100 Days of Putin

Until some of the country's largest companies get it together, the Russian market will show little upside.
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For the Russian equity market, the first 100 days of the presidency of

Vladimir Putin

have been less than stellar, with the market down 28% since his inauguration. Wary from unfulfilled promises in the past, investors aren't paying much heed to the potentially seismic changes in the Russian economic and political scene.

But now that some of the issues that have haunted investors for years are finally being taken care of, investors in Russia are refocusing on corporate governance -- and the results aren't heartening. Until some of the country's largest companies can show investors that they have their act together, the Russian market may have little upside in the short term. But once the picture clears, the stage is being set for Russian assets to be perceived as undervalued -- rather than just cheap for a reason.

Beneath the surface, a lot has changed in Russia since Putin became president on March 26. On the economic front, the government approved a radical package of reforms that, if implemented, would go far toward a true market economy, replacing the present regime of twisted gangster capitalism. Focal points of the program include many issues long decried as obstacles to foreign investment in Russia, such as the Byzantine taxation system; bankruptcy legislation and the stifling bureaucracy. The Russian parliament has even approved a flat 13% income tax (don't cry, Timothy Forbes), in a bid to increase compliance rates.

The reform program's benefits for traded companies will be through the creation of a more transparent business environment. The first steps of restructuring will help strengthen the backdrop for sustainable reform. The deep-seated structural problems will hamstring the economy unless they are addressed in time.

The proof of the economic reform pudding, of course, will be in implementation. Since the end of the Soviet Union, Russia has suffered through roughly a dozen economic reform programs that have created an environment as bizarre as a Bulgakov novel. So far, the indications on the implementation front are good, with the Duma, the lower house of parliament, agreeing to extend its spring session for 10 days to pass the new tax code.

In the meantime, Russia posted GDP growth of 8.4% in the first quarter of this year, while international currency reserve levels continue to grow. Inflation has shown signs of heating up, but should still come in at under 25% per year, a dramatic improvement from the 84% in 1998.

Putin has been similarly revolutionary on the political front, but there the implications are less clear. In an effort to consolidate power, the Kremlin is trying to dull the clout of powerful regional leaders, in part by installing its own regional heads in seven newly formed super-regions. Members of the Federation Council -- roughly the equivalent of the Senate -- are on the verge of having their wings severely clipped as well. The Duma has enthusiastically rallied around the idea of bringing its legislative brethren down to earth, but Putin still may have a struggle overriding the Federation Council's likely veto.

Arguably, the Kremlin needs to centralize power if it is to have any hope of implementing economic reform. Over the past decade, many regions have devolved into the private fiefdoms of local leaders who largely ignore dictates from the Kremlin -- thus negating countrywide reform efforts.

But fears linger that Putin has darker intentions. The Russian constitution already grants the president near-dictatorial powers, and recent legislation will further extend the president's reach. Putin, a career KGB man who hasn't bent over backward to prove his credentials as a democrat, stoked these concerns last month with a heavy-handed attack on a

Vladimir Gusinsky

, one of Russia's oligarchs.

By targeting Gusinsky, Putin turned a potentially positive move (slapping at the entrenched interests of the oligarchs) into a public relations nightmare. Arresting the owner of Russia's largest media organization on an ancient embezzlement charge earned Putin international headlines focused on the threat to press freedom -- not on cracking down on unruly oligarchs. Rather than tossing any one of a handful of other, more dirty and less western-friendly oligarchs in jail, Putin chose the oligarch whose media organization immediately moved into overdrive to portray him as the savior of the free press in Russia.

In general, though, modest restrictions of the freedom of expression aren't likely to spark a mass exodus of investors from Russia (consider China). What has most spooked the Russian market of late has been a reassessment of micro-level problems. Now that the macro-level tribulations of political and economic instability, and the lack of real reform, are in the rear-view mirror, problems with Russian corporations themselves are back in the spotlight.

Investors have for years discounted Russian assets because of corporate governance problems, an issue that has recently re-emerged. The largest concern right now is the proposed restructuring program of market bellwether

Unified Energy System

, the country's monopoly power provider, and the Russian equity market's most liquid stock. UESR, which is headed up by discredited reformer Anatoly Chubais, has claimed that the restructuring program will respect minority shareholder rights. But international investors fear a replay of the insider deals and thinly disguised thievery that has characterized much of the so-called reform process in Russia. The company stock has collapsed as a result, down more than 46% from its 2000 high.

Also contributing to recent jitters is the Moscow general prosecutor's move to reassess the privatization of

Norilsk Nickel

, a massive metals company that is 20% held by foreign investors. Any wholesale reassessment of the privatization process likely would result in mass panic by investors from Russian assets, and even the suggestion of a re-examination is enough to seriously spook the market.

Corporate governance issues likely will continue to haunt the Russian equity market for at least the next few months. But even discounting the possibility of shareholder rights abuses, selected shares offer strong fundamental value, particularly

Surgutneftegas

, Russia's third-largest oil producer. Recently under a corporate governance cloud itself, Surgutneftegas management went on an effective public relations offensive to convince investors that it planned no harm for minority investors when it announced plans to issue new shares. The result has been relative outperformance, in the face of a difficult market environment.

However, once the corporate governance picture clears up a bit, and as some of the benefits of political and economic reform begin to have an impact on the economic and business environment in Russia, equity valuations are likely to benefit. Low valuations are only low if investors are confident that they won't be robbed altogether of their returns. In time, the corporate governance environment likely will improve significantly, paving the way for considerably more enthusiasm for Russian shares.

Kim Iskyan is an equity strategist at Moscow-based brokerage firm and investment bank Renaissance Capital. The following are the firm's analyst recommendations and underwriting relationships for the companies mentioned in this column: LUKoil and Unified Energy System -- short-term hold, long-term market outperformer; Surgutneftegas -- short-term buy, long-term market outperformer. Renaissance Capital has done no underwriting for any of the companies mentioned. Iskyan began his career at the emerging markets trading desk of Oppenheimer & Co. At the time of publication, he held no positions in any of the securities mentioned in this column, though positions can change at any time. While he cannot provide investment advice or recommendations, he invites you to comment on his column at

kiskyan@rencap.com.