from carefully selected sources considered to be reliable. No warranty or representation is given to this effect and no liability can be assumed for the correctness or accuracy of the given information which may be subject to change at any time, without notice. Past performance provides neither a guarantee, nor an indication of future performance. Value of the shares and return they generate can fall as well as rise. Currency fluctuations, either up or down, may also affect value of the investment. Due to continuing market volatility and exchange rate fluctuations, the performance may be subject to significant changes over a short-term period. Investors should be aware that shares in the financial instruments entail investment risks, including the possible loss of the invested capital. Performance is usually calculated on the basis of the relevant NAV unless stated otherwise. Performance shown does not take account of any fees and costs associated with subscribing or redeeming shares. It is assumed that all dividends were reinvested. WIOF prospectus is available and may be obtained through www.1cornhill.com. Before investing in any WIOF Sub-fund(s) investors should contact their financial adviser / legal adviser / tax adviser and refer to all relevant documents relating to the WIOF and its particular Sub-fund(s), such as the latest annual report and prospectus that specify the particular risks associated with the Sub-fund, together with any specific restrictions applying, and the basis of dealing. In the event investors choose not to seek advice from a financial adviser / legal adviser / tax adviser, they should consider whether the WIOF is a suitable investment for them.