JPMorgan Russian Securities (JRS) aims to generate long-term total returns from investing in cash- generative businesses in Russia. Despite the fact the index is highly concentrated and volatile, managers Oleg Biryulyov and Habib Saikaly have managed to generate significant levels of alpha (2.5% annualised over the past five years) on top of the high returns from the Russian market in the period.
Over five years Russia has considerably outperformed the general emerging markets index, as we discuss in the Performance section. However, in 2020 the market has lagged the broader benchmark as China has outperformed and a weak energy price has weighed on the oil- and gas-heavy RTS stock market. JRS has outperformed in this period too, but remains on a considerable discount of 11.7%, although we note this is close to the level it was trading at before the crisis.
Over the longer run, the Russian market has been boosted by improving corporate governance and a drive by the government to see state-owned enterprises pay out higher dividends. This has seen large companies like Gazprom, Lukoil and Sberbank pay out high dividends, and JRS’s dividend has more than doubled over the past five years – the yield is currently 5.1%. Both the management team and the board are convinced that we have seen a secular shift in culture, and that further dividend growth is to be expected. As a consequence, the trust’s objective has shifted to providing a total return rather than just capital growth.
Oleg and Habib’s work has led to a portfolio with some balancing exposures in technology and gold, but fundamentally we think JRS is a high-beta play on a global recovery. While the remainder of this year could see some stumbles as government support programmes run off, by 2021 we should be seeing the beginning of a sustained recovery which should boost demand for energy and thereby for the Russian stock market.
Russia entered this crisis with its public finances in good shape and with its corporate sector displaying much-improved corporate governance. This means the economy should be more resilient and the demand on public funds less onerous, all of which should boost the chances of recovery. Meanwhile, although dividends may be lower in the 2021 financial year thanks to the pandemic, we think the shift to a high-payout culture is permanent and a considerable part of JRS’s total return should continue to come from its high-dividend yield.
The Russian market is extremely concentrated, with three stocks on the index each worth more than 10% of the market capitalisation. We think this means that a closed-ended fund is the best vehicle to use to invest in the country, as UCITS funds cannot invest more than 10% in any single stock and are therefore forced to be permanently underweight to the largest stocks. We also note that JRS has substantially outperformed the managers’ open-ended Russia fund over the long run.
|The Russian market is cheap on a P/E basis and the trust is on a significant discount
||The Russian market is very volatile by global standards
|The shares yield over 5%, and the board has substantial reserves to draw on
||Political interference is high in Russia, making the country unpredictable
|The closed-ended structure offers advantages in a highly concentrated market such as Russia
||Russia’s economy is highly dependent on energy prices, with a heavy influence on the stock market and this trust
JPMorgan Russian Securities (JRS) aims to generate long-term total returns by identifying cash-generative businesses listed in Russia which have the potential for strong and sustainable growth. Managers Oleg Biryulyov and Habib Saikaly aim to outperform the highly concentrated Russian stock market, which has just 34 constituents. They have achieved this over the past five years, adding annualised alpha of 2.5% a year in a strong period for the market. This is only possible thanks to the trust’s structure – as a closed-ended investment trust rather than an open-ended UCITS fund, JRS can hold over 10% in a single security and can therefore take up overweight positions in the largest Russian companies. As of the time of writing, Sberbank, Gazprom and Lukoil each make up over 10% of the index.
The RTS Index, JRS’s benchmark, has struggled this year in the aftermath of the pandemic. However, as we discuss in the Performance section, the Russian economy has weathered the storm relatively well. The drop in global energy prices has been a significant factor behind the index’s underperformance, and this is of course a volatile and cyclical factor. Improving corporate governance in Russian SOEs has been particularly felt in the oil & gas sector, where management have been encouraged to distribute a greater percentage of their profits to shareholders (chief among whom is the Russian state). Payout ratios have risen as a consequence, and JRS’s shareholders have seen a boost to their dividend, which has more than doubled over the past five years.
Energy is a significant part of JRS’s portfolio, although it is actually underweight to this sector versus the index weighting of c. 41%. The emphasis on energy has fallen significantly since the start of the year, when the trust was overweight as first a price war between Saudi Arabia and Russia and then the pandemic negatively impacted the outlook for prices.
While Lukoil and Gazprom remain significant positions, this is balanced by over 10% in the more anti-fragile gold miners Polyus and Polymetal, and by a large position in Yandex, Russia’s equivalent to Google. Like the Belarusian EPAM, Yandex has been a winner from the coronavirus crisis as increasing amounts of economic activity have moved online. Yandex’s food delivery business has had a huge boost from the trend to spending time at home, for example.
