MR. VADIM OGNESHCHIKOV, SENIOR EXPERT, RUSSIAN STRATEGIES
MR. VADIM PALAMARCHUK, EXPERT, RUSSIAN STRATEGIES
MR. ALEKSEI POTAPOV, INVESTMENT ANALYST
MR. MICHAEL O’FLYNN, CONSULTANT TO UFG ASSET MANAGEMENT
Michael O’Flynn: It is an honor to once again host UFG’s end-of-year conference call. After I briefly review performance, Aleksei Potapov, UFG hedge funds’ investment analyst, will give a bit of global and macro overview including UFG’s take on oil in the oil-sensitive Russian economy. Then Vadim Ogneshchikov, UFG’s lead stock picker, will tell you about his best ideas for 2017. Note his top ideas for last year at the same time were Sberbank and Tinkoff Credit Systems (TCS), those have doubled and tripled respectively over the last 12 months. UFG’s Vadim Palamarchuk will close out the team’s comments by going in-depth on the Russian metals and mining space afterward.
I will now briefly review performance for the funds before I pass on the call to UFG experts. As of end of November, UFG Russia Select Fund, our $100 million flagship strategy was up +43% for the year outperforming the benchmark MSCI Russia Index by over 1,000 basis points. The Russian market is up another +10% MTD in December so net returns from the strategy could easily end up topping 50% for the year. This outperformance of course comes after several years of UFG repeatedly besting the index bidding in an up year like 2016, sizably cutting off the tailwind in downdraft years like 2011 and 2014.
Since UFG strategies in risk management protocols were overhauled following the global financial crisis of 2008-2009, starting in January 2010 through the end of November this year, UFG Russia Select is up over +30% while the benchmark MSCI Russia Index is down over −32% over these past six years. Stock picking matters in Russia. Risk management matters in Russia.
In addition, UFG also runs a $210 million hybrid debt and equity, public and private Russian region Special Situations Fund which would post a strong return this year a little bit lower than Select due to its liquid part of the portfolio currently being predominantly invested in fixed income, mostly short duration just over two years on average, and averaging almost 20% in terms of yield to maturity. UFG Special Situations Fund is up +22% so far this year.
«UFG Russia Select, our flagship strategy, is consistently outperforming the benchmark MSCI Russia Index... up over +30% while the benchmark is down −32% over the past six years.»
— Michael O’Flynn, Consultant to UFG Asset Management
All right and for the UFG team, here’s Aleksei to give the big picture backdrop. Aleksei?
Alexei Potapov: Yes, greetings everyone. Global economic situation helped to improve the state of Russian economy in the year 2016. And we think that today, we see that two-year recession is bottoming out and with a possible start of slow growth in the fourth quarter of 2016 as oil prices have rebounded since the beginning of the year and the Rouble has stabilized. The strong Rouble, along with restrictive monetary policy has contributed to bringing inflation down close to its pre-crisis level which is less than 6% and also with the goal of Bank of Russia to reach 4% inflation target for the yearend of 2017.
«We think that Russia should stay aside [in 2017] with much stronger perspectives among other emerging markets economies...[and] fare better than, for example, countries like Brazil.»
— Aleksei Potapov, UFG Hedge Funds Investment Analyst
Business activity has resumed as evidenced by positive industrial production growth after 13 months of consecutive contraction. Improved economic prospects along with some hope for improvement of geopolitical tensions with the Western countries like, for example, expected decline in sanctions pressure has led to whole year rally on Russian stock market leading to nearly 50% gain in main Russian stock index in US Dollar terms year-to-date. The continued tightening of monetary policy in the US had and will from our point of view, will have relatively little effect on Russian economy as energy commodities are going to continue as there are further price increases.
And speaking about energy commodities, we believe that in the year 2017, we will see at least temporary all markets in deficit. We think that Brent oil prices in 2017 can occasionally peak towards $65–67 per barrel due to supply constraints while oil demand in the United States and other developed markets will stay firm.
