Russia's rising middle class is a great investing story. But does that mean U.S. investors can safely play a role in this plot anytime soon?
Reports of widespread corruption and political infighting have long been good reasons for U.S. investors to tread carefully when it comes to throwing money Russia's way. Volatility is also tied to a strong reliance on commodity revenues—as gas and oil go, so goes Russia.
[See Where to Invest in 2012.]
This period of growing pains and political turbulence requires caution. But for some risk-tolerant investors considering emerging-market exposure for the long haul, Russia might be worth a closer look. Its "price tag" is certainly attractive, say analysts. Exposure for individual investors is limited to a handful of Russia-specific mutual funds, exchange-traded funds, and emerging market funds that include Russia.
Urban uprising. While other emerging-market nations have become more transparent and less corrupt, at least as measured by the International Monetary Fund's Transparency International rankings, Russia has trended in the opposite direction despite rising and spreading wealth.
But change is accelerating, especially in major cities. It's evident in a vocal and expanding middle class that's upset over controversial parliamentary election results. Their collective voice has sparked heavy protest ahead of early-March elections.
"Rising wealth levels over the last decade have turned Russia into a middle-class country for arguably the first time in its history. We expect this fact increasingly to be reflected in its politics, and see the current protests as the start of a long process of change," say Citi analysts Kingsmill Bond and Andrey Kuznetsov, writing in a commentary.
In one anecdote of middle class-focused political response, Russian President Dmitry Medvedev turned to Facebook to announce that he had ordered a probe into the allegations of electoral fraud during the country's December 4 Duma vote. His posting prompted mostly angry comments exhibiting doubt that such action would be forthcoming.
Prime Minister Vladimir Putin, whose party won in December, is expected to win the March election but is facing growing protests from mostly urban Russians unhappy with his decision to seek a third presidential term. Putin's political detractors have staged what is widely reported to be the biggest opposition protests of his 12-year rule.
Commodities are sure to remain Russia's fiscal foundation, but an evolving economy is now an important consideration for investors.
For example, 74 percent of the population is urban and 82 percent of people own their own home, a higher level than in most European countries. The vital missing component for the formation of a middle class was money, but that has now come, the Citi analysts report. Income per capita in Russia is over $900 per person per month, nearly half of the European level.
Bridges and bargains. John Connor, portfolio manager for Third Millennium Russia Fund (TMRFX), calls investor attention to what he says are "solid prospects" for the Russian economy and stock market in 2012.
"Even though the markets performed even worse in Brazil, India, and China last year, the Russian market was down over 20 percent so that the market [price-to-earnings ratio] is about five, making it the cheapest in the emerging market space," says Connor. "What actually happened last year was a giant sucking sound throughout the emerging markets as investors 'fled to quality' back to the U.S. At current prices, Russian stocks are a bargain relative to their international peers."
Connor sites low trade and budget deficits, strong central bank reserves and mild domestic inflation, plus a 4 percent GDP growth prediction for 2012.
Global events on Russian soil could improve its profile and boost infrastructure projects like bridge, road, and airport expansion, plus hotel and stadium projects. Later this year, Russia will host the Asia-Pacific Economic Cooperation meetings at Vladivostok's Russky Island where it is building an 1,100-meter bridge. In 2014, Russia will host the Winter Olympics and in 2018, the soccer World Cup. And, Russia joined the World Trade Organization in December after an 18-year tussle over its membership.
Tax revenues from the energy sector account for almost half of the government's revenues. One of the main issues at this time is slowing production from mature fields, which the government has addressed by adjusting the tax regime to stimulate capital investment in new and risky projects in offshore and more remote areas, said Morningstar analyst Patricia Oey, in an analysis of ETF SPDR S&P Russia (RBL).
At the same time, this fund's heavy exposure to commodities may provide diversification benefits for a U.S. investor, as commodities have historically exhibited low correlations to equity markets, she added.
Pro-market moves. The country is also taking gradual steps to open its markets to more foreign investment. The Russian MICEX-RTS stock exchange will launch a government bond trading section beginning in mid-February. And foreign fund flows, looking for opportunity outside of developed Europe, have been channeling money into Russian debt.
But other business dealings remain mired in controversy in some instances, and plagued by uncertain market conditions.
The government is planning to reduce its stake in large, partially government-owned corporations such as Rosneft and Sberbank as part of its efforts to further develop the local capital market, as well as to draw money into public coffers. Privatization efforts have been delayed because of the recent volatility in global markets, and Russian IPOs have not fared very well, said Oey.
There's a greater chance for sudden market volatility because foreign investors hold a significant portion of Russian equities "free float," and not limited by typical exchange rules. So when markets are in a risk-off mode, sudden outflows of foreign funds negatively impact the Russian stock market.
For long-term investors, the statistics may be on their side.
Importantly, consumer optimism may drive Russia's future: More than a third of the country considers itself to be "middle class," the Citi research shows.
Now, government recognition must follow. "If Mr. Putin heeds his own words and democratic practices become even more evident in Russia, hopefully this will greatly reduce the deep 'Russia discount' which investors currently suffer and the Russian stock market will better reflect values relative to international peers," says Connor.
Here's a short list of Russian-focused mutual funds and ETFs: Results are year-to-date through the end of January. Investors should also consider expenses tied to these funds, which can run higher than domestic-focused funds.
Third Millennium Russia Fund (TMRFX), up 10.1 percent year-to-date.
ING Russia Fund (LETRX), up 16 percent year-to-date.
JPMorgan Russia A (JRUAX), up 16.4 percent year-to-date.
Market Vectors Russia ETF (RSX), up 13.6 percent year-to-date.
Market Vectors Russia Small-Cap (RSXJ), up 8.2 percent year-to-date.
SPDR S&P Russia (RBL), up 12.6 percent year-to-date.
iShares MSCI Russia Capped Index (ERUS), up 14.3 percent year-to-date.