Controversy about Russia’s government and its past treatment of foreign investors can turn off investors but valuations of strong, cash-generative companies are extremely attractive and cannot be ignored, an investment trust manager says.

The Eastern European Trust, a closed-ended vehicle with £118 million ($184 million) of gross assets (source: Trustnet), which is overseen by BlackRock, has increased holdings of Russian equities to 62 per cent of the entire portfolio (as of the end of April) from about 48 per cent in December last year.

And Sam Vecht, who helps run the fund, says the East European sector deserves more positive treatment in general.

“Russia’s investment climate is improving; recent data points have indicated that Russia is in robust economic health, and has recorded record-low inflation thanks to improvements in monetary policy,” Vecht told journalists in a recent presentation.

As far as Eastern Europe as a whole is concerned, including the CIS region, Vecht said that markets are “desperately undervalued” and given the plenitude of strong growth stories in some sectors, the market represented a strong bullish opportunity in his view.

“In the context of this supportive background, we are investing in 'hidden gems': investment ideas with great potential and undeservedly low profiles. The wealth of investment opportunity is perhaps exemplified by the diverse span of such companies, from the Russian internet to Turkish gold mining, from pharmaceutical innovation in Hungary to shale gas in Poland,” he said.

Valuation extremes

To illustrate why emerging market assets are so cheap compared with those of Western Europe, Vecht produced a chart showing that, when looking at asset class history in percentiles, German bunds are the most expensive, at 1.0, while emerging market equities are just 0.06. Asian equities have a figure of 0.24, Latin American equities at 0.37 and US equities at 0.41. European equities are 0.15 (source: Bloomberg, DataStream, BlackRock).

Gazprom is 9.6 per cent of the fund’s portfolio and is its joint biggest single investment along with Lukoil. In the case of Gazprom, it delivers a dividend yield of 6 per cent and is very attractively valued, he said.

“The Russian market has gone down a bit…but we are more bullish on Russia than at any time since we took on the fund three years ago,” Vecht said.

Behind Gazprom and Lukoil, in second place by share of portolio is Sberbank, at 8.8 per cent, then Novatek, at 5.8.

Energy figures considerably in the fund’s holdings; Vecht said he dislikes consumer sector firms at the moment, such as retailers. Pharmaceuticals are a sector that are worth considering, he said.

A sign that Russia’s stock market is undervalued can be seen by the number of share buybacks made by firms in recent times, such as Lukoil, Novatek, Sistema, Dragon Oil, Severstal, Rosneft and KMG. In each case, the purchases have been more than $100 million, with some buybacks considerably greater than that, Vecht said.

Vecht contrasted the run of negative stories - such as credit downgrades - on Western European countries and companies, with the upgrades on central/Eastern Europe. For instance, in May, S&P upgraded the credit ratings of Latvia; in April, the ratings agency hiked its outlook for Belarus. Earlier this year, the agency cut ratings on nine eurozone countries. 

The BlackRock-managed fund, which can take short positions in securities, has a 10 per cent limit (as a share of the entire portfolio) of those stocks it can short; at present, the short part of the portfolio is 4 per cent, having been as high as 10 per cent. Gearing in the fund is capped at 15 per cent. Since inception of the fund on 30 April 2009, the fund has delivered total returns of 88.3 per cent, outpacing the MSCI Emerging Europe 10/40 Index (data as of 30 April this year).