Is It Time to Buy Russian Stocks?

NEW YORK (TheStreet) -- Since Russian President Vladimir Putin began to threaten Ukraine, Russian markets have sunk.

During the past three months, iShares MSCI Russia Capped Index Fund (ERUS) has dropped 15.9%, according to Morningstar. Now Russian stocks have reached levels that haven't been seen since the global financial crisis. The forward price-to-earnings ratio of the iShares Russia exchange-traded fund is four, compared with 16 for the S&P 500.

"Russian stocks are among the cheapest in world," says Vitali Kalesnik, head of equity research for Research Affiliates, which operates the RAFI benchmarks used by such ETFs as PowerShares FTSE RAFI Emerging Markets (PXH).

Kalesnik says that bargain hunters should turn their attention to Russia, because investors have overreacted to the political problems. Soon markets are likely to rebound.

To gain a rough idea of how Russian stocks might perform, Research Affiliates looked at market performances during eight earlier conflicts, including Russia's wars with Chechnya in 1999 and Georgia in 2008.

On average, stocks fell 14% in the first three months of the conflict. Then after several more months of bouncing on the bottom, the stocks began to rebound. Within eight months of the start of the war, markets had recovered fully.

"At the moment when the military action starts, investors pay a lot of attention to the conflict," Kalesnik says. "After a while, investors stop paying attention to the news and begin looking for cheap opportunities."

How should investors play a Russian rebound? Kalesnik says that his own RAFI funds are likely to excel when Russia revives. While typical emerging markets index funds have 5% of assets in Russia, the PowerShares FTSE RAFI Emerging Markets ETF has 11% in the country.

Schwab Fundamental Emerging Markets Large Company Index (FNDE) -- which also uses the RAFI system -- has 13% in Russia.

Lately the RAFI funds have paid a price for their Russian exposure. This year the Schwab ETF has lost 1.9%, while Vanguard Emerging Markets Stocks Index (VWO) has returned 0.3%.

The RAFI funds hold big Russian positions because the benchmark weights stocks according to a mix of fundamental measures, such as total revenue and dividends. Under this fundamental system, a company is given more weight if it has more revenue.

That is very different from the traditional benchmarks, such as the S&P 500, which weight stocks according to their market capitalizations. Under the traditional approach, a stock weighs more as the share price rises.

In the Russian market, the fundamental benchmark gives considerable weight to stocks with huge revenue and relatively small market values.

Gazprom (OGZPY), a giant gas provider, accounts for 4.6% of assets in the PowerShares RAFI Emerging Markets fund. But the stock is only 0.9% of Vanguard Emerging Markets ETF, which tracks a FTSE benchmark that is weighted by market capitalization.

Because they don't give extra weight to hot growth stocks, the fundamental benchmarks tend to emphasize troubled value stocks.

The shaky value stocks often do poorly during the downturns that follow the start of military campaigns, RAFI's Kalesnik says. As a result, the fundamental benchmarks trailed in the early stages of conflicts. But when the rebounds began, the fundamental approach snapped back fast as investors gained confidence and bought stocks that had been excessively depressed.

During the 24 months after the start of the eight conflicts that RAFI studied, fundamental benchmarks outperforrmed the standard indexes by wide margins.

The RAFI researchers concede that it is impossible to predict exactly how the current conflict will unfold. But they contend that Russian prices have slipped below the long-term means. At some point, markets will revert to the old patterns.

At the time of publication, the author had no position in any of the funds or stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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