JPMorgan Russian narrowly avoids need for tender – JPMorgan Russian Securities has published results for the 12-month period ended 31 October 2021. Over that period, the return on a net assets basis was +61.0%, and +65.8%, on a return to shareholder basis – good but underperforming the company’s benchmark by 9.3% and 4.5% respectively. The dividend is unchanged at 35p and was just covered by revenue of 35.5p.
The chairman’s statement says that “a significant detractor and the cause for the underperformance against the index was the stock selection in the materials sector, where one or two less liquid stocks we did not hold performed surprisingly well. Another factor was the company’s underweight holdings in financials, partially offset by our investment in a new Kazakhstan based fintech and banking company, Kaspi that came to market as an IPO. We were overweight in information technology stocks and this also detracted from performance as did the selection of stocks in the communications sector.” The manager’s report has a much more detailed look at performance drivers, which we reproduce below.
The company has just managed to escape holding a tender “The performance over the last five years has marginally beaten the benchmark with a total NAV return of +115.3% compared to a benchmark return of +114.6%. Therefore, the condition that there should be a tender offer for 20% of the shares in the event of the failure to meet the benchmark return will not apply, and no tender will take place in 2022.” There will be a continuation vote at this year’s AGM, however, and a new five-year performance measurement period has begun. If the trust fails to beat its benchmark over the five-years ended 31 October 2026, it will hold a 25% tender offer in 2027.
Dividend hike
“Dividends from Russian companies have been rising in recent years and the company has increased its dividends accordingly. We also now have more confidence in the likely level of dividends due in the forthcoming year due to Russian company dividend policies and intend from now on to pay quarterly dividends, forecasting them in advance in the annual report. If then at the end of the year there is a surplus, it will be distributed as a higher final dividend, or if there is shortfall, we will use reserves to top up the final dividend. The aim is that shareholders can be confident about the level of dividends for the year ahead. This year we expect the dividends to be a total 60.0p giving a quarterly dividend of 15.0p. These are scheduled to be paid in March, June, September and January. The large increase in the total dividend forecast in 2022 compared with 2021 arises from the improved income generation performance of many of the companies in the company’s portfolio.”
No war?
The managers’ outlook statement acknowledges the tensions in Ukraine. They say “We do not foresee any significant progress on the diplomatic front, as it would require a major shift in the positions of all parties, and we doubt that the Russian government will withdraw from the Crimea in the foreseeable future. However, we do not expect the situation to deteriorate into actual conflict. The current stalemate is most likely to persist until there are leadership changes in the countries involved in the conflict, or until a deterioration in Russia’s economy increases pressure for a resolution. Sanctions are thus likely to remain in place for the foreseeable future, although we do not expect them to have much economic impact. Russian-US trade is minimal. The EU and China are Russia’s major trading partners, and trade with these countries is likely to continue despite sanctions. We will continue to monitor the situation closely.”
Extract from the managers’ report – drivers of returns
“The most significant changes we made during the review period to heighten the portfolio’s exposure to the recovery included increasing positions in energy and financial stocks, and reducing our holdings of technology, communications services and consumer stocks.
The portfolio remains overweight energy relative to the benchmark at the end of the financial year, and increasing our energy exposure proved profitable. This sector was the main positive contributor to returns over the period, thanks to our stock selection decisions. Our overweight holding in Gazprom Neft, our underweights in Surgutneftegas, and not holding Transneft added most to performance.
We remain very positive about the energy sector outlook. This confidence is reflected most notably in our overweight to Gazprom, which represented 19.4% of the portfolio at the end of the review period, the portfolio’s largest holding, compared to a benchmark weighting of 14.4%. We believe that despite the 155% rise in Gazprom’s share price over the financial year, the market does not yet fully reflect the earnings power of this company. We estimate that Gazprom will trade at a price/earnings multiple of 3.5x, and pay a dividend yield of 15% or more during 2022. We expect positive earnings revisions and further share price gains over the next couple of quarters at least, as the market comes to fully appreciate Gazprom’s future earnings capacity.
