Alpcot Russia Newsletter April 2014

Alpcot Russia Newsletter April 2014. The principal investment objective of the Fund is to achieve long-term capital appreciation through investment in equity securities of issuers in greater Russia

The Fund aims to invest a majority of its net assets in securities of issuers domiciled, significantly investing or conducting significant operations in Russia. It may also invest in securities of issuers domiciled, significantly investing or conducting significant operations in other independent states of the former Soviet Union

Manager Commentary

In April, US equity market was flat (S&P 500 +0.6%) despite relatively robust earnings season. Positive sentiment remained in the majority of the Emerging Markets (EM). Turkey (+6.4%) was the best performer on the back of easing political tensions. This was followed by Brazil (+2.7%), while India (-1.1%) and China (-2.5%) underperformed. Russian equity market remained the maelstrom of volatility, declining 6.5% (MSCI Russia) as the geopolitical risks related to the crisis in Ukraine persisted (all performance figures above are in USD).

A series of protests sparked across eastern Ukraine where protesters occupied local administration buildings demanding a referendum. In response, the active government in Kiev attempted to conduct ‘an anti-terrorist operation’, sending military troops and tanks to these cities. The operation stalled as military met fierce resistance from local militia, forcing the acting President Turchynov to publicly admit the government is not in control of the situation in the eastern Ukraine. Meanwhile, EU and the US imposed another set of sanctions against Russia. Sanctions focused primarily on Russian politicians and a handful of businessmen with close links to President Putin. The sanctions imposed so far have had limited direct impact on the Russian economy.

White House administration insisted, however, that it is prepared to impose much harsher, industrywide sanctions on Russian banks and potentially other sectors. We continue to believe that such a scenario is possible only in case Russia will get involved into a full-scale military action in eastern Ukraine. Although such a scenario is still possible, we assess its probability as still relatively low since whatever President’s Putin end-game may be, it is unlikely to be a full scale military invasion of Eastern Ukraine as this will be strongly opposed by the majority of the population in both Russia and Ukraine.

As we nearing Presidential elections in Ukraine in the end of May, the situation will remain very tense as we are likely to see further numerous provocations from both sides. This, in turn, implies continued increased volatility in Russian equities, which continue to trade at the lowest multiples in the last 10 years (see a chart on the next page). At the same time, we remain hopeful for political solution of the crisis in Ukraine. This, in turn, implies a gradual return to normality in the equity market, with investors starting to pay more attention to company fundamentals rather than military troop movements.

Fund Performance

In April, RUB continued to depreciate (-1.7% and -8.3% YTD) driven by ongoing capital outflows ($50.6 Bn in 1Q14 – please see more on this on the next page). Weaker RUB led to a spike in inflation to 7.1% YoY from 6.9% in the previous month. Reflecting geopolitical uncertainties, Russian companies held off capex spending as investments contracted by 4.8% YoY in 1Q14. At the same time, industrial output growth accelerated slightly to 1.1% YoY in 1Q14 from 0.9% YoY in 2M14. Although retail sales picked up in March to 4% YoY (3.5% YoY in 1Q14), we doubt it is sustainable and expect a slowdown in the consumer spending in 2Q14.

Despite weak equity market the fund’s UCITS ETF significantly outperformed MSCI Russia in April: -3.3% vs. -7.1% (all in EUR): a handful of stocks in our portfolio remained quite resilient to the market weakness, while other shares experienced a strong rebound. In the weak RUB environment, the market continued to favour exporters of the natural resources.

Shares in Evraz (+20.8%) rallied after the company published relatively good results, showing improved cash flow generation, cost control and leverage reduction. In the same Metals and Mining sector, shares of Norilsk Nickel also outperformed (+9.2%) after the company announced dividends yielding 7.3%.

Two other natural resource exporters – Alrosa and Phosagro – also outperformed the market (+2.1%) and (+5.4%), respectively. Alrosa’s shares were also boosted by the company’s resolution to pay dividends yielding 4%.

In Telecom sector, Kcell continued to post improving profitability and recommended 2013 dividends, yielding c. 12%. As a result, Kcell shares spiked by 10.2%. We continue to see potential in Kcell.

