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The great election trade of 1999:
Buy Russian stocks during anti-Russki mass media hysteria!
by James Passin
Bombs... War... Money laundering... Y2K...
The news out of Moscow couldn't get any worse. "Who lost Russia?" is the catchphrase of every armchair curmudgeon with a paucity of ideas and an itch to get on Crossfire. The phrase "Russian stocks" evokes laughter from even hardened international investors...
The CIA, whose Russian expertise includes placing Aldrich Ames in charge of counter-Russian espionage and failing to predict the collapse of communism, has released a "blockbuster" report detailing Russian Y2K vulnerability. This report warranted front-page attention from major newspapers and even triggered a concerned call from my own otherwise cynical and brilliant publisher.
Congress joined the chorus, opening investigations into allegations of Russian money laundering. Of course, this is the perfect tactic for embarrassing Al "give me Chinese money and I'll instruct the Air Force to blow up their embassy" Gore before the presidential elections. "Experts" eat up all the stories about Russian gangsterism and spew out their invective in the New York Times and Washington Post, contributing to widespread anti-Russian hysteria...
Sure. Russia is corrupt and chaotic -- but it's far from the "nuclearized anarchy" described by American politicians. Having traveled throughout Russia several times, I can personally attest that the mainstream's comic book vision of the country is an absurd distortion of reality. Any country that emerges from eight decades of communism and centuries of autocratic rule is going to have problems. But, if all a prominent contrarian "maven" can find wrong with the country in a recent article is the poor tapestry of hotels, I remain convinced that the masses are missing an epic opportunity for wealth-enhancement.
Let the girlies run
The endless barrage of bad news has destroyed sentiment towards Russian stocks. However, the fundamentals in Russia are excellent. The recovery in oil prices is a tremendous boon for the Russian economy. Other commodities, including copper, nickel, platinum, and lumber, are also strong -- keeping the economy liquid and trade balance growing.
Benefits of the 1998 currency devaluation are still flowing through the economy, as ruble costs have plunged for manufacturers. The default on government paper completely eliminated the debt burden from the economy. Once the negative sentiment washes over, the strong economic fundamentals should support a super-bull market in Russian equities.
The catalyst for a bull market in Russian stocks is the election cycle. Duma elections are coming up in December, and presidential elections in 2000. You can almost never go wrong buying emerging market stocks in front of an election. (You would have doubled your money on Indian stocks over the last twelve months if you bought before the elections.) Following the election, Russia should get re-rated to the same "normal" emerging market status awarded to other vigorously corrupt countries -- like China or Venezuela.
It's all about the benjamins
The "money laundering scandal" is a U.S. media invention. There is capital flight out of Russia, but the phrase "money laundering" is a misnomer. It implies that the money is generated from illegal or "dirty" activity and needs to be "washed" into legal or "clean" activity. And "scandal" implies an element of surprise. No one in Russian is surprised by allegations of corruption.
 Yes, there is gangster activity in Russia. But oil, gas, and metal exporters are the big money makers. The Russian money that is flowing through Bank of New York and other accounts mostly results from legal, if unethical, "transfer pricing" schemes. Basically, transfer pricing is a means for management or controlling shareholders to extract cash from a company without compensating minority shareholders. Also, it's a means of avoiding taxes. It should be illegal. But it's not "money laundering."
The "money laundering scandal" is a clear sign of the incredible profitability of Russian exporters. And outright looting is not a sustainable business practice: companies that reinvest in their assets (like SGTZY) or make acquisitions (like LUKOY) have a sustainable generator of cash and access to capital markets.
Plenty of gangster/manager/bankers have fled Russia with misappropriated booty. You can see them in Soho, Miami, or on the Riviera, buying rare art, nightclubs, and villas. They usually have two or three doe-eyed blonde vixens at their side. And enough gold jewelry to close out Ashanti's hedge book.
I don't know why Russian gangsters get more "props" than Colombian or Vietnamese mobsters. But the Russian nouveau riche is outrageously gaudy. Russian gangster expats and their dolled-up wives and mistresses are universally scorned for their detestable manners (not that I'm any better). There's only one place that the Russian nouveau riche can get the "respect" they desperately desire: Mother Russia. I anticipate that the flight capital will return to Russian as the Slavic exodus is socially rejected by the world's entrenched elite. This trend will help support Russian asset markets.
Yeltsin forever
In December, a new Duma (or parliament) will be elected. While I find the vagaries of Russian politics to be boring and inscrutable, the election in itself is highly significant. No matter what party wins the most seats, the reform-friendly centrists will gain seats at the expense of communists and reactionaries.
