1. 09 July 2012
EQUITY RESEARCH
For professional investors only. This document has not been prepared in accordance with legal requirements
designed to promote the independence of investment research. Please refer to important disclosures and
analyst certification at the end of this document
ALEXEI YAZIKOV +7 (495) 213 0340
alexei.yazikov@aton.ru
STRATEGY
The 2008-09 financial crisis and the subsequent collapse in the global economy
exposed Russia’s structural weaknesses and the fragility of the institutions that
underpin its corporate governance practices. With Russia’s key valuation metrics
contracting to levels unseen in other emerging markets and capital flight intensifying
it is becoming increasingly evident that among other concerns, governance issues
are coming to the fore of investors’ attention.
With this in mind, we have conducted an extensive analysis of the corporate
governance quality of the 111 stocks in our research universe and assigned a
corporate governance score (CGS) to each of them. We found that corporate
governance quality remains one of the key non-financial factors affecting stocks’
performance and the risk level of the portfolio. Our work focuses almost exclusively
on governance issues and our conclusions are based on our own assessment of the
corporate governance quality of the companies under coverage. Therefore, it should
be interpreted exclusively in this light.
Our research is not driven by any idealistic or political issues: we found that
focusing on corporate governance enhances investor returns while reducing the
non-financial risk of investments. We emphasise that this is not a penny-pinching
exercise aimed at delivering a few basis points of outperformance to the investor
portfolio – our back-testing shows that the Russian stocks in the top quartile of our
CGS rankings outperformed the lower quartiles of the portfolio by 60-90% and the
RTS Index by approximately 55% over the last three years.
In our view, the next decade will be marked by increasing competition for capital
among emerging market nations. Many emerging economies have exciting growth
prospects and investment opportunities; however, among the decisive factors in
investment capital allocation, the development of local financial markets, investor
protection and corporate governance standards stand out. Given the high
dependence of the Russian equity markets on foreign capital flows, Russia must
begin to pay closer attention to the issue of governance.
For now, Russia is falling behind DM and many of its EM counterparts on all of
these issues and international investors seem to be increasingly cautious on Russia,
while pricing local equities at a substantial discount to peers. This is not to say that
Russia does not offer a significant investment opportunity: on the contrary, Russia's
discount suggests potentially outsized gains, but only if and when a substantial
structural reform gains momentum. By merely halving the discount to EM markets
(all else remaining equal), Russia’s market capitalisation could potentially jump by
1.5x. Of course, CG risk is not the only factor depressing Russian valuations, but it is a
significant one and Russia’s leaders as well as corporate management should take a
pragmatic view of the issue or abandon attempts to attract international capital in
sufficient quantities. Without change, Russia risks being stuck in a vicious circle of
half-baked reforms, ineffectual regulation and economic policies, poor corporate
governance and value-destroying corruption, and will forever remain the land of
unrealised opportunities.
Faulty Powers
CORPORATE GOVERNANCE
xFigure 1: Stocks in top quartile of
corporate governance rating
Company
MktCap
($mn)
CGScore
VimpelCom 12,570 7.3
NLMK 10,380 7.3
Magnit 12,305 7.3
M.Video 1,226 7.2
X5 Retail Group 6,029 7.2
CTC Media 1,318 7.2
MTS 17,399 7.2
MMK 3,091 7.0
Evraz Group 5,686 7.0
Severstal 12,384 6.9
Petropavlovsk 1,459 6.8
C.A.T. oil 313 6.8
NOMOS 1,994 6.8
NOVATEK 31,327 6.8
Mail.Ru 6,742 6.7
Yandex 5,775 6.7
Vozrozhdenie 365 6.7
Polymetal 6,321 6.6
LSR 1,723 6.6
EDC 3,745 6.6
Sollers 441 6.6
TNK-BP 33,756 6.6
BASHTEK 9,867 6.6
Sberbank 58,166 6.6
Transcontainer 1,389 6.5
Globaltrans 2,807 6.4
Integra 272 6.4
Uralkali 22,968 6.3
1 quartile total/avg 271,819 6.8
Source: Bloomberg, Aton estimates
Figure 2: Stock performance by quartile
quartile rank outperform the market
Source: Bloomberg, Aton estimates
Note: Prices as of close 1 July 2012 throughout the
report
2. 2
Russian Corporate Governance in the Country Context
The cost of dishonesty, therefore, lies not only in the amount by which the
purchaser is cheated; the cost also must include the loss incurred from driving
legitimate business out of existence.
