From Russia, With Profits

02/10/2006 12:00 am EST

Focus:

Carla Pasternak

Editor, The Income Investor

"Guess which nation is the world's largest energy producer?" asks Carla Pasternak. "Saudi Arabia? Wrong. The US? Wrong again. Okay, it's Russia." Here, the editor of High Yield Investing looks at a play on Russia and Eastern Europe.

"Think Yukos, the giant Russian oil company that produces 2% of the world's oil. Think Gazprom, the world's largest gas producer, which supplies 20% of the world's gas needs. Thanks to record oil prices and resilient government policies, Russia's two benchmark stock indices chalked up more than 80% returns and were among the top-performing emerging market indices in 2005.

"That helps explain why the Morgan Stanley Eastern Europe Fund (RNE NYSE) delivered eye-popping returns of 68% last year and doled out an astounding $8.04 in dividend payments, giving the fund an unbelievable 22.6% yield. The fund invests in the burgeoning economies of Russia and other Eastern European countries. Russian stocks account for some two-thirds of its portfolio, with the balance invested mainly in Poland and Turkey.

"Its portfolio is diversified across a variety of industries, ranging from consumer stocks to energy to industrials. Top holdings, which now make up about a third of the portfolio, are Russia's premier turbine maker Siloviye Mashiny, Russian cosmetics-maker Kalina, Russia's leading grocery retailer Pyaterochka, Russia-based dairy and juice producer Wimm-Bill-Dann Foods, and Alpha Cement.

"The fund's distributions are powered by share price gains on the sale of its portfolio stocks. Based on the $8.04 per share distributed to shareholders in 2005, the fund now sports an incredible 22.6% yield. About 60% of last year's distribution consisted of long-term capital gains from the sale of portfolio holdings. These gains qualify for the 15% tax rate. The fund also charges a fairly hefty management fee of 2.13%, which reduces the effective yield.

"Investors in this international fund are exposed to the rise and fall of currency exchange rates between the Russian ruble and the US dollar. However, in the case of RNE, this currency risk is no longer a big factor, as the country now uses a basket of world currencies to stabilize the ruble's real exchange rate. Investors should also be aware that the fund has been operating with an earnings shortfall. These operating losses may not directly affect shareholder distributions, but they do expose shareholders to some risk.

"This fund is largely a play on the Russian economy and stock market, which are both linked to oil and gas prices. Given its status as the world's largest energy producer, about 25% of Russia's economy is fuelled by oil and gas. After the Russian government seized privately-owned oil giant Yukos in 2004 foreign investors fled for the exit doors. But what a difference a year can make, as the country's financial markets rose from the ashes of the Yukos debacle, soaring to unprecedented heights.

"Over the past three years, the fund has delivered a dazzling 62% return each year on average. What's the prognosis for the next three years? Can you expect to reap the same fabulous rewards for your patience? Maybe not, but that doesn't mean the returns will be pint-sized either. After all, the Russian economy grew at an amazing 6.4% clip in 2005, following up on an explosive 7% pace in 2004 and 2003. This growth rate is expected to slow to about 6% a year in the next three years, as oil and gas prices back off their record highs. That's still almost double the expected growth rate in the US..

"The Russian economy will also be steadier and less exposed to oil and gas price swings. In an effort to wean itself from volatile commodity prices, the government has started offering tax incentives to industries outside the energy sector, including the automotive, computer, and appliance industries. It will also help that despite its reputation for playing rough with foreign investors, the country is earning high marks in the international investment community. A month ago, Standard & Poor's raised the country's credit rating to a notch above investment. The rating opens up the country to institutional money with more conservative investment criteria.

"The fund hit a peak of $42.95 on December 20, then subsequently lost about 20% of their value thanks in part to a short-term fall in oil and gas prices. Since then, the fund's share price has been fairly stable and RNE is now trading at about a 10% premium to the value of its underlying portfolio, which was valued at $32.11 per share on January 19. If you believe oil and gas prices will remain at record levels, then this fund may be worth your consideration. Given the fund's sensitivity to volatile energy prices, though, I consider RNE a speculative investment."

Related Articles on