We are also optimistic about oil and gas prices, which we expect will be supported by strong demand as the global economy reopens and air travel increases further. Supply constraints will also underpin prices due to ongoing reductions in capital expenditure in conventional oil and gas production, in favour of renewable energy sources.
At the end of the review period, in addition to Gazprom, there were three other energy companies in the portfolio’s top 10 holdings – Lukoil, Rosneft and Novatek – which together comprised 25.4% of portfolio assets. While we like Lukoil as a steady producer, with a clear dividend policy and well-established operations, Rosneft is our preferred name, as we believe the company is in the best operational and financial position to benefit from higher oil prices and stronger demand. In addition, Rosneft’s free cashflow will be boosted significantly by tax rebates and subsidies, which take effect as oil prices rise. And the scale of its Vostok Oil project is not yet fully appreciated by the market. This project will add 1% to global oil production and 10% to Russian output, and increase Russia’s GDP by an estimated 0.5% when it becomes operational in 2024. We increased our position in Rosneft during the year.
We also have a large and longstanding position in Novatek, another energy producer with a great growth story, and a management team with a proven ability to deliver complex projects on time and on budget. Novatek also provides the portfolio with exposure to the transition to LNG, as it is expanding its LNG production.
Still within the energy sector, our underweight to Surgutneftgas and our decision not to hold Transneft are motivated by questions about governance issues, as both companies have unusual shareholder structures, limited disclosures on capital allocation and large variations in profitability. In the case of Tatneft, we were disappointed by the company’s dividend policy and capital allocation decisions in 1H 2021 and so trimmed back our holding. However, we have returned back to the name more recently, due to the rise in oil prices.
Our underweight to utilities made the second largest positive contribution to returns with the exception of our investment in RusHydro. We have avoided this sector due to the complexity of the regulation. The portfolio’s out-of-index exposure to healthcare made a modest contribution to returns. Within this sector, we are very pleased with the performance of MD Medical Group, which provides healthcare services for women and children in Russia. This company has been a prime beneficiary of higher consumer spending on medical services. We prefer it to the recently listed European Medical Centre (EMC), which we do not hold, as it is more dependent on government orders and is less diversified, although we are pleased to see the arrival of new participants in the healthcare sector.
The main detractor from performance at the sector level over the financial year was our exposure to materials. While our underweight to this sector assisted performance at the sectoral level, stock selection detracted. We underestimated the potential gains of low liquidity stocks such as Alrosa, a diamond mining company and high-end jeweller, Phosagro, an agricultural chemicals producer and Rusal, an aluminium producer. We had no exposure to these stocks, but all of them more than doubled in value over the year. We avoided Alrosa, which we see as a play on luxury consumption, on the view that the collapse of global travel and inflationary pressures would diminish demand for their products. We tried to build up a position in Phosagro, but the illiquidity of the stock made this very difficult. Furthermore, a change in export regulations and a price cap on domestic sales have cast a cloud over the company’s earnings outlook, so we have opted to avoid it for now. The justification for the underweight position in Rusal included the change in dividend policy as referred to below.
Staying within the materials sector, our overweight to Norilsk Nickel (currently the portfolio’s sixth largest holding at the end of the review period) also hurt returns. This company produces nickel, copper and rare metals, which are in high demand from electric vehicle and battery manufacturers, and our holding provides the portfolio with useful exposure to these rapidly growing industries. We expected a relief rally after the company settled a fine imposed for a 2020 oil spill, but another accident at its Polar Division halted production for several months and put the share price under renewed pressure. Investors were also unhappy about a change in Norilsk’s dividend policy, which will now offer shareholders the opportunity to receive some cash via share buybacks, rather than dividend payments. (The change in Norilsk’s dividend policy also created a risk for Rusal, which depends on Norilsk’s dividends for its own cash flow and debt repayments.) We are disappointed by Norilsk’s two recent breaches of environmental and safety standards, however we continue to hold the stock as we believe that the company made significant changes in personnel and allocated additional budget for investments to control Environmental risks going forward, so we consider it as a ESG ‘Improver’ now. Our longstanding, overweight positions in steelmakers Severstal and Novolipetsk Steel (NLMK) (both top 10 holdings) detracted from performance during the year due to pullbacks in their share prices after strong gains. However, we have retained both positions, as we like their capital allocation practices and very high income generation.
