Russian Small-Cap Investing: Three Reasons to "Think Small"

By , Money Morning • May 17, 2011

It is the world's largest landmass by a vast margin with 6.6 million square miles. At the other end of the spectrum is Vatican City at only 0.17 square miles.

With Russia you think of giant companies like Gazprom OAO or Lukoil (PINK: LUKOY), controlled by oligarchs in Moscow. The country provides a shining example of the challenge facing investors trying to tap into its potential opportunities.

It has provided limited investment choices, until now...

Investing in Russian ADRs and Pink Sheet Blue Chips

There are mutual funds. Then there are Russian companies that trade on U.S. exchanges as American Depository Receipts (ADRs). There are currently just five ADRs:

• Mechel Steel (NYSE ADR: MTL)
• Mobile TeleSystems OJSC (NYSE ADR: MBT)
• Rostelecom OAO (NYSE ADR: ROS)
• VimpelCom Ltd. (NYSE ADR: VIP)
• Wimm-Bill-Dann Foods OJSC (NYSE ADR: WBD)

There are an additional 37 Russian companies listed over-the-counter (OTC). These "pink sheet" listings are part of a growing trend for even the largest companies like Gazprom and Lukoil, which seem eager to avoid the high cost and regulatory burdens of the big board.

Picking through this list to find the "pink sheet blue chips" takes patience, skill and judgment. My advice: Be careful.

Then there are exchange-traded funds (ETFs) that trade like a stock as a basket of Russian stocks. The highest profile is the Van Eck's Market Vectors Russia ETF (NYSE: RSX) with energy and basic material companies accounting for 68% of its assets. RSX has $4 billion in assets, and 95% of the companies in the basket have a market value greater than $5 billion. RSX is up approximately 20% over the past year.

Three Distinct Advantages of Investing in Russian Small-Caps

But perhaps the best way to invest in Russia is to first change your perspective on the country in the first place. Maybe it's time to think small in Russia. Many small-cap Russian companies offer three distinct advantages over the better-known giants:

• Private Ownership and Control: Government ownership and support comes at a high price. Smaller private companies fly a bit under the radar. They also tend to be more nimble and have the opportunity to grow faster. State-owned and controlled companies can hit speed bumps as the government changes regulations or priorities. With $100 plus oil, Russian energy giants may seem like the place to be, but keep in mind that Moscow raises tax rates as oil and other commodity prices increase. This is a direct hit on profitability and share prices.

• Broader and Deeper Play on Domestic Growth: Even marginal market reforms have and will continue to create winners outside of energy and commodities. The tax revenue from higher commodity prices filters back into the domestic economy, sort of like a perpetual stimulus program. Smaller cap companies in a wide variety of industries are poised to capture this demand and turn it into profits for shareholders.

• Less Research Coverage and "Discovery" Potential: Like small caps all over the world, Russian small caps are largely unknown and are covered by analysts only sporadically. As a test, look at the list of the ten largest Russian small caps below. If you recognize more than a few, you probably hail from Russia. The top ten holdings are:

Up to now, it has been difficult to invest in these Russian cubs. This is why Van Eck's new Russia small cap ETF (NYSE: RSXJ) is attracting a lot of attention.

RSXJ offers good diversification with a 35% weighting in energy and materials, leaving more room for allocations to utilities (18%), industrials (15%), health care (8%), and other consumer (18%) sectors.

Finally, Russia is not only big, but pretty cheap as well. Russia's stock market is trading at just seven times earnings, reflecting a significant discount to the emerging markets index. In addition, Russia now trades at a 40% discount to the MSCI Emerging Markets Index, while India is at a 44% premium.

This article was originally published on Investment U

News and Related Story Links:

• InvestmentU:
  Russian Small-Cap Investing: Three Reasons to "Think Small"
• Money Morning:
  Emerging Markets Forecast: Which Ones to Hold, and Which Ones to Fold
• Money Morning:
  Russian Oil & Gas Sector Headed for Major Shakeup
• Money Morning:
  Russia: Is it Time to Invest in One of the Coldest Countries on Earth?