Florian Fenner, CEO of Moscow-based UFG Asset Management, says he is bearish on Russian listed equities because of the fat pipeline of new supply of listings, but says investors can make big bucks in the little-understood area of Russian bonds.

UFG AM is a boutique-sized asset manager with $1.3 billion of assets under management, and runs a variety of long/short strategies in Russian equities, bonds and private equity.
Fenner addressed the audience at AsianInvestor and FinanceAsia's Russia summit earlier this week in Hong Kong.

As for blue-chip stocks, he says investors should not assume their steep discount to global emerging markets (as steep as 40%) reflects value. The discount has existed since the mid-1990s and reflects their dependency upon commodity prices.

Russia offers a more vibrant consumer sector but among blue-chips there are only two retail stocks. Even the oil sector, because of its structure, does not benefit from rises in oil prices.

Of course, investors can make heaps of money in Russian stocks, as they did in 2009, when it was the world's strongest performing stock market. But Russian stocks are 'high beta'; that is, they can do either spectacularly well, or perform very, very badly. There's rarely a middle ground for this market and, at present, Fenner is sceptical the market is going to deliver attractive returns over the next few years.

This is because there is hardly any local participation in the market -- which explains why Russian companies are so eager to list abroad. By law, local pension funds can't participate in the local stock market, so the market is driven by foreigners. That creates a volatile situation, and company fundamentals don't count in the face of liquidity swings.

Such volatility explains why many global investors, who once valued Russian stocks at a healthy premium to those of, say, Brazil, now underweight Russia as a 'Bric' constituent. (Although this perception is slowly changing.)

Despite this, Fenner says he is quite bullish about his portfolio, which is skewed to small-caps, private equity and especially to fixed income. With a few exceptions, Russian companies have zero debt; the government's upcoming Eurobond issue is about courting investors and burnishing the country's image, because the government doesn't need the money.

Unlike the stock market, valuations in Russian bonds are grounded in reality, because the market is 90% local; this is where local pension funds put money to work. Investors can enjoy a return of 8% or more on high-quality corporate bonds from issuers such as Sibneft, the oil company, and the City of Moscow; Gazprom is in the process of issuing a $10 billion-equivalent bond.

Moreover, the quality of overall issuance has improved over the past 18 months, as companies have found themselves closed to new equity financing due to the plunging stock market and a severe contraction in domestic bank lending.

Fenner notes that Russia is a consumer economy -- a fact not appreciated by global investors. True, it lacks the sheer size of China; you won't see headlines about Russia becoming GM's number-one market. But consumption is quickly rebounding from the difficulties of 2008-2009, and prices in Moscow have recovered sharply. This is unpleasant for residents but shows how strong margins can be for market leaders, from cars to cola.

If investors want to participate in Russia's vibrant non-oil and gas sectors, bonds are the way to go. From food processing to finance, the Russian consumer economy provides plenty of growth, but it is not represented in large-cap stocks. Where such companies are listed, they have small free-floats and struggle with corporate governance. But they do issue bonds.

The Russian bond market is not for everyone, however. There is no culture of bond covenants. Fennan says if a creditor has to rely on covenants -- ie, go to court -- it shouldn't expect a happy outcome, as the Russian legal system does not work well.

The bond market comes with plenty of risks-- last year saw 200 defaults. This requires research. "Last year we had only three defaults in our portfolio," Fennan says. Good fund managers minimise credit risk by sticking to the best issuers, and earn returns via duration risk instead. If the rouble does appreciate in tandem with oil prices, then foreign investors in bonds can do quite well.