Given the rather negative outlook, however, for emerging markets as a whole due to a rise in the US Dollar rate and low probability of increase in prices of other main commodities like, for example, metals because in times of rising USD rates, they usually stay flat. Later on the call my colleague Vadim Palamarchuk will speak about metals and mining space in more detail.
So we think that Russia should stay aside with much stronger perspectives among other emerging markets economies. From this point of view, countries like Russia should fare better than, for example, countries like Brazil, which also experienced a stock market rally in the year 2016 with 66% rise of the main stock index in the US Dollar terms year-to-date. And summarizing the above, Russian economy should experience a modern growth in the year 2017 despite any negative consequences of tightening United States monetary policy and negative outlook for emerging markets as a whole. The Rouble should stay flat or stronger while inflation will continue to fall leading to easing of the Bank of Russia monetary policy, which will support production gains further.
Low inflation and stronger wage increases as well as stronger business activity will support consumption growth and business confidence. However, despite the fact that we continue to think positively about the Russian equity market, in terms of the state of the Russian economy in the upcoming year, we also see some downside risks for that outlook and they are mainly connected with weaker than expected oil prices and the potentially stronger slowdown in China economic activity as well as any new geopolitical tensions with Western countries. Thank you and with this I hand over the call back to Mike.
Michael O’Flynn: Aleksei, thank you very much for your comments. I’m going to hand the call over to Vadim Ogneshchikov, our senior Russian strategies expert and stock picker. I am sorry to have stolen some of your thunder, Vadim, talking earlier about Sberbank and TCS. But they were tremendous calls a year ago. I’m interested to hear what you will have to say for 2017.
Vadim Ogneshchikov: Thank you, Mike. Good morning and good afternoon everyone. 2016 is going to go down as the best year for Russian equity markets returns of this decade. Yes, we still see opportunities to make money in a number of specific Russian companies. Therefore, we expect further gains for our investors in 2017 as well.
«2016 is going to go down as the best year for Russian equity markets returns of this decade... [and] we expect further gains for our investors in 2017 as well.»
— Vadim Ogneshchikov, Senior Expert, Russian Strategies
But first, let me go back to the start of this year. By the beginning of 2016, Russian economy had adjusted to external shocks of the previous two years, which were much lower oil prices and financial sanctions. Bottoming out of the oil price with past winter and subsequent recovery in the spring with a strong catalyst to start buying Russian assets again, and as we may recall, we promptly increased the equity long net exposure to Select to 75% in March from 55% at the start of the year. And our focus was mainly to buy more shares of Russian companies driven by domestic demand.
Indeed, our investments in companies benefiting from a strong Rouble brought us the highest returns. And Russia Select Fund’s investments into financial sector companies such as Sberbank, Russia’s largest bank have doubled. In the case of a smaller financial company, Tinkoff Credit System, our returns have tripled. During the same call a year ago, we highlighted the value we found in Sberbank stock at that time. And in particular, we expected Sberbank net profit to double in the coming year. Our expectations came true and we’re delighted to see that Sberbank has turned out to be the largest contributor to Select performance this year.
Food retailer X5 was another company we were talking about in the call a year ago. And indeed X5 was the second largest contributor to Select performance this year. Residential construction companies Etalon and LSR also contributed significantly to Select performance in 2016.
Going forward, we expect oil prices will have a lesser effect on the Russian economy as the country has already adapted to its relatively low levels. Although we are a bit cautious on the fulfillment of the recent OPEC deal and hence we are a bit cautious on oil prices short term. We believe longer term natural forces of adjustment in supply and demand will lead the oil market to equilibrium and more sustainable levels of oil prices.
