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Catching a Falling Financial Knife

Invest in Russia - Russian Stock Market Surges 71% in 2006

Stock-Markets / Investing Jan 15, 2007 - 09:53 AM GMT

By: Money_and_Markets

Stock-Markets This is the year I return to Russia — for the first time.

My mother's father was born there, but I never met him. He died before I was born — in a New Jersey fire when my mother was just five. Ironically, years earlier, my grandmother suffered a similar fate: Her father died in an accident when she was also just a young girl, in the village of Velozhin, now in Belarus . This double tragedy is a legacy that brings me both gratitude and sorrow. I'm grateful that, unlike my mother and her mother before her, I had the benefit of my loving father by my side for over five decades. But like them, I long to touch base with my roots, which, as fate would have it, have always eluded me.

So a few months ago, I began learning Russian. And a few months from now, I will be in Moscow, St. Petersburg, and one of the small villages of my ancestors. Elisabeth will tour ballroom dance centers and perhaps even compete. I will dig through family archives.


But my main mission is a more practical one — to bring home some hard answers to two pressing investment questions:

Why Did Russia's Stock Market Surge 71% Last Year?
And How Can U.S. Investors Profit from This Trend?

For a preview, I asked my Russian friends what their personal secret is for accumulating vast wealth. Their answer: Control. In the U.S., an entrepreneur can start a small business ... cookie-cutter his success ... and gradually grow rich.

In Russia, many entrepreneurs have found a quicker, easier way: They gained control over a former state-run enterprise and became wealthy overnight. Just ask Roman Abramovich, a young man who suffered a family tragedy that reminds me of my Russian grandmother.

He was born dirt poor in 1966. His mother died when he was just 18 months old. His father was killed in a car crash when he was four. And he was raised in a series of run-down orphanages. But in 1995, Russian president Boris Yeltsin began a program of privatizing state companies, and young Abramovich, just 29 years old, saw his chance.

He had already formed a series of small companies trading in oil and oil products. But he knew that the key to real wealth lay in control of sizable assets. So along with a partner, he became the majority shareholder in Sibneft, an oil company.

Fast forward just ten years, and Abramovich has an estimated net worth of $19.5 billion. He is the richest Russian, the second richest resident of the U.K., and the 11th richest man on the planet. All at the ripe old age of 40. Nor is Abramovich unique. His story is typical of the new generation of Russian oligarchs who have amassed vast fortunes virtually overnight.

Oleg Deripaska, to take another example, began his career in 1994 as the general manager of a smelter in the small town of Sayanogorsk (population 50,000) in the Republic of Khakassia. Today, as chairman of RUSAL, an aluminum company, he has de-facto control of Russia's enormously profitable metals sector. His personal fortune: About $8.3 billion. His age: 38.

Mikhail Borisovich Khodorkovsk, 39, was also one of the world's richest men, responsible for 20% of Russia's oil production and 2% of all the oil produced on Earth. But in 2004, the Russian government charged his company, Yukos, with tax evasion and insisted it pay more than $7 billion in taxes and fines. Unlike Abramovich, Khodorkovsk had not left Russia once he had made his fortune. Instead he had decided to stay in the country and fight for political reform. He was arrested, charged with tax evasion, and is now serving a nine-year sentence in a Siberian labor camp.

The destiny of these oligarchs illustrates a single, fundamental fact about Russia: It remains, as Winston Churchill once quipped, “a riddle wrapped in a mystery inside an enigma.”

Virtually Limitless
Natural Resources!
Turbulent History!

Even after the fall of the Soviet Union, Russia is still the world's largest country ... spanning 11 time zones ... twice the size of the United States ... but with just half the population. That translates into vast, virtually unlimited, oft-untapped natural resources. But, at the same time, Russia is still struggling to overcome the handicaps that accrue from 70 years of Communist domination and control.

It's torn by an enormous gap between rich and poor. Crime, corruption and disease afflict even the wealthiest cities. Many have no electricity, indoor plumbing or adequate sanitation facilities. Millions are still in poverty. Part of this is the inevitable result of its rapid transformation — from an economy of near total state control ... to one that reminds observers of the Wild West of the 1880s. Indeed, it all happened so quickly.

The Soviet Union was legally dissolved in a rapid-fire series of decrees in 1992. Within a matter of weeks, the newly elected Boris Yeltsin removed Soviet-era price controls ... legalizing private trade and manufacture ... cut or abolished subsidies to state farms and industries ... opened the door to foreign imports ... and broke up the state-owned monopolies.

The immediate result: Hyperinflation.

By 1995, inflation in Russia hit double-digit rates per month. The value of the ruble plummeted; the savings of the elderly and others on pensions, wiped out.

Oil, Russia's primary source of foreign exchange, plunged in value, sinking as low as $12. The economy shrunk 40%. The value of the ruble fell 75%. The Russian government defaulted on some $30 billion in loans. And fully half the population was plunged into poverty. That's when the Russian government, cashless and bankrupt, could no longer afford to subsidize the failed state-run enterprises left over from the Soviet era. So it sold them off — to the highest bidders. That's when Russia was finally forced to turn to the kind of gutter capitalism that it had sought so hard to avoid. And, ironically, that's also when it hit rock bottom and began the process of rebuilding.

