Investors misguided about Russia

With its $2-trillion economy, Russia is among the world’s top ten markets.

The World Bank has projected the host of the 2014 Winter Olympics will grow 3.6% in 2013. Its stocks trade at significant discounts to both developed markets and its emerging market peers. Its domestic consumption is exploding.

Yet Russia remains an unloved, underestimated market.

Read: Russia is worth the risk

Good news is drowned out by persistent bad press touting its questionable human rights record, unstable political system, and bizarre policies such as the legislation that prohibits adoptions of Russian children by American families.

But the public perception is misguided, says Igor Danilenko, a senior portfolio manager at BNP Paribas Investment Partners who specializes in Russian equities.

“Russia’s political system is quite stable, much more than in some countries in Europe and elsewhere,” he says. “Political stability in Russia is based on the fact that the economy is doing well.” He adds the federation’s central bank policies are much better than they get credit for.

“Russia’s been getting bad press for years, but [that] didn’t prevent it from having outstanding returns on the run up to the 2008 global financial crisis.” Foreign capital inflows to Russia were over $81 billion in 2007, before the 2008 meltdown put on the skids.

By the first quarter of 2012, they were back up to $36.5 billion. The country remains far below its 2007 peaks with plenty of room for growth.

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“There’s more foreign direct investment by international corporations into Russia than actual portfolio investment,” he says. “So it’s not an overcrowded story where you face headline risk.”

Russia is well-positioned for positive media attention as the host of the 2014 Winter Olympics, a much-needed opportunity for the country to boost credibility with investors.

“It’s a landmark event to attract attention to Russia again,” says Danilenko. “The spending on the Sochi Olympics is mainly on steel and construction and other related sectors, [and] we have seen its impact on the economy in terms of infrastructure spending.”

He concedes the country is not growing as fast as India and China due to its slower population growth.

But what it lacks in population, it makes up for in consumption. Like its emerging market peers, Russia has an expanding middle class with mounting aspirations.

“Despite the impression that it’s a pure oil-and-gas economy, its domestic sectors are driving most of the growth at this point,” he says.

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The World Bank says private consumption will remain the main driver, supported by strong domestic demand and low unemployment.

And domestic demand has already overtaken such traditional drivers as the agricultural sector and natural resources, both on a decline, says a BNP Paribas study.

It adds “the average Russian is 2.5 times wealthier than the average Chinese and six times richer than the average Indian.”

This, says Danilenko, makes sectors such as banking, where consumer leverage is extremely low, and mobile, one of the best cash-flow generators, the most attractive sectors from which to pick stocks.

Read: Emerging markets: where are they now?

And for more conservative investors, Russia’s bond market is attractive due to a strong currency and nearly 5% returns.

According to a Barclays estimate, between $25 billion and $40 billion will pour into the domestic bond market during 2013-2014.

“Russia is extremely low leverage; its sovereign debt is 10% of its GDP,” says Danilenko. “The risks [because of lower financing costs] are lower than perceived and eventually this will reflect in higher [corporate] earnings.”

Read: Don’t spurn global equities

That said, foreigners own only 15% of government bonds. But that’s expected to change.

Foreign investors can now buy Russian domestic bonds through Belgian clearinghouse Euroclear, which will serve as a trading link between buyers and sellers of Russian securities. These transactions are protected under Belgian law.

And while none of this evidence will make Russia a core position in foreign portfolios anytime soon, Danilenko says by allocating “5% of your portfolio to Russia,” investors can gain both growth and diversification while mitigating the attendant risks — perceived or real.