UFG Russia Hedge Funds Conference Call: 2017 YTD Performance & Outlook through the end of the year
October 17, 2017
UFG Russia Hedge Funds Conference Call: 2017 YTD Performance & Outlook through the end of the year

Mr. Vadim Ogneshchikov, Senior Expert, Russian Strategies
Mr. Vadim Palamarchuk, Expert, Russian Strategies
Ms. Pauline Gerasimenko, Partner, Head of IR, UFG Asset Management

Vadim Ogneshchikov: We are pleased to present strong results posted by UFG funds for both 3Q 2017 and 9M 2017. The UFG Russia Select Fund soared an impressive +17% in this year’s 3rd Quarter, while the benchmark MSCI Russia Index increased +15% over the same period. Year-to-Date, both of our UFG funds — the long-short, blue-chip equity strategy UFG Russia Select Fund, and our hybrid public and private, equity and debt UFG Special Situations Fund — are vastly outperforming the country’s benchmark index. The UFG Russia Select Fund is up +20% net of fees, while the UFG Special Situations is up +16% net of fees. Meanwhile, as of the end of September, MSCI Russia was still down nearly −3% for the year.

This exceptional performance by the UFG funds is predominantly driven by successful stock picking. Throughout 2017, we had very low exposure to index heavyweights such as energy giants Gazprom, Lukoil, Rosneft, and Novatek, that is, to the very stocks most responsible for the overall negative performance of Russian equity indices this year. Instead, our focus during 2017 has chiefly been on companies in the high-flying Russian metals & mining sector. This accounted for about half of the total returns for the UFG Russia Select Fund. Other significant contributors that bolstered the impressive performance of our fund were the shares of Globaltrans, Sberbank, Yandex, and X5.

At this juncture, I would like to have my colleague Vadim Palamarchuk elaborate in greater detail on specific stock choices and themes in the Russian metals and mining sphere.

Vadim Palamarchuk: Good evening, ladies and gentlemen. As Vadim Ogneshchikov mentioned, half of our robust performance comes from the metals and mining segment. I’d like to highlight two names here in particular, which were the top contributors — Russian steel producer MMK, and the coking coal producer EVRAZ.

As we have seen, steel prices have continued along a recovery path that commenced in late 2016. For example, in 2017 the global Hot-Rolled Coil steel price benchmark added 35%, reaching $600/t on the global market. The same strong dynamics were in evidence on the local Russian steel market. MMK in particular was able to benefit from this growth, increasing its EBITDA by 30% YoY for 1H 2017. Moreover, MMK announced a new dividend policy in which, rather than paying out 30%, it committed to paying out 50% of free cash flow in dividends. I would also point out that after recent accelerated book building, the company has increased its liquidity and now has an extremely strong chance to enter the MSCI Russia Index during the upcoming November review. The stock has already advanced more than 50% YTD, and we still see further upside in the name.

EVRAZ, which has substantial exposure to hard coking coal prices and partial exposure to long steel prices, recently posted strong financial results for the first half of 2017. The company’s EBITDA increased by 100%, that is, it doubled, making EVRAZ a good deleveraging story, as its Net Debt/EBITDA ratio decreased from 4X to 2X. Moreover, EVRAZ paid special dividends in the first half of 2017, providing shareholders with a 9% dividend yield. We anticipate that hard coking coal prices and long steel prices will remain at their currently strong levels, and thus see further upside in the name.

Thank you.

Vadim Ogneshchikov: Thank you, Vadim. Adding to what my colleague just reported, I believe that environmental issues have been the primary driving force behind price rallies in some specific metals. Due to serious pollution problems in China, authorities there have required reductions or closures of production facilities that fail to meet environmental standards, especially in the aluminum and steel industries. As a result, aluminum prices increased more than +20% this year, while the prices for steel products are up +15% Year-to-Date.

In global automotive markets, we would highlight two major trends — stricter control of car emissions and the growth in the production of electric cars. Stricter emission standards lead to higher usage of palladium, a metal used in the production of catalytic convertors. Consequently, palladium prices have skyrocketed +45% Year-to-Date.

In our view, the proliferation of electric vehicles is evolving into a serious, long-term investment story. Since it is the largest producer globally of electric cars, China recently unveiled a plan in which, starting from 2019, at least 10% of the new cars it produces will be with low or zero emissions. Therefore, thanks to the growing demand from the automotive sector, two metals (nickel and copper) also saw significantly increased demand. As a result, in 2017 prices for nickel increased by +16%, while the price for copper has climbed nearly +30% Year-to-Date.

