Russian equities attract
Russian equities have long been cheap, reflecting political risks and perceptions of corruption, but the current earnings valuation (price/earnings ratio or PE) based on forecast earnings of around 4 is low even by historical standards. It’s also the lowest it’s been since the credit crisis. Cyclically-adjusted PEs are lower relative to the MSCI World index than during the credit crisis.
Comparing asset-based valuations, price-to-book (PB) is also low for Russia at 0.7, while MSCI World trades on a PB of 2.1 and PE of 15.
In terms of other valuation metrics, the average dividend yield for the Russian market is historically high at 4.8%, which compares to 2.6% for MSCI World. Dividend cover in Russia (the number of times dividends can be paid out of earnings) is very high in a global context.
Profits look to be stabilising and Russian companies generally remain cash rich. Recent economic data also suggests a more stable outlook for Russian earnings and economic growth. In particular, the leading economic indicator has improved throughout 2014 and recent business activity surveys suggest expansion.
Less positively, high inflation (currently 7.5%) and the need to defend the ruble will bias central bank policy towards higher interest rates, which could hinder economic recovery. And while evidence of a US-led improvement in global economic growth continues to mount, rising tensions between Russia and the West could continue to weigh on demand for equities and other risk assets.
A major escalation of the crisis cannot be ruled out but there are significant incentives for Russia and the West to resolve their differences. Most notably, several European countries – including Germany and Italy – remain heavily dependent on Russian energy, while Russia is heavily dependent on Western capital.
We believe the potential for a re-rating of Russian equities over the next three to five years outweighs the risk of further near-term volatility. Markets historically perform well when geopolitical tensions ease. Even if forward PEs (i.e. based on forecast earnings) were only to return to around six, which is their average since President Putin came to power, that would still represent significant upside.