Other notable outperformers included stocks in consumer sector: Dixy (+10.9%) and X5 (+12.2%).

Shares of X5 surged after positive 1Q14 results, indicating the management is on track in its program of operational improvements. Dixy was a similar case – 2013 results came in well ahead of the consensus expectations. According to our analysis, the current valuation of both of these stocks implies the worst case scenario of rapidly deteriorating margins, which, given the latest financial results, does not seem to be the case.

The worst performers were Global Ports (-22.9%) on no particular news. In addition, shares of Sberbank (-13.5%) and Gazprom (-6.3%) remained under pressure, reflecting investors’ concerns regarding possible US/EU sanctions on these companies.

Sberbank remains our favourite exposure to Russian banking sector. We believe the current valuation (0.7x P/BV) is unjustified, given company’s high profitability (18-20% return on equity)

Performance chart %

 

On Capital Outflows

Much has been said in the media in regards to Russian capital outflows YTD. Indeed, the amount mentioned by media ($50.6 Bn in 1Q14) seems staggering at the first glance especially as it is roughly equal to the capital outflows from Russia for the entire previous year. However, we would like to dispel several myths associated with this indicator and its performance in 1Q14.

According to the study published by Ernst and Young in 2012, the indicator of capital outflows calculated and reported by Central Bank of Russia (CBR) is only an accounting figure that does not reflect the economic nature of the transactions. The indicator as currently calculated may include transactions that do not constitute real capital flows. Moreover, the methodology of calculating capital outflow that is currently used by CBR is not used by any other countries (hence, Russian indicator is not directly comparable to similar indicators internationally).

According to Ernst and Young’s analysis, there is no statistical relationship between investment climate and reported capital outflows figures.

When it comes to capital outflows reported for 1Q14, in particular, it is interesting to see that the most significant capital outflows in this period were related to the so-called dollarization of savings ($19.6 Bn), i.e. population and banks selling RUB and buying foreign currency (USD and EUR, presumably). Not a surprising amount, considering that RUB depreciated by 8.8% in 1Q14. However, it is important to understand that the bulk of these funds can easily be converted back to RUB if confidence returns. Therefore, this can hardly be accounted as a capital outflow. Reduction of direct investments (by $14.6 Bn) was the second largest component of the capital outflows indicator reported for 1Q14. Given that direct investments declined by $93.6 Bn in 2013, the figure for 1Q14 is concerning but not alarming in our view.

All told, we are not too concerned yet with the capital outflow figures reported by CBR for 1Q14. As RUB rate seems to be stabilized around 36, dollarization of savings should subside, reducing capital outflows indicator.

On Government Measures to Stimulate Economic Growth

In the previous newsletter, we highlighted several reasons why Russian equities remain fundamentally attractive (attractive dividends, high profitability and a structural long-term demand growth across several industries). Below we turn readers’ attention to several initiatives currently discussed in the Russian government as a response to both US/EU economic sanctions and macroeconomic slowdown.

A combination of geopolitical risks, capital outflows and higher inflation prompted government officials to downgrade their expectations of 2014 GDP growth to 0.0-0.6% from above 1% initially expected at the beginning of the year. Before the crisis in Ukraine escalated, Kremlin officials admitted that they were not satisfied with economic growth, and efforts to revive growth have only become more important. In February, the Ministry of Economy prepared a list of reforms to be implemented in 2014-15, aimed to stimulate economic growth in near- and long-term. Hence, should geopolitical risks subside and assuming Russia avoids Iranstyle sanctions, the government may return to the reforms agenda, implementation of which should boost economic growth already in 2H14 and beyond. Among the measures proposed in the Ministry of Economy’s plan are the following:

– De-offshorization – a proposal to impose taxes on offshore entities of the Russian individuals and corporates. If implemented, this should slow down the pace of capital outflows and improve corporate governance.

– Higher dividends from state-owned enterprises (SOEs) and mandating SOEs to pay 25% of their IFRS profits. This idea is not new and it is still under the active discussion in the government as some SOEs already switched to IFRS-basis for dividends while others are likely to do so only in 2015-16.

