Russian stocks exiting the darkness – profits should climb as economy recovers

File Photo of Cash, Coins, Line Graph

(Business New Europe – bne.ru – UralSib – June 11, 2014) Our year-end RTS target of 1,520 implies 14% upside. Our yearend RTS target now stands at 1,520, implying 14% upside from the current level. Based on our calculations, the dividend yield for the index is currently 4.3%, which would put the total return at roughly 18%, so we have a positive view on the market over the n…

Our year-end RTS target of 1,520 implies 14% upside. Our yearend RTS target now stands at 1,520, implying 14% upside from the current level. Based on our calculations, the dividend yield for the index is currently 4.3%, which would put the total return at roughly 18%, so we have a positive view on the market over the next 6-12 months. The recent downgrades of domestically-oriented stocks and sectors in light of the weaker ruble, poorer economic conditions and higher country risks are compensated to a considerable extent by the advantageous position of exporters, which comprise a large percentage of the Russian public stock market.

Positive case building for 3Q14. We believe that June will be a particularly volatile month for emerging market equities, especially Russian stocks, as macro momentum remains negative, with corporate margins still under pressure. With no end game in sight in eastern Ukraine, geopolitical uncertainty still looms over the market, although we note that Russia appears to have distanced itself from the turmoil in May. By mid-July most stocks will go ex-dividend, which will naturally translate into a market correction. However, in late-July and early-August, institutional investors will reinvest their dividends, which could potentially lead to significant gains in 3Q14. Our top-down assessment also suggests that we will see gains in 2H14, as we expect the economy to recover towards the end of the year, with the recovery carrying over into 2015. Globally, the main downside risks are naturally the pace of global economic growth and its influence on commodity prices, while the key domestic risks are the economic slowdown in Russia, the state’s involvement in the economy and further sanctions.

We see the earnings recession ending next year. The Russian equity market has been in an earnings recession since mid-2012, and we do not expect to see a reversal in this trend until next year. We estimate that the RTS index is currently traded at a 2014E P/E multiple of 6.2, which contracts to 5.6 on next year’s earnings. As we have previously stated, the low P/E of the RTS index is due mainly to the heavy weighting of oil and gas names, which have stagnant growth profiles and often generate minimal free cash flow. We therefore pay little attention to the ratio.

RTS rebound to above 1,350 corresponds to a mild recession. We believe that the RTS dropping below 1,100 to the lowest level since August 2009, and then rebounding to above 1,300 is a reflection of investor uncertainty regarding the economic prospects and profit dynamics of corporate Russia over the next few quarters. As we wrote in our report Fork in the Road: Slow Growth or Recession, published in September 2011, the track record of equity markets in recessions, adjusted for the highly cyclical nature of the Russian equity market, suggests a 1,350-1,500 range in a mild recession and 1,350-750 in a prolonged (12 months or longer) recession. The 1,063 level that the RTS index hit on 14 March corresponds almost exactly to the mid-point in the case of a prolonged recession. In other words, investors seem to have been pricing in a prolonged recession in March. However, we do not have the recession extending into 1H15 in our base case, nor does the consensus. Hence, the recent rebound seems to indicate that the market believes the current recession is a rather shallow one and expects the economy to begin recovering in 4Q14. Since we concur strongly with this viewpoint, we expect the RTS index to rise to above 1,350 unless the economy fails to recover.

 

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