An Amazing Turnaround
In 2000, just as the U.S. was beginning to sink into its longest bear market since the Great Depression, Russia finally began the long road to recovery.

Oil prices started to climb to record levels, and oil export revenues surged from $8.8 billion in 1998 to more than $58 billion in 2004. Foreign capital, spooked by the earlier default, began flowing back into the country. By 2005, GDP was growing by 6.4 percent annually — the seventh consecutive year of strong growth. And in 2006, it was nearly 6.9 percent.

The primary remaining shadow hovering over the economy: Putin's increasing willingness to re-assert state control over private enterprise.

Putin has taken over the privately-owned Russian oil giant, Yukos. He has cut off the flow of oil to Russia's neighbor, Lithuania — for the sin of agreeing to sell an oil refinery to Poland. In the middle of winter last year, he shut down the flow of natural gas to the Ukraine to force a price increase. And just last week, he used a similar strong-arm tactic with Belarus , the same region where my Russian ancestors were born.

This new authoritarianism stems from the need to curb the power of Russia's new oligarchs. But it also reflects a rampant corruption that has plagued Russia's governments since the days of the Czar — another way for government insiders to steal billions. This is bad. But, for better or for worse, it does not seem to be standing in the way of rapid growth for Russia or big profits for investors. The main reasons:

Reason #1
Russia is the World's Second Largest Exporter Of Energy, Surpassed Only by Saudi Arabia.

Russia has a whopping 13 percent of all global oil and gas reserves in the world — including 60 billion barrels of oil valued at $15 trillion. Russia also holds the world's largest natural gas reserves, the second largest coal reserves, and the eighth largest oil reserves.

Reason #2
Russia's “Gangster” Economy Is Part of A Transition, Not a Permanent Fixture.

You can look at Russia's turmoil as a cup half empty. Or you can see it as a cup half full — an enormous opportunity reminiscent of the 19th century America, complete with robber barons, unbridled entrepreneurial bravado ... but also with a strong, almost universal zeal to build a modern economy with modern institutions. Indeed, savvy international investors are turning lemon into lemonade: They are using this transitional period of gangster capitalism as their window — to jump in and buy Russian assets for pennies on the dollar.

That's probably why Russia saw more than $13.1 billion in foreign direct investment pour into the country last year — more than three times as much as in 2002, according to the World Bank. And that's also probably why Russia has experienced double-digit growth in fixed capital investment for three years straight, now up to a healthy 18 percent of GDP.

Reason #3
Finances Improving Steadily

Vladimir Putin has instituted a flat-rate income tax of 13 percent, something that flat-tax advocates like Steve Forbes have been recommending for the U.S. for years. Whether it can work here is still the subject of intense debate. But in Russia, it's fait accompli. The flat tax has been a boon to entrepreneurial development and industrialization — and, ultimately, to Russia's tax coffers as well.

Net result: Russia's government is currently flush with cash. Its federal budget has a surplus. And in 2005, that surplus hit a record $57.2 billion, or 7.5 percent of GDP. Meanwhile, Russian's balance of payments continues to move from strength to strength, with $250 billion in foreign exchange reserves, the third-largest cash hoard in the world.

Russia has even managed to pay down its debts. It had a total national debt of 90 percent of GDP just a few years ago. Now its debt is about 15 percent of GDP. In contrast, the total U.S. public debt now stands at $8.7 trillion or 64.5 percent of GDP.

Bottom Line
The Russian Economy Is Galloping! The Russian Stock Market Is Flying!

The Russian domestic economy has grown each of the past eight years.

Household incomes grew 11.5% for the year, hitting 7.411.8 trillion rubles.

The official poverty rate declined from 17.8 percent in 2004 to 15.8 percent in 2005.

And as I pointed out at the outset, the Russian stock market was up 71% in 2006.

Three Ways to Invest in Russia

Years ago, investing in foreign markets was extremely difficult for the average investor, and investing in Russia, unthinkable. You had to open special brokerage accounts abroad. You had to deal with foreign currency conversions. And you had to invest in large amounts to make it worthwhile. Not today. You can buy U.S.-traded funds and stocks in virtually every major market, and Eastern Europe is no exception. This doesn't remove all the risk — far from it. The more an investment soars, the more likely it is to also suffer periodic tailspins.

So invest sparingly. And wait for sharp dips before buying.

Three Ways to Invest in Russia

The most efficient vehicle: Templeton Russia and Eastern Europe Fund (TRF). This closed-end fund rose an eye-popping 68.6% in 2006, and for the past five years has averaged yearly gains of an equally impressive 44.3%. But it's also had its share of ups and downs, especially last year, as you can see from the accompanying chart.

It's invested in 32 Russian stocks, with the top five being Lukoil (11.8%), Savings Bank of the Russian Federation (9.84), United Energy System of Russia (8.91%), Mining & Metallurgical Norilsk Nickel (6.35%), and Severstal OAO (6.15%). Like an ETF, you can buy it like a stock. And like a stock, if it does not perform, you can sell it without restrictions.

Good luck and God Bless!

By Martin Weiss

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.MoneyandMarkets.com


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Catching a Falling Financial Knife