– Higher SOE dividends should primarily come as a result of better cost control and improved capital allocation policies. One evidence of a such cost control efforts is Rosneft’s recent pressure on all company’s suppliers, demanding 10-15% discounts.

– As another measure to improve SOEs’ efficiency, the government has recently approved a set of recommendations mandating SOEs to develop and implement a set of key performance indicators (including return on equity and shareholder return) in order to improve SOEs corporate governance. In addition, government has approved in February a new version of the Corporate Governance Code, which is aligned with the best international corporate governance practices.

– Reform of Federal Anti-monopoly Service (FAS) in order to exclude small and medium enterprises (SME) from FAS control to stimulate competition.

– Other measures to support SMEs include twoyear tax holidays for new SMEs, lending to SMEs from the National Wellbeing Fund with a national system of guarantees for such credits.

– In addition, the government has been in a long discussion in regards to a possible use of National Wellbeing Fund to finance significant infrastructure programs.

– Other proposed measures to stimulate investment demand and improve infrastructure include doubling federal budget spending on roads in 2015-17. Given the poor condition of the majority of roads in Russia, we believe improving road infrastructure may have a multiplier effect on its GDP provided that corruption in kept under control.

– One of the critical measures is also aimed at decommissioning the old machinery, property and production equipment, and stimulating machinery upgrades. This, according to Ministry of Economy, can be implemented via raising a property tax on the old equipment, while newly purchased equipment currently enjoys tax holidays enacted in 2013. If successful, these measure alone can significantly improve productivity of the Russian enterprises, given that the bulk of the currently used equipment is still from the Soviet times and almost fully depreciated (50-75% on average).

– In addition to these measures, government remains firmly set on improving the business climate, measured by World Bank’s Ease of Doing Business ranking. The government made substantial progress in 2013 improving this indicator to 92 from 111.

– As one of the measures to optimize public spending and reduce bureaucracy, Prime Minister Dmitry Medvedev publicly suggested that government may implement 10% redundancy across the entire bureaucracy staff in the country.

– Further, we remain hopeful that a pension reform launched in 2013 will continue. The government has recently approved law allowing participation in equity offerings for state and private pension funds. Given that equity allocations currently remains very low (c. 6%) amongst Russian pension funds, further pension reforms are likely to add substantial depth to the Russian equity market.

P/BV – Russia vs. Other Emerging Markets

Om Alpcot Russia Fund

Fondens övergripande målsättning är långsiktigt värdeskapande genom att investera i värdepapper i bolag inom Ryssland och övriga f.d. Sovjetunionen.Fonden investerar en majoritet av nettotillgångarna i värdepapper vars utställare har hemvist, gör betydande investeringareller har verksamhet i Ryssland.

Fonden kan också investera i värdepapper vars utställare har hemvist, gör betydande investeringar, eller har verksamhet i andra oberoende stater i f.d. Sovjetunionen.

Alpcot Russia is a compartment of Alpcot SICAV, an open-ended Luxembourg investment company with variable share capital (Société d‘Investissement à Capital Variable) incorporated on 25 October 2010, with registered office at 11, rue Aldringen, L-1118 Luxembourg. Alpcot SICAV is organised under Part I (UCITS) of the Luxembourg law of 2010 on undertakings for collective investment, as amended, for an unlimited period. The custodian of the assets of the fund is KBL European Private Bankers S.A., 43, Boulevard Royal, L-2955 Luxembourg. The information in this document shall not be regarded as an offer, solicitation or recommendation for an investment. This publication is not directed to you, if we are prohibited by any law of any jurisdiction from making this information available to you and is not intended for any use which would be contrary to local law or regulation. Consequently, the fund shares may not be offered, sold, transferred or delivered, directly or indirectly, in the United States, its territories or possessions or to US Persons (as defined in Regulation S under the Securities Act) except to certain qualified US institutions in reliance on certain exemptions from the registration requirements of the Securities Act and the Investment Company Act and with the consent of Alpcot SICAV.

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