Russia: A Dirt-Cheap Profit Opportunity

This article published with permission from InvestmentU.com.

Russia is one big country.

With 6.6 million square miles inside its borders, it is the world’s largest sovereign landmass. Giant companies such as Lukoil dominate the Russian economic landscape. The big bosses in Moscow control these behemoths.

Right now, the Kremlin is struggling with political uncertainty, rampant corruption, weak productivity and falling energy prices, all of which have hammered Russian economic growth. The country’s GDP numbers for February showed growth of just 0.1%.

So why in the world would anyone in their right mind invest in Russia right now?

An American entrepreneur and investor who has made a bundle in basket-case countries like Russia and Argentina put it to me this way: “To make money, it doesn’t have to get great, it just needs to get a little bit better.”

This is why dirt-cheap Russia presents us with a great value opportunity.

But Russia is also a good example of the challenges facing investors trying to tap into emerging market opportunities.

Limited choices

There are a few mutual funds, of course. And there are four Russian companies that trade as ADRs such as Mechel Steel (NYSE: MTL), Mobile TeleSystems (NYSE: MBT), Rostelecom (BE: RTL) and VimpelCom (NYSE: VIP).

There are an additional 37 major Russian companies listed over-the-counter. These “pink sheet” listings are a growing trend for even the largest companies (like Lukoil) that are eager to avoid the high cost and regulatory burdens of the big board. Picking through this list to find the “pink sheet blue chips” takes patience, skill and judgment.

Be careful.

Finally, there are exchange-traded funds (ETFs) that are composed of a basket of Russian stocks. The funds trade just like stocks.

The highest profile is the Van Eck’s Market Vectors Russia ETF (NYSE: RSX). Energy and basic material companies account for 68% of its assets. The fund has $4 billion in assets, and 95% of the companies in the basket have a market value greater than $5 billion.

But while the fund is a decent proxy for Russia’s overall economy, it is very top heavy.

Small size has its advantages

I suggest you look at many smaller Russian companies that offer the following advantages over the better-known giants:

Private ownership and control

Government ownership and support comes at a high price. Smaller private companies fly under the radar. They also tend to be more nimble and have the opportunity to grow faster. State-owned and controlled companies can hit speed bumps as government regulations and policies change.

Broader and deeper play on turnaround

Even marginal market reforms in Russia have created and will continue to create winners outside of energy and commodities. The tax revenue from higher commodity prices filter back into the domestic economy sort of like a perpetual stimulus program. Smaller companies in a wide array of industries are poised to capture this demand and turn it into profits for shareholders.

Less research coverage equals “discovery” potential

Like small caps all over the world, Russian small caps are largely unknown and are covered by analysts sporadically. As a test, look at the list of the 10 largest Russian small caps below. If you recognize more than a few, you probably hail from Russia.

While it is difficult to invest in these Russian bear cubs, Van Eck’s Russia Small Cap ETF (NYSE: RSXJ) will get the job done.

The ETF offers good diversification with a 35% weighting in energy and materials, leaving more room for allocations to utilities (18%), industrials (15%), health care (8%) and other consumer (18%) sectors.

Try a double-barreled shotgun approach with the two ETFs listed above and take advantage of a market trading at only seven times earnings — a significant discount to the emerging markets index and about half that of the S&P 500.

Carl Delfeld is a senior analyst at InvestmentU.com. See more articles by Carl here.