Financials were the second largest detractor from performance over the period. Although we eliminated our underweight position in financials over the course of the year, with hindsight, we should have closed the underweight entirely, as sector allocation still detracted from returns, as did stock selection. Avoiding TCS Group, an online retail banking and financial services provider, proved especially costly to relative performance. We had concerns over governance issues and the potential reactions of government regulators. The share price rally in the first half of the financial year made TCS Group look very expensive – we believed such a high price/book multiple could not be justified for a company such as TCS, which has exposure to subprime and unsecured loans. Our small underweight to Sberbank also hurt relative performance. This bank is a solid performer and a ‘go to’ stock for investors seeking exposure to Russia, and our second largest position. However, due to concentration risk and our preference for exporters, we had a slight underweight in Sberbank in the period under review.
The adverse performance of these financial holdings was partially offset by significant positive contributions from our acquisitions of two out-of-index Kazakh banks during the review period. We participated in the initial public offering (IPO) of Kaspi, a profitable bank and fintech company, with a very reasonable valuation and a source of the market’s highest dividends. This is strategic holding, which we expect to maintain for some time. The second Kazakh acquisition was Halyk Savings Bank, which is perceived as the ‘Sberbank of Kazakhstan’, i.e. a proxy for exposure to Kazakhstan, which will benefit from the country’s exposure to high oil prices. As with Kaspi, Halyk’s valuation is reasonable and it offered a dividend yield of 15% in 2021 – probably the highest bank dividend yield available anywhere in the world.
Still within financials, we acquired an exposure to Moscow Stock Exchange (MOEX) during H121, which detracted from returns over the period. We subsequently took profits, closing the position on valuation grounds and due to rising competition from the newly listed St Petersburg Exchange.
While we reduced our overweight to information technology over the year, exposure to this sector was still negative for relative performance, as the performance of tech stocks lagged the index. Our exposure to QIWI, an online payments and credit company, which was hurt by regulatory changes, also detracted, as these changes resulted in the loss of a major part of its business and it incurred hefty associated fines. We closed the position in September as there is little prospect of the company recovering from this blow in the foreseeable future. This loss on QIWI was partially offset by the favourable impact of our longstanding position in EPAM, a digital platform and software developer, which is one of the portfolio’s top 10 holdings. This company has an exceptional record of growth and strong returns, and it made one of the largest contributions to returns in the past year, as the share price doubled. However, we are becoming concerned about the stock’s valuation which now has a P/E of more than 70x, and we have begun trimming the position.
The portfolio’s exposure to communication services detracted modestly from relative performance. Over the course of the year, the portfolio’s exposure was shifted from a notable overweight of around four percentage points, to an equally sizable underweight, and this move contributed to returns. However, the positive impact of this shift was more than countered by the detrimental impact of stock selection decisions, particularly our overweight in Rostelecom. We prefer this company to mobile players, as we see potential for it to monetise its broadband network in the regions. Rostelecom also has a monopoly on the provision of cloud data services for the Russian government and State controlled businesses, a fact which is not fully reflected in the share price. The portfolio’s overweight in Sistema had a small adverse impact on returns. Sistema is a holding company which we favour because it provides exposure to several mobile telecommunications services subsidiaries, including Mobile TeleSystems, at a discount. We continue to hold both Rostelecom and Sistema.
