Having studied Russian politics and history under the tutelage of Henry Kissinger at Harvard, and learned the language from a cigar-smoking, vodka-drinking woman who had gone to school with daughters of the last czar of Russia, John Connor had reason to become fascinated with Russia.
Connor, who went on to become the deputy director of East-West trade at the U.S. Department of Commerce and to teach international monetary economics on a Fulbright grant in India, is now the portfolio manager of the
(TMRFX)Third Millennium Russia fund, which he started in 1998.
The fund, which has only $3 million in assets, posted a whopping 145% total return in 1999 before coming back down to earth last year with a negative 29% return, but has achieved a 13.6% return so far year to date. Here he explains why he feels Russia is becoming a better and better place to invest, and which companies in particular he likes.
TSC: What is the current political situation in Russia right now?
Connor: The big deal in Russia is that they want to become a normal country. It sounds like a modest goal, but it's not that easy. You and I take a lot for granted. We have a very complex system that works very well, except for we found out on Sept. 11 we are sometimes a little too trusting. I find this drama of Russia trying to become a normal country just totally riveting.
Russia has a couple generations of a system that was dysfunctional. It did not produce well for the people and was not free and open. The big deal now in Russia is they
do have a functioning democracy, and there
is freedom of the press.
It's not the Wild West, or the Wild East, that we saw a few years ago, when these people were truly robber barons. They have made a lot of progress politically and from a macroeconomic standpoint. The economy is growing now at about 5%. If you look around the world today, how many economies can you say that about? To me, that equates to a relative safe haven. The problem is, at the microeconomic level, building a profitable business system.
TSC: What are some profitable enterprises right now over there?
Connor: The two big breaks they got, of course, were the increase in the price of oil and in commodities like the nickel and platinum group. Brent crude, which is the spot price for oil by the barrel, went up to the mid-$20s. Russia is the biggest exporter of oil in the world after Saudi Arabia. They have very large reserves, and [there are] five public companies that our fund is invested in, all of which have shown real good profits in the last year, including
Lukoil(LUKOY),
Surgutneftegaz,
Tatneft(TNT),
Sibneft(SIB) and
Yukos(YUKOY)
They also changed the tax and accounting codes. These oil companies are beginning to declare substantial dividends because of the change in the tax system. The tax system took them
years to get squared away. In addition, Russian companies are beginning to adopt GAAP [Generally Accepted Accounting Principles]-accounting audited financial statements. Corporations that had been hiding profits are now finding profits.
Russia now has a stable tax regime, legal regime and government.
TSC: What about the recent sharp decline in the price of oil? Won't that hurt these big Russian oil companies you are invested in?
Connor: If the world enters into an economic recession, the price of oil will go down even further. For the current situation, it's still a very good price in terms of Russia's export earnings, i.e., its trade balance. In fact, oil will continue to make Russia a lot of money down to about $13 a barrel, but I don't think it will go down that low.
TSC: Besides oil, it appears that your fund is heavily invested in energy, technology and utilities. What are some of the other companies that you like right now?
Connor: I look for performance and investor interest. Earlier this year, I got into gold and telecom and that has done very well for us this year. And I went into one of their cell phone companies traded on the New York Stock Exchange,
Vimpel-Communications(VIP). It's the second-biggest cell phone company in Russia and they have done alright this year.
Besides the oil companies, I am also invested in
Norilsk, a nickel company located on the Arctic Circle. They're doing extremely well. I have also gone heavy into utilities. My biggest single stock is the national utility,
United Electrical System(USERY), run by Anatoli Chubais, who headed the privatization of public utilities under Boris Yeltsin.
There are stocks that I would like to own, but there is no investor interest in retail -- zero. The
Bloomingdale's of Russia is
Gum on Red Square and the
Macy's of Russia is
Tsum, the latter of which commands 12% of retail sales in Russia and has great profitability.
TSC: Given Russia's history with Afghanistan, how would a conflict in that area impact the nation and the companies in which you have invested?
Connor: Not at all. But, here's a radical thought. If Russia is used as a U.S. and NATO base for a conflict, this will be very much to Russia's long-term benefit. It would make it more closely integrated with Europe and closely identified with the U.S., as it would be standing shoulder-to-shoulder with us.
Objectively speaking, Russia is one of the few countries that stands to gain from the current situation because it gives them an opportunity to show their loyalties. They really are Europeans, you know.
TSC: What's happened to the Russian black market?
Connor: The black market has ceased to function since they freed prices to reflect the market in any given commodity, so there really is only [one] market. Only in small instances are there cases of smuggling. The problem in Russia has not been crime and corruption, even though that is what you always read about in the media.
Competence has been the problem in Russia.
TSC: Why do you say that?
Connor: Total lack of experience. If you grew up on the moon and came to earth, how would you do? And they grew up under communism.
TSC: Aren't there foreign talent and intelligentsia working there?
Connor: There's no foreign direct investment in Russia compared to, say, China. And that is an anomaly. It's really hard to explain on a rational level why people have put so much money into China and no money into Russia. Russia does have
Ford(F) and
Gillette(G) and a few other major U.S. corporations, but compared to China, there is no foreign direct investment.
I think that might change now that the perception is deepening that Russia has become a more stable place and that you can depend on your legal rights, although I am not sure that is always the case. Until that changes, you really won't have that many foreigners relative to other countries.
TSC: What's going on with corporate governance there, and on a related note, how arduous is it to do investment research on Russian companies?
Connor: This is the big recent news, I think. Our system is a very complex system where we channel greed in constructive channels so that people work for their own self-interest, but it turns out to create wealth for everybody. I think it's safe to say that the management of these big public firms in Russia have figured out if they want to get the market cap of their company way up, they've got to start being more like these Western companies. Many of these companies have multiples in the single digits and they want to get them up to where their international peers are.
We are beginning to see an emphasis on corporate governance, minority shareholder rights and even environmental concerns. It's very important to find companies that are audited, that are investor-friendly, that are liquid and that are market leaders. That is my criteria for buying a Russian stock. I have to say, I have a hard time buying a portfolio of 30 stocks.
Many of these stocks don't have liquidity, so the 50% of them or so that are not traded in the Russian over-the-counter market but are available as American Depository Receipts, I buy them as ADRs. I mark down to the bid when I buy a stock that doesn't have too much liquidity.
>To order reprints of this article, click here:
Reprints
Connect with TheStreet