Don’t Rush into Russia Just Yet

01/22/2009 12:01 am EST


John Connor

Founder and Portfolio Manager (retired), Third Millennium Russia Fund

John Connor, manager of the Third Millennium Russia Fund, thinks Russia will come back, but not until confidence is restored in the global markets.

Q. John, besides rapidly falling oil prices, what do you see as the primary factors that caused the more than 72% decline in Russian stocks in 2008?

A. Aside from a general flight to quality from emerging markets into the US dollar, the Russians had a couple of things that made it worse: Putin is tired and cranky and should retire, making mistakes with Mechel Steel (NYSE: MTL), [putting] unfair pressure on BP (NYSE: BP), and of course, his overreaction with Georgia. The Georgians started the conflict and if Russia had any public relations sense, the country would have been out in front, telling its side of the story, including its peacekeeping role since the 1990s. Instead, investors bought Georgia’s PR, causing them to dump Russian equities, including great companies like Lukoil (Frankfort: LUK.F), which is now trading at a little more than three times earnings.

Q. What is your outlook for inflation in Russia this year?

A. Inflation in Russia is higher than hoped, and will probably be 11%-13% this year. Russia still has strong currency and reserves, and is managing the devaluation of the ruble okay. But they are experiencing flight of capital, aided by the government’s soft stance on repatriating capital infusions into US dollars.

Q. What is the good news (if any) for investors in the Russian markets?

A. The positive story is the Russian domestic economy, expected to grow 3%. Consumer disposable income is projected to go up high single digits. The middle class is still growing from 25%-40% of population, and they are spending money. Unemployment is not as bad in Russia today. Overall, their domestic economy is more positive than ours in the US.

There will probably be some interest in buying in Russia in the third quarter, specifically into the oil companies like Lukoil and telecom businesses, such as Rubicon and Mobile Telesystems (NYSE: MBT), which have always done well. They are profitable businesses, but that’s not yet showing in their stocks.

Q. Experts have been talking about the underinvestment in Russia's energy production for quite some time. When oil prices were high, the aging fields were able to make money. Now, they need billions in investment capital to continue cranking out high profits. Where do you think they go from here?

A. Russian energy companies are having a real tough time accepting that they could use the capital and technology of the Western majors. We should make nice and get them into the World Trade Organization (WTO) tomorrow. Secondly, there's a 12-month land lease atop Norway to get tankers through to the US. The US should get majors to pipe oil from there to diversify our sources of energy. Right now, we basically take no oil directly from Russia. Our major companies, like Exxon (NYSE: XOM) and Chevron (NYSE: CVX), are sinking in terms of their reserves and position in the world. Russia would be the perfect place to shoehorn them in some capacity like this.

Q. A couple of months ago, you announced plans to start a hedge fund focusing on Ukraine, commenting that you set up a Russian fund two months after the country defaulted on its debt in August 1998, with stellar long-term results (although 2008 saw your Third Millennium Fund fall 74%). Where does that fund stand now?
A. Right now, we are looking at doing private deals and not yet investing in public companies. Eventually, the Ukraine will be a bread basket, similar to the New Jersey truck farms.
Q. Lastly, John, if you could go back in time, what would you have done differently in 2008 in your fund?

A. At the end of the second quarter, my fund (Third Millennium, TMRFX) was rated number two, up 8% for the year. Then, in a flash, Russia went from safe haven to pariah, and by year-end was one of the bottom three emerging markets. Government actions made it worse, and foreign investors fled with their money.

Looking back, the sequence of events happened so fast, it left little time to quickly change strategies, and my investors don’t pay me to go to cash. As it was, my investors were hit with a 9% dividend at the end of the year; had I gone wholesale to cash, they would have incurred a 25% dividend, making them very unhappy, tax-wise. My redemptions have not been as substantial as other funds, and I believe I am sitting with a very good hand. I have done some rebalancing and fortunately had lightened up fairly early on Uralkali (Berlin: M6B1.BE), but would have sold more if things had not happened so quickly.

Having said that, I have increased my cash allocation to around 24%. I still like the fundamentals, but there is so little volume and interest in equities right now that good fundamentals are just not reigning. It’s now a game of wait and see.

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