Description

I am proposing that one creates long exposure to the Russian ETF RSX. Two reasons why:  A. The valuation of the companies encompassing RSX is cheap and B. The Ruble is significantly undervalued against the dollar. Additionally one doesn’t have to go searching around for individual companies in Russia with all its idiosyncratic risks.

“You will always make a lot more money when things go from truly awful to merely bad than when they go from good to better.” This is an interesting quote I got from a friend. And it is true that things look pretty awful when one looks at Russia right now, being … Putin running the country as a quasi-dictator, a shrinking economy, a proxy war in the Ukraine, an economic and diplomatic conflict with Europe and the US which led to significant sanctions on both sides, high inflation, low oil and other commodity prices, significant corruption, etc. On the other hand the country also has a few positives to report like, low debt to GDP, a current account surplus and massive amount of natural resources. So overall one could say the situation looks pretty terrible. But my thesis is that this is already very much reflected in the prices, not just for Russian stocks, but also for the Ruble. Currently the CAPE for midsized to large Russian public companies is about 5 and the currency looks to be about 40% undervalued. A CAPE this low has always provided those that bought at that valuation point with significant returns … in the US.

So I took the CAPE spreadsheet from Professor Shiller’s website and looked at the 10 year forward real return for every 1 point of valuation of the CAPE going back since first recorded. And once the CAPE valuation metric goes below 7 your expected 10 year real return (ex-dividends) for the market is about 10% compounded for those 10 years. But even better, each time it happened one had a doubling of the market valuation within a period of two to four years, all ex dividends. Now Russia isn’t the US you say. I agree Russia’s experience is not guaranteed to be linear to the one in the US, but there are enough characteristics that are similar, most importantly being the valuation of its stocks. After all, one can buy the same thing with one unit of earnings made in Russia than with one unit of earnings earned in the US. And what about the risks and uncertainties that you see in Russia now? Well, the periods where the US markets ended up with a similar CAPE valuation than Russia’s now, where also scary. The first one was around 1920. Besides the fact that the country, meaning the US, and its stock markets were markedly more corrupt back then, this is what your experience would have been in the two decades up to 1920. The 1902-1904 recession, the 1907 panic, the panic of 1910-1911, the recession of 1913-1914, WWI, the post WWI recession and the depression of 1920-1921. Every one of those recessions made industrial activity shrink by more than 10%. The low point in CAPE valuation was in 1921 in the middle of a massive depression that saw industrial production shrink by 30%. In addition you would have seen the market’s CAPE valuation fall by 80% over that 1902 – 1920 period. Or to say it differently in 1921 stocks overall were trading at a lower nominal price than they did in 1902. One could be forgiven for having had a negative view about the prospects for the United States and stocks at that time. The next time was in 1932 about 10 months before the great depression ended, a period that lasted 3 years and 7 months and took GDP down by 27% and unemployment up to 25%, while another recession 4 years later would take GDP down again by 18% and unemployment up to 19% again, all only a few years before we entered WWII. Then the next time we hit this level was around 1982 after a long period of two oil shocks, the lost war in Vietnam, Nixon’s resignation, the Iran hostage situation and most importantly a period with persistent inflation that resulted in a period of stagflation finally resulting in a serious recession caused by Volcker in order to bring inflation down. Again a period where the US population wasn’t too big on itself and stocks.

All this is kind of the same concept as is being used with the Magic Formula. If you made a list of everything that is wrong with the companies included in the Magic Formula you wouldn’t touch most of them, but somehow the group outperforms the market easily over time. It is all because the bad news is already discounted in the price and as humans we tend to place significantly more weight on what has gone wrong or can go wrong than on what can go right. And remember the big money is made when things go from truly awful to merely bad. We only need things for these companies to go to merely bad, not to good or great.

So what about the Ruble? Over the years I have used the Big Mac index by the Economist and when it comes to extremes this has worked pretty well. Especially the adjusted version which adjust the cost of the Big Mac by the GDP per capita I have found to work as a decent proxy for purchasing power parity. Now as I said before, it does not seem to have much validity for currencies that are valued relatively close to the mean, but it does work for those currencies that have a large variance to the mean which is very much the case with the Ruble now, as the Ruble looks to be about 40% undervalued.

So my thinking is that after so much bad news the valuation of the Ruble and the Russian stock market already incorporate the bad news and we will not need much good news for sentiment to change so the currency or/and stock market valuation can rebound markedly. We only need enough good news for people to feel things have gone from truly awful to merely bad for the valuation to turn around.

So why RSX? Well it has decent liquidity. You avoid idiosyncratic risk, meaning you do not have to go looking for individual stocks in a place where you do not speak the language and it is good proxy for the Russian stock market. It is mostly exposed to oil and basic materials followed by banking and communications. I on purpose have only looked at its industry exposure and not started digging into the companies as I am sure that after one day I’d guaranteed talk myself out of this investment. Sometimes the thesis is simple and there is no need to make it more complex than it needs to be. In addition I have been in this situation a few times before, for example during the financial crisis when convertibles bonds had sold off massively. I knew the overall space was very attractive and I could just have bought a number of convertible closed end funds. Instead I started looking for the most optimal solution and by the time I was done with my research the opportunity was mostly gone. Don’t let better perfect be the enemy of good.

Now depending on how you feel you can just buy RSX or on the other hand one could also create exposure by buying Jan 2017 call options. FYI. The implied volatility is in the 30-35 percent range. Although the options aren’t cheap, it would be a good way to protect one’s downside. After all, Black and Sholes becomes less relevant when valuing options over a longer period of time and when one expects a significant move.

So what are the risks? Well there are numerous ones.

For one Seth Klarman got his head handed to him in 1998 in Russia.  If Seth Klarman can get clobbered in an area, so can I. Now the issue back then was that Russia had a hard peg which ended up in a currency that was way overvalued. In defending the peg the Russian central bank sucked all the oxygen out of the Russian economy. Eventually the capital flight caused by the fear of a devaluation of the Ruble forced Russia to float its currency causing a huge devaluation from about 7 Ruble to a dollar to 21 Ruble to the dollar within a one month period. We don’t have that problem at this time as there is enough flexibility in the Ruble exchange rate. In short, in 1998 the Ruble was massively overvalued as was proven out by the massive devaluation. In addition today the Ruble has already devalued markedly over the last 20 months. At the start of January 2014 for every dollar one received 32.7 Ruble. Today, August 17, 2015 one gets 65.32 Ruble per Dollar. Btw. If one would have bought post the 1998 Ruble currency collapse one would have done quite well. The RTS in dollar terms went up tenfold in the five years following the crash. After all economies and their stock markets tend to do well after a serious currency collapse. As long as you buy the asset post the devaluation. That is why I am still waiting/hoping/praying for a Grexit.

Then there is the plethora of other things I mentioned prior that are currently going bad for Russia. Yes, things could get worse. For example, I just read over the weekend that some think oil might bottom out at $20 a barrel. Who knows? I for one believed that oil prices could fall below $100, but I had no expectation I would see a WTI price in the $41 range today. And who knows, maybe oil suddenly ends up trading close to $100 again. Another real weakness for emerging markets is always their foreign currency denominated external debt. But the situation has improved markedly there. In July 2014 Russia’s external debt denominated in USD was $733 billion, where now it is down to $556 billion.

Anyway, my point is that much of the bad news is very likely already included the price of the stocks and currency and that over a 3 to 5 year period of time one should have very satisfactory returns. We do not need much to go right for that to happen.

Khoroshego dnya.

Catalyst

No specific catalyst available. Putin falling of his horse. Any good news will do.