Doomsayers predict that Yeltsin will declare martial law and suspend the 2000 presidential elections. I find this hard to believe. I'm not a psychic, but I would suspect that Yeltsin wants to be remembered in history books as the father of Russian democracy (and he also wants a big fat bank account in Switzerland, total immunity from prosecution and a lifetime supply of vodka on the side). The political bickering will be vicious, if not violent, during the election campaign. The vote counting will be rigged. But the presidential election is likely to occur...
A new president... a reform-friendly Duma... a new era in Russian history may be imminent... if oil prices remain robust, Russia should be one of the top performing markets in the world in 2000!
World class oil giant
Lukoil (LUKOY - OTC) is the Exxon of Russia. Lukoil's oil reserve base is massive. On a consolidated basis, LUKOY owns an estimated 18 billion barrels of proven + probable oil reserves -- more than the combined reserves of Chevron, Texaco, Arco, and Elf Aquitaine. LUKOY produces 9 million barrels of oil per annum. And LUKOY's refining operations are massive, with an annual refining capacity of 2 million barrels. In terms of reserves, production, and refining, LUKOY is one of the top ten oil companies in the world.
But LUKOY isn't just an asset story. It's an earnings story. LUKOY will generate a projected US$1.5 billion in net income in 1999. LUKOY's low cost structure (costs are in rubles and sales are in dollars) and strong balance sheet (debt/equity is only 12%) let the company convert its monster assets into shareholder value. Unless there's another crash in oil prices, LUKOY's current US$5.2 billion market cap is going to look like a joke in one to two years.
At current levels, Lukoil is trading at just 4x earnings, 3x EBITDA, and US$0.39 per barrel of reserves. Despite the rally in oil prices, Lukoil is trading at just US$30 per ADR, more than 70% below the 1997 peak.
Bad to the bone
The most leveraged way to play LUKOY is Lukoil Preferred (LUKPY-OTC). The preferred stock is just like the common, except that you don't enjoy voting rights. If Lukoil misses a dividend payout to preferred stockholders, then the preferred stock is automatically converted into common.
Voting rights mean almost nothing in Russia. If management wants to screw you, they'll find a way to screw you. Proxy fight are worthless in a country where contract disputes are settled with assassinations. Even if you are a common shareholder, you may not be able to get into the annual general meeting (I personally experienced this with Surgutneftegaz in May 1998).
Lukoil Preferred (LUKPY) trades at a preposterous 60% discount to LUKOY. There's no reason for LUKPY to trade at such a steep discount. Historically, LUKPY has traded at an average 30% discount to LUKOY. Just to return to the average discount, LUKPY would have to double in price.
1 LUKPY ADR = 2 Lukoil preferred ADR shares. To compare the preferred to the common, you have to multiply the preferred ADR price by two. LUKPY is currently trading at US$6, which equates to a US$12 ADR price. LUKOY is trading at US$33. The discount is excessive.
Preferred stockholders are entitled by the company's charter to 10% of net profits. There are 77.2 million preferred shares outstanding. If LUKOY generates US$1.5 billion in net income, preferred stockholders would be entitled to US$150 million cash dividend, or US$1.94 per share or US$0.97 per ADR. This would imply a dividend yield of 17% to preferred ADR holders. Theoretically, you can't lose: either management pays out the 17% dividend, or your preferred shares are converted into common (immediately recapturing the 60% discount).
Of course, management will probably use fancy accounting tricks to lower the dividend. But if Lukoil pays out zero dividends, you shares will be converted into common stock! LUKOY is making acquisitions with preferred stock, so there will be some dilution to preferred shareholders. However, LUKOY is generally making accretive acquisitions that add value to the company.
If LUKOY rallies to US$60 and the discount contracts to 30%, LUKPY will rally to US$21. This is 260% above the current price. If LUKOY eventually returns to the US$100 level and the discount contracts to 15%, LUKPY will rise 640% to US$45.
The preferred stock is relatively illiquid. However, if you're going to tie up money in Russian stocks over the long term, illiquidity is not a big deal. LUKPY gives you maximum "bang for your buck" if LUKOY rallies.
Lukoil Preferred trades on the Pink Sheets under the ticker LUKPY. I rate LUKPY as an extremely high risk, illiquid, long-term Speculative Buy under US$7 with a one- to two-year target of US$20+. You can track LUKPY for free on the following website: www.adr.com.
If you need a broker who can trade LUKPY, I recommend contacting Peter Schiff, Euro Pacific Capital, 330 Washington Blvd., Suite 511, Marina Del Ray, CA 90292, tel. 310-448-8000, tel. 800-727-7922, fax. 310-448-8008.
James Passin is a Portfolio Manager with Firebird Management and Contributing Editor to Taipan. Several funds managed by Firebird are currently shareholders in Lukoil common and preferred. James Passins' views are strictly his own and not necessarily the views of Firebird Management or Taipan.
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