RUSSIA ACTIVE VIEWPOINT TALES FROM THE ROAD: GLOBAL EMERGING MARKETS

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1 ACTIVE VIEWPOINT GLOBAL EMERGING MARKETS MAY 2017 FOR PROFESSIONAL CLIENTS ONLY TALES FROM THE ROAD: RUSSIA Andrew Ness Portfolio Manager Global Emerging Markets Russian newsflow is dominated by geopolitics, painting a picture of heightened risk for investors. However, the economic reality often differs greatly from received wisdom a fact reinforced on my recent research trip to Moscow. I found evidence of well-run companies that have weathered recent economic turbulence and, crucially for long-term investors, that display a growing willingness to engage on their sustainability. I also gained clearer insight into the structural reforms necessary to spur the country on to greater levels of growth. There are two distinguishing features of Russian companies (and the country s economy as a whole): resilience in the face of adversity, and the flexibility to come out of a crisis in a stronger position.

2 RUSSIA CLIMBS OUT OF RECESSION For me, there are two distinguishing features of Russian companies (and the country s economy as a whole): resilience in the face of adversity, and the flexibility to come out of a crisis in a stronger position. Russia is emerging from two years of economic turmoil. During that period, an oil price collapse and punitive international sanctions led to a weaker ruble and a dramatic drop in Russia s international reserves (falling from more than US$530 billion to US$356 billion between 2013 and 2015). * However, the economy didn't go into meltdown, as it might have done in other systems, and the situation is now stabilising (reserves have recovered to nearly US$400 billion). Russia s central bank and finance ministry have emerged from this period with strengthened reputations for steering the economy through the storm. Companies, meanwhile, have played their part by demonstrating a determination to succeed. This was evident to me when I visited in April, from speaking to a number of firms across different sectors which have survived and thrived despite a challenging backdrop. Fall and recovery: Russia's international reserves during sanctions and oil price weakness 600, ,000 6 March (US), 17 March (EU) Asset freezes/travel bans 16 July (US), 29 July (EU) Sectoral 12 September (US & EU) Sanctions Oil price US$ millions 400, , June US$ January US$ January US$ , ,000 Apr 2013 Jun 2013 Aug 2013 Oct 2013 Dec 2013 Feb 2014 Apr 2014 Jun 2014 Aug 2014 Oct 2014 Dec 2014 Feb 2015 Apr 2015 Jun 2015 Aug 2015 Oct 2015 Dec 2015 Feb 2016 Apr 2016 Jun 2016 Aug 2016 Oct 2016 Dec 2016 Feb 2017 Source: Central Bank of Russia. *Source: Central Bank of Russia. A full list of companies visited is available on request. Russia s central bank and finance ministry have emerged from this period with strengthened reputations for steering the economy through the storm. Companies, meanwhile, have played their part by demonstrating a determination to succeed. 02

3 SANCTIONS FORCING POSITIVE CHANGE From an investment point of view, the perception that investors are shunning Russia can certainly be challenged capital inflows have actually increased over the last year. While political risk undoubtedly remains high, a key factor for the businesses I spoke to was that the sanctions put in place in response to Russia s manoeuvres in Crimea have, in fact, helped force positive change for the economy: Significant deleveraging at both a government and corporate level has seen Russia s total debt fall by about 30%, from when sanctions were imposed in 2014 to the end of December 2016 (around US$733 billion to US$513 billion). * With sanctions curtailing trade with the European Union (EU), Russia is developing new trade partners. For example, we are seeing deepening financial ties with China, alongside greater gas exports to the region and major infrastructure programmes there. Most importantly, Russia s relative isolation has enabled greater self reliance. In agriculture, for example, the Kremlin s response to EU sanctions has been a self-imposed trade embargo on fresh produce from the region. This has led to higher farming production targets and a reduction in dependence on foreign staples. In fact, agriculture has grown to such a degree, it is now reportedly Russia s second-largest export market generating more income than defence. Russia's growing agricultural strength: World wheat flour and products exports USA EU Australia Canada Russia Argentina Ukraine Kazakhstan Other (inc. Turkey, Mexico & Serbia) 2012/3 27, /8 27, /3 22, /8 31, /3 21, /8 22, /3 18, /8 22, /3 11, /8 29, /3 7, /8 14, /3 7, /8 11, /3 6, /8 7, /3 24, /8 17, ,000 10,000 15,000 20,000 25,000 30,000 35,000 (million tonnes) *Source: Central Bank of Russia. Source: US Department of Agriculture. Foreign Agriculture Service, May ACTIVE VIEWPOINT: GLOBAL EMERGING MARKETS 03

