Russian Reform; Glacial But Inevitable

By Jesse Sherman, Portfolio Manager, Russian Equities, Renaissance Asset Managers.
In Russia the trading of Global Depositary Receipts (GDRs) at a premium to local shares is a common occurrence despite their equal economic value and voting rights. While most Russian share classes trade within 1% or 2% of each other reflecting often nothing more than conversion costs, there are a handful of local shares trading at discounts of more than 10% to their respective GDR. Trading reforms in 2013 will mark an inflection point in the Russian financial system through broadening access and lowering roadblocks to ownership, and in our view now is the time to use the local market access to leverage returns in attractive stocks.
The modernisation of the Russian financial system has moved at a glacial pace, leaving many international institutional investors constrained from purchasing equities on the local exchange owing to issues including low liquidity, sameday settlement in local currency, the inability to hold shares on record with the custodian, and a lack of fungibility. However, we believe key structural changes this year will mark a major turning point.
With the establishment of the Russian Central Depository (CD), investors will finally be the ultimate beneficiary of record by the end of 2013 (accounts will take time to setup), thus removing this investment barrier. The movement to T+2 (Trade Date + 2 days, from T+0 now) is also expected to be a staged process in 2013 – an initiative that should also reduce transaction barriers as it removes the need for investors to hold funds on account in rubles. Testing T+2 for the Top 15 stocks went live on the 25 March with sole trading on this basis from 1 July. By 1 January 2014, all 1,780 securities are planned to trade on T+2. In our estimation, the combined impact of these two structural changes should lead to higher liquidity locally. Once the market is effectively trading on a T+2 basis, we expect increasing pressure to remove the 25% GDR cap – which limits the value of the GDRs to no more than 25% of a company’s value. We take positively the comments by the Deputy Head of the Russian CD earlier this year that fungibility between Russian GDRs and local shares will only be allowed from 2014. In our view, the caps will be lifted and Russian officials are simply being prudent to help ensure that no material issues arise from the implementation of the changes in 2013.
For those sceptics of Russian reform, we point to the Moscow Exchange (MICEX), which publicly listed last week. MICEX requires ongoing Russian reform to ensure its long-term investment case, in particular the competitive position vs. international exchanges (e.g. LSE) for future listings and trading volumes. Further financial reform is also necessary to enable the Russian privatisation strategy to go ahead and fulfil the Government’s objective to establish Moscow as a global financial centre.
In our portfolios we hold the local shares of companies we find attractive like Magnit, MTS & Novatek since they offer significantly cheaper valuations to the GDRs. As the T+2 implementation progresses, we expect these shares to outperform the GDRs with the discounts reducing to high single digits, enhancing returns for our investors. Removing the GDR caps and allowing full fungibility of the shares will likely be the last push to make the discounts de minimis. While overall, like many other investors, we view Russian reform with healthy scepticism, we do believe that the glacial path of market reform whilst slow is hard to stop.

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