by Chris Hackett
Investing in companies is difficult under any circumstance, but it can be especially treacherous in emerging markets. More difficult yet is the valuation of equity in newly ìmarketizedî economies like Russia. It is little wonder that the winners in the Russian economic revolution are not the captains of Wall Street and western corporations, but a newly formed Russian merchant class. So how can we benefit from the opportunities in Russia?

It is generally accepted wisdom among many fund managers and interested western companies that Russian equities are undervalued. Often cited examples include comparisons of the valuation of Gazpromís and LUKoilís reserves to those of Exxonís or the cost of Rostelekomís customer base to AT&Tís. Other money managers cite the replacement costs of Russian assets as an indication of their value. These types of comparisons assume that these are comparable assets which will generate comparable cash flows for their owners. This is not a valid assumption.

The flaw in the assumption is not that adjustments need to be made for Russian market conditions. (e.g. ìRussians spend less on telecommunications, therefore we need to make an adjustment to our valuation.î Or îRussian oil fields are in worse shape than western oil fields, so we will figure this into the valuation.î Nor is the flaw the often heard ìWe must allow for Russiaís poor custodial arrangements and securities regulations.î). Rather, the flaw is the belief that Russia has a market economy.

There are several elements which underlie market economies; among them are:

• A legal framework which acknowledges and protects property rights.
• A cultural respect for private property.

Neither of these exist in Russia today. The implications of this situation are far reaching. Corporate governance rests on property rights. The lack of property rights (both legal and cultural) manifest themselves in the difficulty of governing Russian organizations. With neither a commercial code nor legal tradition which respects commerce, there is no legal recourse to enforce contracts. Bottom line: there is little correlation between owning shares in a Russian firm and having a share of the firmís profits. There is also little correlation between share ownership and having a say in how the organization is managed.

A well known example of the governance problem is the case of British based Transworld Group. Transworld has extensive experience in the Russian market, yet in the fall of 1994, their 20 % equity stake in the Krasnoyarsk Aluminum Smelter was erased by a disgruntled faction of smelter managers. Aluminum Company of America recently canceled plans to invest at this same smelter, apparently concluding that they could not control their investment. (The Krasnoyarsk smelter is the second largest facility of its type in the world). What western companies and investors are finding is that, in practice, influence in Russian firms is typically split between management factions and a collection of local, regional and federal authorities. In this system, the shareholdersí role is limited to supplying capital.

Who is succeeding in Russia?

Given this situation, under what conditions may one safely invest in Russian companies? After all, substantial fortunes have been made in Russia in the last few years.

Investors who are succeeding in the Russian market typically solve the corporate governance / lack-of-commercial-law problems in two ways:

• Controlling inputs and outputs of the companies they invest in.
• Practicing the art of the small deal.

These investors control the raw material inputs to the companies they invest in as well as control the products (outputs) these companies make. Inputs are controlled by having access to Russian raw material producers, world markets, import licenses and transportation to and from the plants. Outputs are controlled by access to channels of distribution, transportation and export licenses. In addition, successful Russian investors usually control the bank accounts (domestic and off-shore) and capital budgets of the firms in which they invest. This means that the successful investor in Russian equities is not only active in one companyís management, but has built a vertically integrated chain of companies. This situation leaves little room for institutional money managers used to investing in western securities and western companies without a vertically integrated Russian network.

For example, successful investors in Russian oil companies control the companies who make the equipment and technology the oil producers use for pumping the oil out of the ground. They also typically control the refining, distribution, shipping, and export licensing of the oil and derivative products. Additionally, they must satisfy (i.e. financially reward) the governmental gate keepers who oversee each of these steps. This is a level of vertical integration that few western companies have achieved in their own markets. What is developing from this are large Russian trading / investing companies that resemble the zaibatsu of Japan which emerged during the 19th century. (Russians call them the ìNew Russiansî). Like the Japanese zaibatsu, these trading / investing companies typically enjoy close relationships with government officials. And because of their elaborate networks and extensive vertical integration, these Russian companies are able to enforce contracts and protect their rights as investors. (e.g. If a portfolio company does not deliver the products according to contract, the Russian trading company/ portfolio manager shuts-off the raw material supply).

Whatís the big deal?

Traditional wisdom is that large projects are easier to implement and more profitable than small projects. The thinking is that every deal includes overhead; larger deals can absorb overhead easier than small deals. Additionally, it is thought that if the necessary power constituents buy-off on a big deal, the project will be implementable. This approach hasnít worked in Russia. Russiaís political and legal systems are in a state of flux, with few if any constituents with the power and will to implement large projects. Additionally, big deals draw attention, which in turn, encourages groups at all levels of Russian government and society to posture for a piece of the deal. This posturing continues until nothing is left for the investors; perhaps the best documented example of this was the ill fated White Nights oil development project.

In order to avoid this, successful Russian investors have perfected the art of the small deal. By stringing together numerous small projects, each generating positive cash flow but not unwanted attention, these investors have accumulated significant wealth.

From the perspective of these ìNew Russianî investors, an investor can apply traditional discounted cash flow methods to value investments. Finally, to hedge the risk of losing control of a critical link in the chain, successful Russian investors apply a high discount rates and abbreviated pro-forma income statements to value their investments.

The Russian market is not a market for even experienced foreign investors looking to make a quick rouble, but rather the domain of local trading / investment cliques who have built the vertical chains necessary to control their investments. For foreigners looking to capitalize on the growth of the Russian market, the best strategy is to form an alliance with one of the emerging ìNew Russianî companies specializing in the target industry and focusing on low profile deals.

© Christopher J. Hackett, 1996