4 SELF RELIANCE AND SELF BELIEF Russia s growing self sufficiency in food production and basic goods is not simply spin, it is evident at a very basic level the shelves in supermarkets remain fully stocked. There may be an absence of French cheese, for example, but stores have adapted their wares accordingly. Food retailer Dixy, is sourcing most of its products, except exotic foods, domestically. The message from retailers we saw was, however, that the consumer environment is still extremely challenging. It remains price sensitive and shoppers are in savings mode. The central battleground is between convenience-store operators, but there are interesting dynamics elsewhere too. For example, I found hypermarket operator Lenta is focusing its attention on the supermarket format, which it believes is an under-served segment. It aims to increase its selling space in this area by eight times over the next three years. It is resolving the problem of finding the larger real estate necessary for new developments by renovating sites, including old Soviet cinema halls, and sharing space with other partners. Lenta is also making effective use of the data it has gathered from its customer base of 10.5 million active loyalty-card holders, including personalised offers to loyal customers where visits are declining. * Sberbank, the state-owned bank, was also adamant that, after three years of sanctions, Russia is now in a far stronger position. It has stress-tested its business model for another dramatic fall in the oil price and is confident of its survival under a scenario of US$25 per barrel. Technology has been an important part of its drive towards self sufficiency and the company is developing its new IT platform in-house, with the ultimate aim of shifting all transactions from teller windows to the online channel, making use of phone banking and peer-to-peer payments. It has 27 million active users, and continues to see strong growth. * The result of this shift to home-grown software has meant large multinationals losing a foothold in the country. Oracle, which provided IT systems for a number of banks, is being displaced. The same is true for hardware. Visa and MasterCard, which had blocked transactions from some Russian banks, now face a strong challenge from Mir, the domestic payment platform. Over 5 million Mir cards have been issued and are accepted at 2 million operational terminals. Contactless payment is due to become operational this year, and more than half of Russia s credit institutions have joined the Mir payment system. Also in Sberbank s favour, although loan growth might have been expected to suffer due to large sectors (such as oil, metals and chemicals) focusing on debt repayment, I found smaller and medium-sized companies are borrowing more as they look to expand. COMPANIES MORE ENGAGED THAN EVER One of the most significant insights I gained on the research trip was the level of awareness on sustainability issues. All too often, the assumption is that emerging markets equates to political difficulties and sub-optimal governance with Russia the poster child for this image. However, companies I spoke to were open to change and the most engaged I have ever seen in Russia, a definite shift in attitude from previous visits. In part, this is due to the increased investor interest in environmental, social and governance (ESG) issues, and an attendant rise in due-diligence questionnaires. I found Russian firms are keen to reach a minimum hygiene level for governance and therefore have a genuine interest in what investors want to know. However, businesses also wanted guidance on how to navigate the channels of ESG questioning. Our reputation on governance issues has helped in this regard, having been awarded an A+ rating by the PRI (Principles for Responsible Investment) for our overall approach to responsible investment and the appointment of David Sheasby, our Head of Governance and Sustainability, to the PRI Engagements Advisory Committee. Russia s growing self sufficiency in food production and basic goods is not simply spin, it is evident at a very basic level; the shelves in supermarkets remain fully stocked. * Source: Company meetings and Lenta financial results December A copy of the PRI Assessment for Martin Currie is available upon request. The PRI Transparency Report and Assessment Methodology are available to download from org. The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the securities discussed here were, or will prove to be, profitable. 04

