Meet the Russia Bulls

Where some investors see escalating risks, others see bargains.

As Russia's standoff with the West over Ukraine unfolded, with mutually detrimental sanctions flying back and forth further darkening the country's already dim economic outlook, many people couldn't get their money out fast enough.

In the first six months of 2014, the Russian government reported that $75 billion was moved out of the country -- more than in all of 2013. Other estimates put that number, which captures not only investments but also Russians moving their money out of the ruble, even higher. The European Central Bank said in May that about $220 billion in capital had flowed out of Russia so far in 2014 and President Barack Obama said Aug. 6 that between $100 billion and $200 billion had shifted out of Russia since the conflict began. In July, Malaysia Airlines Flight 17 was shot down over eastern Ukraine, deepening the conflict and raising fears about the unpredictable ways it could affect the global economy. At the end of July, the United States and Europe responded with the toughest sanctions yet targeting Russia's energy, defense, and banking sectors. Investor concern over Russia was running so high by that point that index provider MSCI Inc. created a separate emerging markets investment benchmark without Russia for investors who wanted nothing to do with the country.

But that kind of pessimism smells like opportunity to some investors.

Investment from U.S. funds fell from $42 billion at the end of last year to $37 billion at the end of March, according to data provider eVestment. By the end of June it was back up to almost $41 billion. That number could climb even higher as more funds report.

Alexander Branis, director of Prosperity Capital Management (RF) Ltd., one of the largest hedge funds focused on Russia, says investors have pulled out about 5 percent to 7 percent of the $3.4 billion fund recently. A much smaller group, though, is putting more money in. Russia, he says, is cheap now.

"We have clients that have added to their portfolios: one U.S. university endowment, one large pension fund from Northern Europe," Branis told Foreign Policy from Moscow.

"If you focus on the long term, you have potential to make a lot of money."

Started in 1996, Prosperity has always focused on Russia, with only 10 percent to 15 percent of its assets in Ukraine and Kazakhstan. Branis says this latest kerfuffle over Ukraine isn't changing their strategy; in fact, they've weathered far worse economic times in Russia. Nonetheless, the firm has suffered. At the end of July, the company's flagship Russian Prosperity Fund was down 7.3 percent from the beginning of the year, though Branis noted that is a better return than funds based on the broadly used MSCI Russia index produce.

The firm could see even harder times if the United States and Europe expand sanctions in response to Russia's support of separatists in eastern Ukraine. Branis said his firm owns some Sberbank stock, which is already sanctioned. The bank was barred from issuing new debt or equity in Western markets at the end of July. But Branis doesn't expect that the bank's existing debt and equity will be targeted because it would hurt shareholders more than Moscow. That's not his only reason for brushing off sanctions -- Russia is not as blameworthy for the conflict as officials in Kiev and Washington suggest, he proffered.

"I don't think there is a lot of credible evidence that implicates Russia," Branis said. "I don't think there is something so credible that you could base the next round of sanctions on it."

The Russia-based funds are not alone in their bullishness. Kopernik Global Investors, a Tampa-based firm started just last year, is also betting on Russia. Founder Dave Iben told Bloomberg he was buying Russian stocks he saw as trading at half of what they're worth. The firm's flagship $890 million mutual fund has 15 percent of its assets in Russian companies, including 4 percent in Russian energy giant Gazprom and 3 percent in Sberbank. Iben spelled out his philosophy on Russia in a recent conference call.

"I believe that when people get really, really, really negative on something it almost always proves to be overblown," he said, according to a transcript of the July 23 call. "And now there's a lot of emotion in Russia. I'm not saying it's wrong. I'm saying I suspect time will show that it's overdone."

Wade O'Brien, senior investment director with U.S.-based Cambridge Associates, said it makes sense that value investors with long-time horizons are scooping up Russian assets while everyone else is selling them.

"When something that was already fairly inexpensive on a relative basis sells off sharply on the basis of macroeconomic concerns, it's not unusual that value funds will go in and buy stocks," O'Brien said.

Other money managers aren't pulling out of Russian investments entirely, but are shrinking their stakes. The head of a smaller fund based in London, who didn't want to be named, said he reduced Russia investments from 15 percent to 5 percent of the portfolio. However, he will continue investing in Russia, unless Europe slaps more restrictions on Russia or Moscow limits how much money can leave its borders.

"We're always reassessing things, but as long as they don't do anything that precludes our ability to operate, we would do it," he said.

Still, most investors are focusing on the overall economic picture in Russia, which is bleak. Economists worry that President Vladimir Putin's retaliatory sanctions are driving a faltering economy closer to recession. On Aug. 7, the Kremlin banned some U.S. and EU agricultural products, heightening fears that the country, which imports 40 percent of its food, could see prices spike. On Aug. 11, the Russian government reported that the economy had its worst quarter in over a year, as growth continues to slow. Russian GDP expanded only 0.8 in the second quarter of 2014 compared to the same time last year, Bloomberg reported Aug. 12. The Russian Micex stock index is down 6 percent from the beginning of the year.

Although some investors are making contrarian bets, said Tim Ash, head of emerging-markets research at Standard Bank Group, buying into Russia long term is not a common strategy.

"I think other investors are just seeing this as a paradigm shift in the Russian story -- negative," Ash said. "The relationship with the West has been significantly damaged, and will be difficult to rebuild."

The result will be a less friendly environment for foreign businesses and declining investment and growth, Ash said.

