Russian Small-Cap Investing: Three Reasons to "Think Small"

by Carl Delfeld

Russian Small-Cap Investing: Three Reasons to "Think Small"

by Carl Delfeld, Investment U's Emerging Markets Expert

Friday, April 29, 2011: Issue #1502

Russia is one huge investment opportunity. Literally.

It is the world's largest landmass by a vast margin with 6.6 million square miles. At the other end of the spectrum is Vatican City at only 0.17 square miles.

With Russia you think of giant companies like Gazprom or Lukoil, controlled by oligarchs in Moscow. The country provides a shining example of the challenge facing investors trying to tap into its potential opportunities.

But, it provides limited investment choices, until now...

Investing in Russian ADRs and Pink Sheet Blue Chips

There are mutual funds. Then there are Russian companies that trade on U.S. exchanges as ADRs. There are currently just five ADRs:

There are an additional 37 Russian companies listed over-the-counter (OTC). These "pink sheet" listings are part of a growing trend for even the largest companies like Gazprom and Lukoil, which seem eager to avoid the high cost and regulatory burdens of the big board.

Picking through this list to find the "pink sheet blue chips" takes patience, skill and judgment. My advice: Be careful.

Then there are exchange-traded funds or ETFs that trade like a stock as a basket of Russian stocks. The highest profile is the Van Eck's Market Vectors Russia ETF (RSX) with energy and basic material companies accounting for 68 percent of its assets. RSX has $4 billion in assets, and 95 percent of the companies in the basket have a market value greater than $5 billion. RSX is up approximately 8 percent this year.

Three Distinct Advantages of Investing in Russian Small-Caps

But perhaps the best way to invest in Russia is to first change your perspective on the country in the first place. Maybe it's time to think small in Russia. Many small-cap Russian companies offer three distinct advantages over the better-known giants:

  • Private ownership and control

Government ownership and support comes at a high price. Smaller private companies fly a bit under the radar. They also tend to be more nimble and have the opportunity to grow faster. State-owned and controlled companies can hit speed bumps as government change regulations or priorities. With $100 plus oil, Russian energy giants may seem like the place to be, but keep in mind that Moscow raises tax rates as oil and other commodity price increases. This is a direct hit on profitability and share prices.

  • Broader and deeper play on domestic growth

Even marginal market reforms have and will continue to create winners outside of energy and commodities. The tax revenue from higher commodity prices filters back into the domestic economy sort of like a perpetual stimulus program. Smaller cap companies in a wide variety of industries are poised to capture this demand and turn it into profits for shareholders.

  • Less research coverage and "discovery" potential

Like small caps all over the world, Russian small caps are largely unknown and are covered by analysts only sporadically. As a test, look at the list of the ten largest Russian small caps below. If you recognize more than a few, you probably hail from Russia. The top ten holdings are:

Top 10 Russian Small Caps

Up to now, it has been difficult to invest in these Russian cubs. This is why Van Eck's new Russia small cap ETF (RSXJ) is attracting a lot of attention.

RSXJ offers good diversification with a 35 percent weighting in energy and materials, leaving more room for allocations to utilities (18 percent), industrials (15 percent), health care (8 percent), and other consumer (18 percent) sectors.

Finally, Russia is not only big, but pretty cheap, as well. Russia's stock market's is trading at just seven times earning, reflecting a significant discount to the emerging markets index. In addition, Russia now trades at a 40 percent discount to the MSCI Emerging Markets Index while India is at a 44 percent premium.

Good investing,

Carl Delfeld

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