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Outlook for Russian and former Soviet Union stocks
 I am rabidly bullish on Russian stocks. A powerful, lasting rally has already begun. Strong oil prices and the imminent presidential elections are unequivocal positives that are not fully discounted by the market. Bearish sentiment by misguided foreign investors is setting up for an unbelievably explosive rally.
Russia is one of the world's top performing markets in 1999, up over 90% year-to-date. I expect this outperformance to continue in 2000. You can almost never go wrong buying an emerging market in front of an election (India was the last great election trade).
Lukoil Preferred ADR (LUKPY-OTC)
Russia began an explosive rally within two weeks after I initiated coverage on Lukoil Preferred (LUKPY-OTC). Lukoil is considered a top-tier Russian stock--and is an excellent proxy for the market. A world-class, vertically-integrated oil giant, Lukoil even owns branded filling stations in the U.S. Foreign investors jump into Lukoil when they decide to enter the market. At 4x earnings, Lukoil is still dirt cheap.
Lukoil Preferred is an excellent vehicle for playing Lukoil common stock. LUKPY is just like the common, except that you don't get voting rights--and have preferential treatment to dividends. According to the bylaws of Lukoil's charter, 10% of holding company profits will be paid out to preferred shareholders as dividends.
 Analysts estimate that Lukoil could generate over US$1.8 billion in profits in 1999. Historically, profits at the holding company level have equaled 70% of consolidated profits. This would imply a distributable dividend of US$3.25 per ADR--equating to a massive dividend yield of 44%!
Unfortunately, Lukoil declares the dividend in rubles (even though the profits are mostly in dollars)--and can wait almost a year before distributing the dividend. You need to discount for the probable devaluation of the ruble. If you knock 40% off the dividend (which is conservative), you would still be entitled to a theoretical dividend of US$1.95 per ADR-- a generous dividend yield of 27%!
Discounting for the time value of money with Russian interest rates, the net present value of the dividend is US$0.78 per ADR, a dividend yield of 11% (in my view, this analysis is much too conservative). And management could use fancy accounting tricks to lower the dividend. Even if the dividend is reduced by 50%, you'll still get a 6.5% dividend (discounted to the present).
Whether the present value of the dividend is 6.5% or 44%, you are still buying an income-generating asset at a huge discount. LUKPY trades at a glaring 60% discount to the common stock. Since voting rights mean almost nothing in Russia, the discount is unwarranted. Historically, the preferred stock trades at an average 30% discount to the common. If Lukoil failed to pay a dividend to LUKPY shareholders, LUKPY would acquires voting rights and would be converted into de facto common stock.
If you hold LUKPY for a year, you could receive a cash dividend yield of 27% or higher. (Russia will impose a 20% withholding tax on the dividend. If you are a U.S. citizen and hold the stock in a taxable account, you should receive a tax credit.) At the same time, the discount to common is likely to contract to 30%. If the underlying common stock rallies (and I believe Lukoil common could double in 2000), LUKPY could rally 4x in twelve months--before dividends.
 Surgutneftegaz ADR (SGTZY-OTC)
Surgutneftegaz (SGTZY-OTC) is unequivocally the best-run company in Russia. SGZTY has grown oil production every year since 1995--even during the 1998 oil crisis! Unlike most other Russian oil companies, SGTZY has reinvested in its physical assets, while refraining from transfer-pricing and other asset-stripping schemes.
Analysts estimate that SGTZY will generate almost US$1 billion in net profits in 1999. And SGZTY is sitting on a US$1.5 billion cash hoard--with absolutely no long-term debt. SGTZY's US$4.6 billion market cap is ridiculous.
In 1998, SGTZY secured PSA approval (production sharing agreement) for a major undeveloped oil field. The PSA agreement establishes the maximum tax rate that the Russian government can levy on sales or profits generated from the field. This gives SGTZY security against any adverse changes in the government following next year's presidential election.
I initiated coverage of SGTZY when it traded in the mid-US$7 range in early 1997. SGTZY has subsequently traded as high as US$16 and as low as US$0.78. If you averaged down into the Russian crisis, you made a killing on the rebound. SGTZY is currently trading around US$9.
Over the next twelve months, I expect SGTZY to re-test its 1997 peak. Fundamentally, SGTZY has never been stronger. Costs have been radically reduced by the ruble devaluation. Global oil prices are robust.
My three- to five-year target is US$30.
Please read on...
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