In 2017, we built significant positions in the shares of two Russian companies— Norilsk Nickel and Rusal. These two companies directly benefit from the higher demand for palladium, copper, nickel, and aluminum.

In terms of Russia’s macroeconomic environment, inflation continues to surprise on the downside. For example, Year-to-Date inflation is a mere 1.7%, and there seems to be significant potential that inflation can finish this year below the 3% level. By way of reminder, we would point out that the Central Bank of Russia («CBR») aims to make further cuts in interest rates. The upshot is that inflation in Russia is running at a rate significantly below the 4% target set out by the CBR. Hence, we are convinced that the present CBR rate of 8.5% is extremely high (CBR further reduced the rate subsequently to 8.25%). With such a high refinancing rate Russia’s Central Bank is running what is likely the most restrictive monetary policy in the world. Since this is the case, we anticipate the CBR will cut rates more aggressively.

We expect that the lower cost of capital (thanks to cheaper debt and the lower cost of equity) is a strong catalyst that should drive Russian equity markets higher.

Thanks to an improving macro environment — first and foremost very low inflation and recovering economic growth registered at 2.5% in 2Q 2017 — we see upside potential for the Russian market in general. In the meantime, we are sticking with our investment strategy of seeking specific Russian companies that are leaders in the current macroeconomic environment. Our top holdings currently include not only steelmaking companies, such as Magnitogorsk (MMK) and EVRAZ, but also the food retailer X5 and the transportation company Globaltrans.

Thank you.

Pauline Gerasimenko: We are now opening the call for questions and answers.

Question 1: You talked about the CBR rate. At present, how much is the fixed income market «pricing in» the future rate cuts, for example in terms of one year forward rates?

Vadim Ogneshchikov: Well, of course the markets are already «pricing in» rate cuts by the CBR. For example, Russian Federal Debts yields are at approximately 7.3%, 7.8%, and 8%. So obviously they are lower than the current 8.5% refinancing rate (CBR further reduced the rate subsequently to 8.25%). However, we see that real rates are still very high, even if nominal rates are above 7%. And, rapid disinflation in Russia is really surprising, both for us and for the entire financial services sector in Russia. The upshot of all of these factors is that Russian fixed income instruments are looking very attractive at the current inflation rates.

Question 2: Do you still have sizeable positions in Sberbank and X5, and what is your view on those stocks going forward?

Vadim Ogneshchikov: Well, X5 is indeed a very good example of alpha, thanks to a successful turnaround and efficient management of the company. Generally speaking, macro trends in Russian retail sales are still not very certain. In fact, the beginning of this year was very weak for the retail sector, with the segment showing negative growth (i.e., a decline in retail sales). It has only been in recent months that retail sales have resumed growth. Thus, in the first half of the year retail sales have shown flat dynamics overall. Nevertheless, X5 continues its rapid expansion. The company recently announced its 3Q 2017 operating results, and the opening of a record 800 new stores in the 3rd Quarter alone (and over 2,100 stores for 9M 2017). The company is growing very fast, and despite its aggressive expansion, X5 managed to exhibit strong dynamics in like-for-like sales. This proves that X5 is successfully taking market share from competitors in the food retail segment, but also taking market share from players in the non-modern food retail segments. We continue to look for such companies, those that can show outstanding results even when the general macro environment is not very supportive.
Sberbank represents another good example. We believe that Sberbank will be the biggest beneficiary of the rapid and ongoing clean-up of the Russian banking system. Consequently, we expect that because Sberbank is the strongest bank in Russia, it will attract more customers and will continue to grow.

Thank you.

Pauline Gerasimenko: Thank you, as it seems there are no further questions... Vadim, would you please make closing comments for this call so that we can let everybody get back to work.

Vadim Ogneshchikov: We are very pleased with the robust results of our UFG funds. We expect that in general the Russian market should be stronger, particularly since the flat YoY and YTD returns being posted thus far by Russian equity markets do not reflect the improving financials (such as much lower inflation). So, there should be much lower forward interest rates and also a lower cost of capital for Russian companies.

On the other hand, we also very pleased to see that Russian economic growth has turned around. In the 2nd Quarter of 2017 Russian GDP has shown +2.5% growth YoY. In the meantime, we are sticking to our stock picking approach, and we expect to continue delivering strong results for our investors.

Pauline Gerasimenko: Thank you everybody for joining this call.