Top ten holdings as at 31/07/2020
|X5 Retail Group
Source: JPMorgan Asset Management
The portfolio therefore offers access to a number of global themes and trends, albeit within a Russian context and with Russia-specific risk. The sanctions regime and the country’s authoritarian style of government and desire for independence from the Western system mean that the market contains a lot of national champions which have strong positions in Russia’s large and growing market. Yandex, for example, does not have to face competition from Google. That said, there are obvious risks from this approach to government.
Oleg and Habib are highly active in their approach within the constraints of a highly concentrated index of just 34 stocks. While the active share seems low at 31%, this is deceptive given the highly concentrated nature of the index. It has also been rising as more emphasis has been placed away from energy stocks this year, and the largest of these are the largest companies in the index.
As well as increasing the exposure to technology, in 2020 Oleg and Habib have been tilting the portfolio more towards the domestic economy, specifically those companies with strong positions in the industries which have seen a greater proportion of consumption expenditure. This includes a new position in Detsky Mir, Russia’s largest children’s clothes and toy retailer and one of JRS’s largest overweights, and another in MTS, the mobile operator. Like the British, the Russians have been working from home more, and spending more (particularly online) on home and online entertainment rather than going out.
When we met Oleg recently, he explained that the Russian economy had been relatively resilient. GDP falls of 8.5% in Q2 were substantially better than the c. 12% EU average and the UK’s 20.4%. Oleg attributes this to two main reasons. The first is the relatively restrained actions of the Russian government during the pandemic. School closures were short-lived and efforts focussed more on protecting the vulnerable, allowing more of the economy to remain open for more of the time. Meanwhile, the state offered less direct support to businesses. Secondly, much less of the Russian economy and Russian employment is made up of smaller businesses, which generally have fewer resources to fall back on and fewer sources of lending to support themselves through tough times.
Nevertheless, the short-term outlook for the Russian and global economies is clearly cloudy. As a highly cyclical market, the P/E on the index has been rising in a recessionary period as earnings drop faster than valuations. JRS is now on a higher forward P/E than the index too, although both fund and benchmark are much cheaper than the FTSE 100, for example, which is trading on a forward P/E of c. 20 times (Source: Bloomberg estimates, as at 08/09/2020). The higher ROE (visible in the table below) is also indicative of a slight shift towards growth, which is explained by the reduction in the energy weighting.
Portfolio characteristics, as at 31/07/2020
|Five-year expected growth
|Number of issuers
|Net debt to equity
Source: JPMorgan Asset Management
Oleg and Habib base their stock selection on the fundamental company research done by the emerging markets analyst team. This research focusses on three key areas: economics, duration and governance. Under the ‘economics’ heading the team aim to identify companies with a sustainable return on equity, and also those which are cash-generative, with pricing power and strong balance sheets. Under ‘duration’, they aim to uncover what time frame the business is expected to perform in. This depends on the structure of the industry, any cyclicality in the business and the competitive advantages the company has, as well as environmental and social factors which might threaten long-term performance. Under ‘governance’, they analyse capital allocation and distributions to shareholders as well as whether the interests of management and shareholders are aligned.
Corporate governance is a key consideration, as we discuss further under ESG. An example of this having practical significance came earlier this year when Norilsk Nickel attempted to cover up two environmental disasters: an oil spill and the leakage of toxic waste into Siberia. Oleg and Habib have been selling down their position following the incidents, which have led to a huge fine and huge reputational damage for the miner. This indicates that the attention paid to ESG is more than just lip service.
Clearly the largest macro sensitivity of the portfolio is to the oil price. At below $40 per barrel, the US shale producers are unprofitable, so this period of low prices should help the Russian companies gain a competitive advantage globally. That said, a sustained rise on the oil price could be necessary to see the Russian market outperform. The saying goes: “the cure for low commodity prices is low commodity prices”, and Oleg thinks that a recovery in demand by 2022 will be boosted by production cuts as a response to this period of disruption. In the meantime, the Russian budget for this year balances at $49 per barrel, and so with a significant National Wealth Fund from the good years, Russia has the firepower to come through this crisis. In fact, Oleg thinks that the 15% depreciation in the rouble this year was too much and that there is scope for significant appreciation if the oil price stabilises.