5 MAKING THE CASE FOR INVESTORS LUKOIL: A CASE STUDY Relative to their global peers, Russian oil producers have been sheltered from oil price weakness, as variable taxation and a weakening ruble have meant the average price per barrel in ruble terms has fallen less than the headline dollar figure. Oil price weakness has been less severe in local currency terms Crude oil Urals ruble per barrel Crude oil Urals US$ per barrel 100 Oil price Jul 2014 Oct 2014 Jan 2015 Apr 2015 Jul 2015 Oct 2015 Jan 2016 Apr 2016 Jul 2016 Oct 2016 Jan 2017 Apr 2017 Source: FactSet as at 11 May, Chart shows US$ price compared with ruble-adjusted oil price index. Lukoil, one of the largest global oil producers, is one of two Russian holdings in the Martin Currie global emerging markets strategy (the other being retail chain Magnit). The company has featured in our portfolios for more than a decade and is a company I know well, having first met management during its initial public offering roadshow in the mid 1990s. There are a number of positive attributes supporting the investment case for Lukoil at this stage. It has substantial proven reserves of both oil and gas that give it a strong platform to generate sustainable cash flows for many years to come. The company s production profile is moving towards newly developed oil fields and this will allow it to finally reap the benefit of tax exemptions, introduced years earlier to encourage greenfield resource development. This will bring a welcome boost to Lukoil s profitability at a time when the world s oil producing nations are signing up to production cuts. While this gives Lukoil something to cheer about against an otherwise lacklustre global oil industry backdrop, it is now crucial for the company to retain the tax benefits it has taken and not suffer from future changes in oil sector taxation. We are never fully comfortable relying on a benign tax regime in the resources sector, but the Russian government has recognised that the majority of the country s easily accessible oil reserves have already been developed, so oil companies need to be incentivised to develop more challenging areas. ESG disclosure is likely to be another positive driver for Lukoil, as it attempts to attract more foreign investment. Russia has toughened its environmental requirements (including platforms having to operate under zero-discharge principles, and ensuring water-cleansing policies are in place) and the company is showing a notable increase in sustainability activity. We have been encouraged by the way Lukoil has recognised the importance of managing its governance and sustainability and, as such, we plan to share our experience in this area by advising the company on disclosure practices and other sustainability considerations. We are already seeing the benefit of Lukoil s better disclosure in its communication of, and commitment to, dividends. The company has one of the highest free cash flow yields among oil companies globally and management has committed to paying a high and rising level of dividends. Past performance is not a guide to future returns. The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the securities discussed here were, or will prove to be, profitable. ACTIVE VIEWPOINT: GLOBAL EMERGING MARKETS 05

6 THE NEED FOR STRUCTURAL REFORMS A clear message coming from companies I met was the urgent need for structural reform. More privatisation (and therefore less state involvement in the running of the economy) is necessary to support long-term growth. To do this, there needs to be a predictable environment for business and economic policy which aids the investment process, such as taxation and support for exports. The central bank is under pressure to slash interest rates, as real rates are among the highest in the world. The Ministry of Finance, meanwhile, is facing demands to provide relief for pensions and consumers, who have borne the brunt of fiscal adjustments. The question of course, is how likely these reforms are to be enacted the shape and pace of the reform programme likely to be dictated by the presidential election being held in March next year. INVESTING IN RUSSIA CHALLENGING PERCEPTIONS While geopolitical machinations may appear, at a surface level, inextricably linked to company fortunes, it s important they should not be allowed to overwhelm the assessment of Russian companies. As such, it is imperative to keep a clear focus on a firm's economic fundamentals. The kind of on-the-ground dialogue I ve had with Russian businesses on my recent trip has only strengthened this view. We have retained long-term interest in Russia. Structural reform will improve the investment landscape, but companies are already challenging the perception that Russia is uninvestable and the trip reinforced my conviction in the resilience of the country s economy and its businesses. For me, the most welcome aspect of the visit was the palpable change in the approach from many companies on governance and the willingness to engage with investors on sustainability. We have retained long-term interest in Russia. Structural reform will improve the investment landscape, but companies are already challenging the perception that Russia is uninvestable and the trip reinforced our conviction in the resilience of the country s economy and its businesses.

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