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May 8, 2006 6:59 pm

John Dizard: Choose Russia over roulette

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It’s time to cut back on commodities in your personal account. Raking in fistfuls of sweat-dampened chips from the dice table and throwing them in front of a lizard-eyed blackjack dealer is not what the Financial Times is here to encourage. We are here to help our readers carefully plan long-term investments, both as fiduciaries and stewards of their own assets. It’s just that the commodities markets aren’t co-operating.

In my April 11 column I suggested that, as gold had reached my $600 target for the year, it was time to liquidate that position and put the proceeds into copper. From then until late last week, the active US futures contract for gold had risen 13.8 per cent, and that for copper by 23.3 per cent. This is over less than a month. From a chin-stroking, impassive observer of macroeconomic data and political economy, I’ve turned into a sleep deprived, red-eyed squinter at every squiggle in the logarithmic price charts.

These commodities derivatives moves are beyond the bounds of reason. You can quote factors such as Nigerian rebellions or Chinese growth but by now the cash coming into commodities markets from dimmer and dimmer institutions, as well as ever greedier members of the public, is front-running itself. So sell those copper contracts and let your commodities account go dormant. If there are profits to be made from commodities long positions in the next couple of months, let others make them. They probably need the money more than you.

I assume most of readers’ portfolios follow some sensible asset allocation programme. That means you are still going to be itching for something to do with the wedge you have set aside for edgier stuff. Russian stocks could be a good use of the riskier pocket. True, you are not getting in on the beginning of a move but you can still apply reasonable measures of value to Russian equities, such as price/earnings ratios, or the price of oil reserves in the ground. And the stocks are three or four times as volatile in annual percentage terms as those in western markets.

This seems to be part of the Russian nature. I noticed this in the recent New York auctions for Russian art at Christie’s and Sotheby’s. Some paintings went for 10 times the highest estimates, while other works, some equally interesting aesthetically, went untouched. You can make money where there’s that kind of discontinuity. The psychology is the same in the Russian stock market, which you could diagnose as a sort of financial bipolar disorder. Right now it is in the start of a manic phase. From the first quarter of 2005 to the first quarter of this year the CSFB ROS index of Russian stocks rose by more than 105 per cent.

Harvey Sawikin is the manager of the Firebird Republics Fund, a closed end fund that invests in Russia and the other former Soviet republics. Firebird has consistently outperformed the Russian indices. He says: “Even if there were a downward adjustment in commodities prices, Russian stocks would be hit briefly and then go back up with multiple expansions. The trade surplus is like a firehouse of liquidity into the country and capital flight has declined.”

My own base case is for oil to correct back down to $40 a barrel over the next 18 months to two years. That would be consistent with the historical experience of corrections in the energy market and would still leave the price above high-cost unconventional sources such as tar sands and deep ocean fields. Still, at that level, Russia would have a trade surplus and a balanced budget.

William Browder, manager of the $4.1bn Hermitage Fund, which also invests in the former Soviet Union and has also done very well, points out that Russian energy companies’ earnings are compressed as oil prices go up and cushioned on the way down by Russian tax policy. “Oil production for refining and internal use is not taxed as heavily as exports. Exports, which are 40 per cent of the total production, are taxed at 85 per cent of the price difference above $27 a barrel.” The driving force of the Russian market, Mr Browder says, is domestic liquidity. “Now the Central Bank of Russia is printing roubles, which will create a domestic asset price inflation.”

To protect domestic manufacturers, the CBR recently announced a policy of keeping the rouble from appreciating against foreign currencies. That means more expansion of the money supply, which would support any new position in Russian equities. So what to buy? Mr Sawikin says: “As a tourist in the market, you want to keep it simple. Stick to the winners, which have liquidity and global depository receipts.” He likes Lukoil, Gazprom, Surgut (another oil company) and UES (an electric holding company). The oil companies are cheap compared with international competitors, with p/e ratios in the single or low double digits. The component companies of UES could do better after a planned spin-off.

He also likes Norilsk Nickel, in spite of lingering issues with corporate governance. “With nickel, copper and palladium at these levels, it trades at less than 10 times 2006 earnings. [CEO Vladimir] Potanin has shown himself to be a smart manager.”

For his part, Mr Browder likes the oil companies, doesn’t like Mr Potanin’s governance and thinks of UES as something you trade rather than own. While Russian stocks recently seem to be correlated with global flows into emerging markets funds, over time they are more likely to be lifted by internal Russian demand. So you’ll have someone to sell to, which you might not have much longer with some commodities.

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