Gains in several other holdings within this sector partially offset losses on these two positions. For example, our position in Yandex, an internet content and information platform which is Russia’s equivalent to Google, performed very well. We took some profits, reducing our exposure significantly in Q1 2021, although the stock remains among the portfolio’s top 10 holdings. A change of CFO has resulted in an increase in spending on ‘blue sky’ projects. While such projects are exciting and bode well for the company’s longer term future, the associated capital spending has taken a toll on current profitability. Our position in Mail.Ru, Russia’s largest Russian language internet and social networking company, also added to returns. However, we have closed the position, as we have been disappointed in the company’s efforts to monetise its social network and gaming offerings. We also have concerns about governance and regulatory risks, as control of the company has recently changed (along with its name, which became VK in October 2021), and the government is demanding more control over social media.
The portfolio’s overweight to consumer staples detracted from returns due to both asset allocation and stock selection decisions. Our longstanding position is grocery retailer X5, which is a leader in the sector, had the largest negative impact. We held an overweight to this stock versus an underweight to its rival Magnit. However, X5’s share price has been subject to some pressure as the rise of the e-grocery industry has threatened its market dominance, especially in Moscow and St Petersburg. At one point during the year, we exited our position in Magnit, as we did not like the company’s deal to acquire DIXY, Russia’s third largest food retailer after X5 and Magnit, and we expect the company to face ongoing operational challenges. However, we did not want to be underweight this sector, as in our view, food retailing in Russia is becoming a value rather than a growth sector and we expect strong cash generation and higher than market dividends from this sector, so we re-opened the position in Magnit in Q321.
We were also overweight in consumer discretionary and this detracted modestly from performance over the year due mainly to stock selection decisions. Our overweights in Detsky Mir and Fixed Price Group, both had small adverse impacts on returns. Detsky Mir is a leader in the department stores and digital retail sector. It is cash rich, capable of internally funding expansion and it pays an attractive dividend. In addition, the market is overlooking the potential upside in its online pet supplies business Zoozavr, which we expect to increase to more than 30% of Detsky Mir’s market cap within a couple of years. We purchased department store operator Fixed Price during its IPO, at what we believed it to be a fair price, but the shares de-rated after floating as the IPO valuation was elevated and market made some adjustments later to more realistic multiples. However, we continue to hold the stock, as we are attracted to its strong cash generation and growth prospects, and we expect the price to recover with time.
Within real estate, we sold two long term holdings in residential real estate developers, Etalon and LSR, eliminating our exposure to this sector, after both holdings undermined performance over the past year. New regulations have taken a greater than expected toll on the residential construction sector, destabilising these businesses and increasing earnings volatility. In addition, the introduction of special escrow accounts to protect home buyers has made the sector much more capital intensive.
The sale of these two mid-cap companies is consistent with our previously discussed plan to reduce the overall risk level of the portfolio by cutting our exposure to smaller, less liquid stocks, as they tend to underperform in rising markets. We sold Ros Agro for similar reasons. This company is an agricultural producer which has experienced wide swings in its fortunes due to fluctuations in the prices of soft commodities including wheat, sugar and meat. Such price volatility raises the risk of state regulation of prices, which has undermined our conviction in the stock. We also disposed of Global Truck, a small-cap transport and logistics company, as we have concerns about the company’s ability to withstand cost pressures and expand its business.
The Russian market saw several high profile IPOs during the year, which we welcome for the same reason that we are pleased to see greater participation from Russian domestic investors – new arrivals, like new investors, help to deepen and diversify the market. However, in several instances, we did not participate in the listings, due to what we viewed as excessive valuations. IPOs in this category included Renaissance Insurance Group, Segezha, a forestry and packaging company and OZON, an e-commerce company, where we are particularly cautious, on the basis that competition in e-commerce is intense and the sector requires heavy capital expenditure to generate meaningful returns.”
JRS : JPMorgan Russian narrowly avoids need for tender