George Akerlof, The Market for Lemons: Quality Uncertainty and the Market
Mechanism, 1970
The 2008-09 financial crisis and the subsequent collapse of the global economy
exposed Russia’s structural issues and the weakness and fragility of the institutions
that underpin its corporate governance practices. With Russia’s key valuation
metrics contracting to levels unseen in other emerging markets and capital flight
intensifying, it is becoming increasingly evident, in our view, that among other
concerns, governance issues are coming to the fore of investors’ attention.
Russia competes with all other emerging markets for capital from foreign
investors. Many emerging economies offer exciting growth prospects and
investment opportunities, but among the decisive factors in investment capital
allocation, the development of local financial markets, investor protection and
corporate governance standards stand out.
Corporate governance remains one of the key factors constraining Russia’s
attractiveness to foreign capital providers and, in particular, potential long-term
shareholders. For most investors in Russia, assessing corporate governance can be
fairly difficult because there is insufficient objective information available on
governance infrastructure and a lack of company-level analysis of corporate
governance quality. Only a handful of Russian companies have received corporate
governance assessments from S&P (mostly outdated), while most shy away from
exposing flaws in their internal governance structures. The absence of sufficient
information increases the perceived and real risks of investing and investors simply
apply the most conservative discount possible to reflect the cases of acute violations
of minority rights, while overlooking the more positive track record at many
companies. In this way, they penalise Russian stocks and the country as a whole via
an elevated cost of capital. The overall effect of the spread of bad corporate
governance is therefore risk contamination.
For most of the last decade, Russia has traded at a significant discount not only to
developed markets, but also to its emerging market peers. More disconcerting,
however, is the fact that over the last three years, the Russian market seems to have
been de-rated: the discount has considerably widened and is currently well below its
long-term average.
3. 3
Figure 3: Russia’s discount to DM and EM (based on fwd 12M P/E)
Source: Bloomberg, Aton estimates
Figure 4: Russia’s current valuations vs EM (based on 12M forward P/E)
Source: MSCI, Bloomberg, Aton estimates
We are not claiming that Russia’s discount can be entirely attributed to governance
issues. However, since headline GDP growth fell from an average of 7% in 2000-08 to
4-4.3% in the last two years, corporate governance issues and other risks suggest
that exposure to Russian equities may no longer be worthwhile. Indeed, it seems
that foreign investors are becoming more concerned over these risks than with
macroeconomic growth prospects. To this should be added Russia’s dependence on
foreign capital flows and foreign commodity demand, which positions it as a price
taker for cost of capital and for its major export commodity, oil. These factors make
the local economy extremely volatile and sensitive to shifts in the global risk profile.
-80%
-70%
-60%
-50%
-40%
-30%
-20%
-10%
0%
Jul-07 Sep-08 Nov-09 Jan-11 Mar-12
RU/DM
RU/EM
RU/EM disc. avg
RU/DM disc. avg
4.6
7.4
8.2
8.5
9.1
9.6
9.7
9.9
10.0
10.2
10.6
11.0
11.4
11.9
12.8
12.8
13.6
14.5
15.0
16.3
16.5
17.2
0 5 10 15 20
Russia
Egypt
Hungary
China
Korea
Turkey
Brazil
EM
Poland
Czech Rep.
Morocco
Thailand
Peru
S.Africa
India
Indonesia
Colombia
Taiwan
Malaysia
Chile
Philippines
Mexico
4. 4
Figure 5: Real GDP growth in BRIC countries – Russia’s economy is most volatile
Source: World Bank, Aton estimates
Investors can be quite cynical and are often prepared to tolerate authoritarian
tendencies in a country’s political structure, corporate governance risks and endemic
corruption as long as above-average growth and returns are in place. Once the pace
of growth falls, micro rather than macro issues start playing a larger role, including
non-financial risks such as corporate governance.