JRS does not generally use gearing and has no loan facility in place. The Russian market is highly volatile – annualised volatility over the past five years has been c. 30% – and the board takes the attitude that gearing would only amplify this and in any case is not necessary to generate high long-term returns.
Russia has been an excellent place to be invested in recent years. JRS’s five-year NAV total return is 152%, considerably ahead of the 130% returned by the RTS Index, JRS’s benchmark. This is far in excess of the returns in a generalist emerging markets strategy: the average NAV total return of the AIC Global Emerging Markets sector is just 28%. Furthermore, Russia is one of those markets where we think it only makes sense to invest in the closed-ended structure thanks to the extreme concentration of the index. This means that open-ended UCITS funds cannot match the weighting of the largest companies on the market because they are restricted to the 10% and 40% rules, and so are structurally underweight to these, irrespective of their attractiveness. As an illustration, in the chart below we display the open-ended fund Oleg runs under the same strategy. Although both are ungeared, the difference in returns is stark, due to the need for the open-ended fund to follow the MSCI Russia 10/40 Index with its restriction on the size of single-stock positions.
Whilst returns have been strong historicallyRussia has been an extremely volatile place to invest too. The annualised volatility of 32.9% on the Russian index is considerably higher than the 20% of the MSCI Emerging Markets Index (both in dollars). While it may seem natural that a single-country market would be more volatile, Russia and its corporates had to cope with a recession following the invasion of Ukraine, a collapse in the oil price and the imposition of sanctions all before 2020 and the emergence of the pandemic. The market’s strong performance reflects the waning of sanction pressure, a rebound in oil prices and improving performance from de-levered corporates.
This arguably put the country and companies in a stronger position to deal with the current crisis. Russia entered 2020 with a large surplus in its National Wealth Fund, and spent only 10% of it in handling the pandemic. In fact, Russia’s total fiscal support amounted to less than 5% of GDP compared to over 20% for the UK, according to the IMF (although these figures do not distinguish spending from guarantees). The fall in annualised GDP in Q2 was 8.5%, considerably better than the EU average of 11.9% and the UK’s 20.4%.
Nevertheless, the market has been hit hard, with the RTS Index down 16.4% year to date (as of the end of August). The MSCI Emerging Markets Index was down just 0.6% over this period. The collapse in the energy price is clearly an important factor, and although Russia’s domestic economy seems less harmed by the pandemic than those of other countries, the market is only likely to recover when the global economy does and with a high beta thanks to the importance of energy and materials.
JRS is down just 13.5% year to date, with the portfolio boosted by its 10%-plus position in gold miners Polyus and Polymetal. The metal rallied hard after the initial market crash, and provides a counterweight to the cyclical exposure through oil & gas. The off-benchmark position in Belarusian company EPAM was another major contributor: EPAM is a software and product design company which helps companies develop digital offerings, and has therefore been a beneficiary of the trend towards homeworking.
The below annual returns chart shows Russia’s strong performance in 2018 and 2019. In this period the new dividend policies of the state-owned enterprises saw rapid appreciation in their shares. For example Gazprom, one of the largest stocks in both the index and JRS’s portfolio, rose roughly 70% in 2019 (in roubles) as a response to the increased payout. The shares have since given up all those gains. We think this sort of re-rating could be on the cards once demand for energy normalises, although we note Oleg thinks demand is unlikely to reach pre-pandemic levels until 2022.
Dividend growth over the last few years has been remarkable. From 14p in 2016 the payout more than doubled to 35p in 2019, and as a result the dividend yield on JRS’s shares is now 5.1%. Dividend growth has been boosted by earnings growth but also by rising payout ratios, thanks to significant political pressure. State-owned enterprises were ordered to lift payout ratios to 25% in 2016 and have been encouraged to lift them to 50% since. Indicating that both board and manager believe high and rising payout ratios are a new permanent feature of the Russian market, in 2018 the formal objective of the trust was changed to a total return objective rather than a purely capital growth objective, and the board stated its intention to pay out substantially all the income received as a dividend.
The impact of the coronavirus pandemic on the income account has not yet been fully felt. The dividend paid in 2020 will be mostly paid from income earned before the crisis hit, and Oleg acknowledges that income will be down for the 2021 financial year. However, Russia did not see the same level of state support to businesses as was seen in the UK or Western Europe, and has not therefore pressured companies to reduce or delay dividends. On the contrary, as a major shareholder of the large energy companies and many other dividend payers, the Russian state has an interest in seeing payouts maintained. Falling demand for oil and gas is the major headwind for JRS’s income account. The board notes that the dividends in the second half of the financial year (ending October) will be reduced. However, the board can pay out of capital if it wishes, and has stated it will supplement the income received with reserves if it finds that to be appropriate from a longer-term perspective.