Money managers are also constantly changing strategies as the Ukrainian crisis unfolds. Therefore, its full effect on foreign investment in Russia might not be clear for months. Investment research firm Morningstar estimates that U.S. funds allocated just 1 percent of their assets to Russia at 2013's end; that amount fell only slightly by the end of June.

Some money managers who earlier this year saw opportunity are now shifting gears. Luz Padilla, head of the emerging-markets group at DoubleLine, oversees about $3.6 billion. Her emerging-markets bond fund grew 11.2 percent between Aug. 1, 2013, and Aug. 1, 2014, beating returns posted by 96 percent of her peers, according to a Bloomberg analysis.

At the end of March, she saw potential as Russian assets' prices fell after Putin annexed Crimea. She told Fortune magazine that she boosted the funds' holdings of Russian bonds by a full percentage point after the West first sanctioned Russia in March. But then DoubleLine analysts attended IMF meetings in mid-April and conferred with Russian experts, leading her to reverse course. Mark Christensen, who helps manage the firm's emerging-markets portfolio, said the Russian banks and economists he spoke to changed his mind.

"Despite the rebound in the market, they still anticipated that the crisis was going to last longer than people were expecting," he told Foreign Policy. "We just came to the conclusion that the Russia/Ukraine crisis and the price volatility wasn't going to go away anytime soon."

By the end of June, Christensen and his team had reduced the funds' exposure to Russia drastically, to less than 2 percent from more than 13 percent at the end of last year.



Poached Salmond

Offshore energy fueled Scotland's dream of independence. The eclipse of North Sea oil and gas is killing it.

Scotland's push for independence is in the homestretch, with a much-awaited televised debate on Tuesday and a final vote on whether to leave the United Kingdom slated for mid-September. But if the prospect of oil and gas riches helped drive the push for Scottish independence, the bleak reality of what's really offshore is dooming the effort.

The Scottish National Party is banking on years of offshore oil income to fund its dream of an independent state. However, sober assessments of the limited bounty available from Britain's North Sea oil and gas reserves undercut both the SNP's energy promises and, by extension, much of its ambitious political program. Independence isn't advancing in the polls; the latest surveys show about a 14-point lead for remaining part of the U.K.

"If you don't believe the big numer they present in terms of revenues they can bring online from natural resources, it calls into question everything else the SNP has put forward about what they're looking to achieve," said Mujtaba Rahman, the head of Europe for risk consultancy Eurasia Group.

Scottish independence movements date back centuries, ever since the crowns were united in the early 18th century. The discovery of oil and gas in the North Sea off the Scottish coast in the 1960s renewed such efforts; indeed, "It's Scotland's Oil" became a populist rallying cry during a decade of strong electoral success for the SNP.

Alex Salmond, head of the SNP for the second time, has used Scotland's increasing autonomy --such as the recent formation of a parliament -- to push for a total break, promising voters there will be plenty of gain and little pain in leaving the U.K. The Proclaimers' paen to Scottish independence, "Cap in Hand," is the movement's unofficial anthem (immortalizing just how lowly Stranraer lies).

The Scottish question has implications beyond the United Kingdom. European countries are watching closely for signs of what might happen in their own restive regions, especially Spain, which is dealing with a similar independence push from the northeastern region of Catalonia. NATO is carefully watching: the U.K.'s nuclear sub fleet is homeported in Clyde.

All year, the leader of the SNP has been laying the groundwork for the crucial yes-or-no referendum slated for Sept. 18. Salmond toured Washington, D.C., and New York earlier this year to make the case for why an independent Scotland is both sensible and viable. The key pillar of his whole project? North Sea oil and gas that turned cities such as Aberdeen into bustling capitals of European energy production.

Speaking at the SNP conference this spring, Salmond pointed to the oil rigs and oil-service vessels plying nearby harbors as Scotland's ticket to independence. "The oil, and the tax revenue, will continue to flow. What a shock this scene must be for the opponents of independence," he said.

Last year's white paper, which serves as the movement's intellectual blueprint baldly states that Scottish independence will be underwritten by decades of oil and gas royalties. This summer, an expert commission outlined ways to "extract every last drop" from the fields--and the money.

The SNP's latest estimate is revenues will hit 48 billion pounds through 2018; profits from Scottish waters came to 10.6 billion pounds in 2011-12. What's more, the SNP tells Scottish voters that the North Sea will provide even more oil and gas. "The industry (will) continue to make a substantial contribution to tax revenues for decades to come," the SNP's website promises.

There's just one problem: Aging fields have long threatened the North Sea's long-term production. The U.S. Energy Information Administration says that U.K. oil production peaked in the late 1990s at about 3 million barrels daily, plummeting to about 800,000 barrels today. In 2013, the U.K. became a net importer of petroleum products for the first time since 1984.

Adding grist to the independence debate, the latest estimates by the U.K. Office of Budget Responsibility predict even less future oil and gas revenue. Some Scottish nationalists have taken issue with the OBR report, given the timing of its release by London.

"Oil and gas receipts are on a declining trend as total production from the U.K. continental shelf moves towards its ultimately recoverable capacity," the report concluded.

As a result, the OBR slashed its receipts estimate by one-quarter--now a paltry 40 billion pounds of tax revenue between 2020 and 2040. The report further stated that governments cannot expect that revenue to cover even current budgets, let alone the pension requirements of an aging population. This comes as the SNP campaigns for a bigger welfare state in an independent Scotland.

"The energy question is important because it feeds into the big question of what the financing of an independent Scotland would look like," said Eurasia Group's Rahman.

The disconnect between the SNP's lofty ambitions and what looks to be dwindling means to achieve them "raises questions about how credible the plans are for independence," he said.

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