Russia’s corporate governance landscape suffers from many deficiencies that are
common for most of its emerging market peers. The most commonly cited list of
problems includes:
Lack of effective definition and enforcement of ownership rights
High concentration of ownership and strong block-holders’ influence
Opaque ownership structures
Influence of the state which is often detrimental to shareholder value
Limited depth of capital markets, small free float and low liquidity
Underdevelopment of the domestic investor base – both institutional and
private
Nascent pension fund industry with limited exposure to the equity market
Cronyism
Weak internal controls
Poorly enforced accounting standards
Limited transparency
Low shareholder activism
Low board effectiveness and a lack of independence
The extent of the problem is different and varies from country to country. We will
therefore provide a brief overview of the corporate governance environment in
Russia before moving on to a detailed assessment of CGS at the company level.
Brazil
China
Russia
India
-10.0
-8.0
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Brazil China India Russia
5. 5
Russia’s Capital Markets Remain Shallow and Highly Dependent on Foreign
Fund Flows
In a Global Financial Centres Survey prepared by the City of London's commercial
think tank Z/Yen Group last year, Moscow ranked only 68
th
and St Petersburg 69
th
among the world’s 75 financial centres, casting a shadow on Russia’s ambition to
become the pre-eminent financial centre for CIS markets in this decade. As might
have been expected, Moscow was rated low on a number of institutional factors
such as transparency, absence of a level playing field, poor predictability of
regulation, and underdeveloped market infrastructure. Above all, the market
remains highly illiquid with limited depth, a small number of issuers and a nascent
domestic investor base.
Figure 6: BRIC countries – selected domestic equity market metrics
No. of listed
companies
MktCap
($bn)
MktCap as %
of GDP
Free float
MktCap
Free float
as % of
total
MktCap
Trading
volume
($bn)
Mutual
funds NAV
($bn)
as % of
MktCap
Pension
funds NAV
($bn)
Russia 354 695 36.9% 216 31.0% 1.75 16 2.3% 80
China 2,422 3,757 53.8% 1,452 38.1% 24.9 545 14.5% 41
India 6,791 1,014 69.0% 391 38.6% 2.1 111 10.9% 3.3
Brazil 370 1,124 44.7% 774 68.8% 3.5 980 87.2% 301
Source: IMF Co-ordinated Portfolio Investment Survey, Z-Ben Advisors, World Federation of
Exchanges, Aton estimates
Among the more notable market indicators across the four BRIC countries are
differences in the domestic investor base. Local mutual funds in Russia represent a
tiny proportion of the market and the retail investor base is similarly small with
mutual funds and brokerage accounts constituting no more than 0.5% of GDP and
only 6-7% of net household assets. As a result, there is huge dormant pool of capital
of around $340bn in retail bank deposits – this figure exceeds the total investments
in mutual funds by more than 20 times.
Only a fraction of the population has invested in stocks with brokerage accounts
totalling $4-5bn or a mere $60 per capita of equity investments. This contrasts with
China where mutual funds total $394 per capita or, closer to home, with Poland,
where the mutual funds industry holds nearly $1,000 of investments per capita. In
Europe, between 12% and 50% of total household financial assets are invested in
stocks and other securities, according to Eurostat. Furthermore, another large
potential pool of money is currently locked within the Russian state and private
pension funds, which are allowed to invest only a fraction of their capital into
equities. All this makes the Russian equity market highly vulnerable to swings in
global risk sentiment and sensitive to international capital flows.
6. 6
Figure 7: Equity market funds in Russia ($bn) Figure 8: Russia accounts for around 9% of global EM funds
Source: EPFR Global, Investfunds
In terms of trading activity BRIC markets are similar with only China standing out:
average daily trading volumes represent approximately 0.3% of market capitalisation
in Brazil, Russia, and India, and about 0.7% in China. In Russia, however, much of this
volume is concentrated in the trading of just a few dozen blue-chip companies. In
Brazil and China, on the other hand, hundreds of companies’ trade, and in India,
there are thousands. The top-5 most liquid Russian stocks account for 70% of the
total average daily turnover on the local exchange and the top-10 for over 80%.