JRS has been managed by Oleg Biryulyov since 2002. He was joined by co-manager Habib Saikaly in 2018. Oleg has 25 years’ experience, all at JPMorgan Asset Management, making him one of the most senior members of its emerging Europe, Middle East and Africa (EMEA) portfolio management team. He is Russian, so brings to the table local understanding of the country and its culture. Oleg and Habib also manage open-ended funds investing in Russia, emerging Europe and Africa. JRS has substantially outperformed the open-ended Russia fund thanks to the benefits of the closed-ended structure, as we discuss in the Performance section.
Oleg draws on the research of nine JPMorgan analysts who cover the EMEA region. They are divided by sector and sit within the broader emerging markets and Asia Pacific equities research team, which has over 40 analysts, so can debate and share knowledge with their colleagues covering the same sector in a different country or region.
JRS’s shares are trading on an 11.7% discount to NAV, close to that of the average generalist global emerging markets trust (at 11.5%). They have historically been on a much wider discount, with the five-year average extra discount being 4.7 percentage points. This gap has largely been closed by widening discounts on the generalist trusts; JRS, on the other hand, has been trading in the same range it was prior to the March crash (after the initial panic saw the discount widen).
The board has an active discount control policy which since 2018 has committed it to buying back 6% of the share capital each year, subject to market conditions. Buybacks have accelerated following the emergence of the current crisis, with 591,000 shares bought back in the six months to the end of April, and 1,510,000 since then. In total this amounts to 4.5% of the share capital at the start of the financial year.
We think it is unlikely that buybacks explain the difference between the fate of JRS’s discount and that of the average emerging markets trust, however. The high yield (see the Dividend section) and Russia’s relatively strong economic performance (if not stock market performance) may be encouraging investors to hold through the current volatility or increase their exposure to a highly cyclical market at a low point of the cycle. JRS is also the only option for investors who want to access Russia exclusively in a closed-ended structure (although BEE offers exposure to Eastern Europe). There may also be a tender offer next year should NAV total return performance be behind the index between 1 November 2016 and 1 November this year. As of 31 August, NAV total return was exactly in line with the benchmark. Any tender would be for up to 20% of the shares at NAV less 2% costs.
A further discount control mechanism is a continuation vote provision. A vote will be held in 2022 and every five years thereafter. Even if this is passed, shareholders have some protection against a persistent discount.
The latest ongoing charges figure (OCF) is 1.28%, but this is lower than that of the trust’s closest peer, Baring Emerging Europe (BEE), at 1.49%. On the other hand, it is higher than the 1.11% weighted sector average of the AIC Global Emerging Markets sector (JRS is in an AIC sector of its own). The KID RIY is 1.7%, which is also lower than BEE’s 2.13%, although we caution that calculation methodologies do vary. The OCF is measured against net assets, but the management fee of 1% is charged against total assets. Because the management fee is included in the OCF this means that the OCF rises when the trust takes on more gearing and vice versa; although as the trust is not currently geared, this is not an issue at the moment.
ESG is fully integrated into the stock-selection process through the risk assessment which is completed as part of each analyst’s research into each company considered for investment by the managers. The analyst completes a 98-question checklist regarding the risks of investing in each company. Three-quarters of these questions are focussed on corporate governance or other ESG issues, including those regarding emissions, other environmental issues or labour relations. An assessment of these risks is factored into any buy or sell decision, with a greater expected return required for a riskier stock. The managers will also engage with portfolio companies on ESG matters to encourage better practices.
That said, the major issue for many ESG-inclined investors will be the trust’s high exposure to fossil fuel companies and other materials producers with a high environmental impact. This is inevitable given the structure of the market. Oleg and Habib take a constructive view, believing that by encouraging better practices they can help reduce the environmental impact of these industries over time. They also note that gas companies could be major contributors to reducing harmful emissions if they manage to supplant coal, which is still extensively used in China and other emerging countries. A shift from coal to gas would lead to a dramatic reduction of emissions per output. Realistically, they argue, this is a far more likely step towards ameliorating climate change than expecting coal-powered countries to skip directly to wind and solar energy.
In our view, therefore, ESG-minded investors could well consider JRS an appropriate investment. However, a good next step for the trust might be for the managers to report on the incremental changes being made by portfolio companies each year, to allow shareholders greater visibility on the changes being made.