On the macro side, we think that the rapid deflation in Russia in 2016 has been one of the strongest achievements. Year-to-date inflation recently registered at 5.2% while only a year ago, that number was 12.5%. Nonetheless, the Central Bank of Russia remains very reluctant to cut rates targeting 4% annual inflation. Currently with Central Bank of Russia key refinancing rate set at 10%. Central Bank monetary policy remains very tight. Certainly, high real rates in Russia are attracting a lot of foreign interest into Rouble fixed income especially, which helped the Rouble to appreciate against the US Dollar by 17% year-to-date. On the other hand, high rates are also preventing the Russian economy from a more dynamic recovery. And disappointingly, GDP growth is still in the negative territory in 2016.
However, as inflation is rapidly approaching the Central Bank target level, we expect more rate cuts from financial authorities in 2017. On the other hand, lower interest rates would then attract higher demand for loans. For example, Sberbank expects its loan book to post 5–7% growth in 2017, which compares well with approximately 3% decline in corporate loans so far this year. We expect that a combination of low rates and a recovery in lending will bring Russia’s economy back to growth trajectory.
In our investment strategy, we rely on two pillars. First is risk management driven by our hedging strategy. And we continue to stick to stock-specific investment which consistently helped Russia Select outperform the benchmark MSCI Index in 2016. Actually, index stocks represent only 25% of Select’s equity portfolio now. And we continue to see interesting opportunities in a number of non-index companies which mainly focus on domestic demand.
Despite their strong performance we see here some of such companies still trade at 50–70% discount of their price levels at the beginning of 2014. As a major macroeconomic theme, we expect lower rates will encourage high demand for loans and mortgages in particular. That’s why we like Sberbank, our top second position in Select now. And we also like homebuilders Etalon and LSR. Food retailer X5 remains the top holding in Select at the moment. We also have sizable investments in Russian transportation companies such as Globaltrans and Global Ports.
Finally, we keep substantial exposure to Russian steel and mining sector and I would like Vadim Palamarchuk to elaborate on this investment theme. Thank you.
Vadim Palamarchuk: Good afternoon everybody. Indeed 2016 brought several black swans in metals and mining space which once again underlined the dominant position of China on the global commodity markets. First time in March when China stimulus program caused rally in iron ore, coking coal and steel prices, and for the second time in summer when Chinese new ecological policy aimed at cutting coal production in the country forced coking coal prices to more than triple during the second half of this year. This price growth was reviving for all global players in the coking coal segment, which struggled from the recent low prices. For example, premium hard coking coal benchmark rocketed above $300 per tonne starting from $80 per tonne in the middle of this year.
This situation which seemed to be unsustainable almost for all analytical agencies and banks turned out to be pretty sustainable during five consecutive months of constantly growing coking coal prices. So speculating on the relative sustainability of this trend, we build positions during this summer in several Russian companies from metals and mining space with a significant part of sales coming from coking coal segment right at the beginning of this trend. During the second half of this year, prices of stocks from our basket doubled and tripled while our total weight of the basket amounted to 7% of the fund and finally brought profit in the size of 5% of the fund.
With the first signs of price decline in late November, we took profits in our coal-exposed stocks, but built long positions in the Russian steel companies as growth in iron ore and coking coal prices (two main components of steel) forced producers to transfer cost inflation to the customers and steel prices started growing. That’s what we believe to be the second stage of the coking coal rally and we expect it to go into 2017. At the same time, we expect coking coal prices to continue the decline which already started in December and we expect to continue into the start of 2017.
At the moment so we built exposure in two Russian steel companies in total size of 9% of the fund. And these positions already brought us some gains but we expect strong prices to go into 2017 and our stock picks to benefit from it. At the same time, even in case steel prices decrease by 15% from current levels, we expect our holdings will continue to deliver a healthy free cash flow yield of around 9% on average. With this I conclude my comments on this sector. Mike?
«We expect our holdings [in Russian steel companies] will continue to deliver a healthy free cash flow yield of around 9% on average. These positions already brought us some gains but we expect strong prices to go into 2017».
