The Bottom Line: Taking profits in Russia

www.upi.com By Gregory Fossedal Special to UPI From the Business & Economics Desk

WASHINGTON, Feb. 21 (UPI) -- As regular readers know, "The Bottom Line" has advised investors to hold a significant position in Russian stocks for some time, and funds we manage and advise have been invested accordingly over the last several years. It's been a great ride, with the Moscow Times Index nearly tripling since January of 2000 and rising more than ten-fold since 1999.

It may also be a sign that the Russian market as a whole is about to take a breather, settling into a slower growth track of 10-20 percent per year, with some sectors actually heading south.

It's not time to go short, but may well be time to lighten up, take profits, and find countries that are in the position today that Russia was in several years ago. (Some leading candidates, to be discussed in future articles, include Argentina, Israel, Southern Africa -- ex South Africa itself --, India, Iraq, and the Philippines.)

Even after this long surge, Russia today has several factors in its favor. Over most of the last few years, each has been generally moving in the right direction for Russia. These positive factors account for true political and economic synergy, which is generally what's needed for markets to double and triple in a matter of a couple years.

Factor one is the price of oil, Russia's largest export and the source of more than 40 percent of its federal government revenues last year. This has put Russia in a strong fiscal position, enabled it to pay off some (but not all) of a large number of short-term debt obligations, and put the budget in surplus. The surplus has relieved pressure on the tax code, particularly pension liabilities, which had been driving much of the Russian economy underground. In Russia, as in Sweden, 80 percent tax rates make for an economy of barter and bribes.

Oil at $35-plus a barrel, however, is unlikely to last. Oil prices are nearing their peak, with uncertainty over both Iraq and Venezuela driving oil close to $40 -- not coincidentally the price at which it peaked during the last Gulf War.

To be sure, there are ways to hedge against declining oil prices, both for the Russian government and investors in Russia. But many important effects of a declining oil price may have to do with feedback impacts that spread throughout the political economy. If you don't believe this, consider what happened to prices for houses, commercial real estate, savings and loans, financial services, and other sectors in Houston, Texas during the 1980s and 1990s oil price busts. Political careers ended and webs of corruption were uncovered.

We may be seeing the beginnings of such troubles in the scandals over Lukoil today in Russia. With a parliamentary election less than a year away, it wouldn't be surprising if Vladimir Putin's supporters, authors of the current prosperity, were to lose seats in the traditional manner of incumbent parties -- even successful ones -- and move into a more defensive posture.

Diplomatically, Putin appears well-positioned. This matters, especially for emerging countries. A strong and respected Russia has a stronger case for joining the World Trade Organization, and resolving trade disputes with protectionists both in Europe and the United States. Putin has built a friendship with George W. Bush that few European or Asian leaders save Tony Blair enjoy, but at the same time maintained his independence.

Still, it's hard to see how Putin has been able to use, say, his support for the war on terror, or acquiescence in America's strategic defense deployment plans, as leverage for relief from U.S. or European trade curbs. My own guess is that in the months after Iraq, Colin Powell will lead a rigorous effort to rebuild America's relationship with Germany, France, Russia, Korea, and others -- and these countries will benefit from dropped trade curbs, new free trade agreements, or both. Even if that's right, however, it's months away, and you can buy it when there are early signs of a détente.

The strongest bull case for Russia rests on domestic economic policy. This is, to be sure, the most important element of any international investment strategy, but particularly one that is buy-and-hold, focused on the long run, rather than trying to time buys and sells and make gains from trading. (The fund managers and advisors that work with me tend to do some of each, having a base position that is still "long Russia," but moving in and out on the margin based on events.)

The Russian tax code, thanks to Putin's reform, is one of the most labor-friendly in the world, with a 13 percent flat rate on income rivaled only by Hong Kong, Bolivia, and Botswana. The real estate market has been deregulated and is opening up to foreign ownership -- another Hong-Kong style measure that should not only be a boon for all Russians, but will make the whole country more attractive as a place to locate top-level managers and high-value-added production.

There are many little flies in this ointment, however. Russia's information technology sector, for example, has enjoyed much of its surge through piracy. Where piracy is concerned, China, with more clout with U.S. companies who feel they dare not alienate a nation of more than a billion consumers, is better positioned to steal and get away with it. Where honest, low-wage software and IT work is concerned, India seems to have an advantage.

Russia's stock market is loaded with companies with price-earnings ratios as low as 1-1, and averaging less than 3-1 overall. Still, one must question those earnings statements, and beware of the risk for catastrophic declines in individual companies likely to be involved in intellectual property suits, domestic or international corruption scandals, or sheer continued economic weakness in such major Russian trading partners as Germany and France.

Given this mixed picture, we're still invested in Russia, particularly the telecom, aerospace, real estate, and mining sectors. But we are selling off some of our holdings, and establishing a growing short position on oil as a hedge -- not just against Russian oil company declines per se, but the kind of political spillover that seems to happen in commodity economies (Texas, Mexico, Venezuela) when things turn sour. Emerging markets portfolios that have had Russia at 10 to 12 percent of assets should probably be moving that down to 6 to 8 percent, particularly when oil prices drop.

Are the bears gathering in Russia? Hardly. But the bulls look to be slowing from a stampede to a gallop, maybe even a trot. In a world where very few markets have been up, one can give some advice on Russia that's rare but refreshing: Take some profits.

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(Gregory Fossedal is chief investment officer of the Democratic Century Fund, managed by the Emerging Markets Group, dcfund.net. His firm may hold some of the securities mentioned in "The Bottom Line." Individual investors should contact their own professional adviser before making any decisions to buy or sell these or any related securities.)