— Vadim Palamarchuk, Expert, Russian Strategies
Michael O’Flynn: Well, thank you very much gentlemen. We now open the call for questions and answers.
Question 1: What impact do you expect to see on the Russian market due to the election of Trump?
Vadim Ogneshchikov: Well actually, we’re already seeing the positive impact of Trump election for the Russian market as benchmark index is already up 10% month-to-date in December. So I basically believe that the change of political leadership in America creates positive opportunities to improve relationships between Russia and the United States just because at the moment they are indeed at a very low point and there is a lot of room for improvement. Needless to say, any improvement in relationships between Russia and West will be a very powerful catalyst for further strong performance of Russian equities. So we will monitor the dynamics closely and expect that further gains in the Russian equity market will continue. Thank you.
Question 2: More recently in the US, Federal Reserve Bank signaled that it wants to increase its lending rate three times over the course of 2017. How do you see the impact on these further US interest rate hikes to affect the Russian market?
Vadim Palamarchuk: Let me briefly answer this question. Well, as I said before, tighter US monetary policy is not the main risk today for the Russian economy and the Russian stock market, which is already priced in. The main downside risk for our outlook is actually weaker than expected oil prices and potentially stronger slowdown in China, as well as new geopolitical tensions.
And speaking about US monetary policy getting tighter, you should also take into account that the Bank of Russia’s monetary policy remains tight too. And this leads to a rather good carry trade in Rouble assets so we expect that further tightening of the US monetary policy will not lead to any significant outflow of investors that are interested in a good carry trade. And actually, you can even see it right now in December already. The US Dollar is appreciating to nearly all currencies including the Euro, Japanese Yen, the Australian Dollar and so on. But at the same time, the Rouble rate is steady, which means that the Rouble is appreciating with the US Dollar simultaneously. Thank you.
Michael O’Flynn: Thank you very much. I have my own follow-up question to that. You guys said that you saw oil would keep going up in the next year. What are your favorite oil stocks? We didn’t really talk about the oil sector. Do you guys like Rosneft? What’s the big theme in terms of the portfolio? I know you are looking at consumer-related stocks and Rouble-related stocks, but are there any oil companies that you might want to own?
Vadim Palamarchuk: Thank you, Mike. We are staying positive on oil prices both talking about our focus on domestic economy, and companies driven by domestic demand, and we also have sizable investments in some specific oil companies, for example, Tatneft, which shows very strong operational results this year. But in general, we believe that Russian non-oil companies, the non-oil sector benefits more from stronger oil price just because of peculiarities of taxation regime. For example under the shifted oil tax regime, the Russian government is collecting taxes about $30 per barrel. So actually selling crude oil at $50, Russian oil companies receive net revenue of about $20 per barrel. On the other hand, stronger oil price also means stronger Rouble. So it means that in dollar terms, costs for Russian exporters are also increasing. So that’s why we believe that non-oil sector is simply more sensitive to higher oil prices.
Michael O’Flynn: That makes sense. Vadim, do you want to make closing comments.
«We see even higher potential in some specific stocks which we think can double or triple on the road to further Russia’s economic recovery.»
— Vadim Ogneshchikov, Senior Expert, Russian Strategies
Vadim Ogneshchikov: Yes, to re-iterate, we are very pleased with the strong performance of the Russian equity market and UFG funds in 2016. Nevertheless, we see a strong potential for further gains going forward as the benchmark index is still down 25% from its levels at the beginning of 2014. We see even higher potential in some specific stocks which we think can double or triple on the road to further Russia’s economic recovery. As I already said during today’s call, we continue to focus on companies driven by domestic demands like Russian banks, homebuilders, food retailers, transportation, internet and telecoms and steel mining. We expect further strong gains for the investors going forward. And thank you very much for joining our call today and our warmest season’s greetings and best regards for a prosperous new year.
Michael O’Flynn: Thank you, team, and thank you everyone for joining the call today.