Figure 9: Top-ten most liquid Russian stocks
Stock Avg. daily traded value (RUBbn) As % of total traded value
SBERBANK 14.1 32.1%
GAZPROM 8.4 19.3%
LUKOIL OAO 4.1 9.5%
ROSNEFT OIL 2.4 5.5%
VTB BANK OJSC 1.7 3.9%
NORILSK NICKEL 1.6 3.7%
SBERBANK-PRF 1.5 3.4%
SURGUTNEFTEGAS 0.91 2.1%
AK TRANSNEFT-PRF 0.91 2.1%
URALKALI 0.80 1.8%
Top 10 36.4 83.2%
Total 43.8
Source: MICEX/RTS
The local market’s low liquidity is one of the most often-cited reasons for Russian
companies to list and raise capital abroad, rather than domestically. In the last 15
years domestic exchanges have attracted only a small fraction of Russian IPOs and
secondary equity issues.
Domestic
equity funds,
$6.9bn
Foreign
Russia-
dedicated,
$12.5bn
GEM funds,
$24bn
EMEA funds,
$7.8bn
BRIC funds,
1.9bn
Other, $6.1bn
GEM, $327bn
Asia ex-Japan,
$216bn
Latam, $39bn
EMEA, $28bn
Russia, $60bn
7. 7
Figure 10: Russian equity placements by exchange, % of total capital raised
Source: ThomsonReuters, Bloomberg, Aton estimates
Ownership is Highly Concentrated and the State Remains the Largest
Shareholder
The ownership of public companies in all BRICs is highly concentrated with Russia
having the smallest percentage of free float among the four countries. Out of the
111 companies in our corporate governance sample (which have a total market
capitalization of $706bn), only seven have a free float of 50% or better, which could
be considered as widely dispersed ownership. However, even in these cases there is
a likelihood of concealed or hidden holdings and shareholder agreements that allow
certain investors more influence than would otherwise appear. Most of the stocks
have a dominant shareholder and in 60 companies in the sample, minority
shareholders don’t have even a blocking stake (i.e. minorities in the aggregate
control less than 25% of the stock). This kind of strong ownership concentration is
associated globally with an elevated risk of shareholder rights abuse.
The government plays a dominant role in many public companies among the BRICs.
In Russia, state-owned enterprises (SOEs) account for over 50% of domestic market
capitalisation with the top-five SOEs controlling roughly 40% of the total. In Russia,
the government’s influence is particularly strong at large ‘strategic’ enterprises. The
combination of a bureaucratic approach to management and continuing pockets of
government corruption are hindering the development of more effective corporate
governance.
It can be safely said that shareholder value creation is not the highest priority at SOEs
in Russia, as they are mostly seen as an economic policy tool rather than businesses
in their own right. Most SOEs have a social function in addition to their commercial
goals and carry sizeable non-core assets on their balance sheets. For example,
utilities are often seen as a tool for ensuring cheap energy supplies to domestic
industry and a social policy tool that can be manipulated in the run-up to elections.
Similarly, SOEs provide support and liquidity to local state-controlled financial
institutions by depositing substantial cash reserves with them; in turn, these banks
may be required to provide cheap financing to select enterprises favoured by the
state. To this should be added the organisational confusion between the state’s
ownership and regulatory functions, which is particularly noticeable in the utilities,
financial, oil and gas and telecom sectors. This often has a detrimental effect on
shareholder value.
0%
20%
40%
60%
80%
100%
RTS/MICEX LSE NYSE HK Other
8. 8
State ownership does not seem to enhance the quality of corporate governance.
SOEs in Russia are generally less transparent in terms of their business practices,
board appointment procedures, decision-making processes and related party
transactions than other public firms. SOE managers are often accountable only to the
respective state bodies and their responsibilities are not clearly defined. Moral
hazard is also ever present, due to the SOEs soft budget constraints, reduced
disclosure requirements and an implicit government guarantee against the risk of
bankruptcy. This may incentivise managers to pursue risky strategies which could be
detrimental to shareholder value – the state can back the company in case of failure
but any recapitalisation would ultimately damage the economic interests of
minorities.
What does high ownership concentration and the dominance of SOEs in the equity
market means for investors? Given the large weight of SOEs in the Russian equity
indices, investors in Russia are often reduced to examining “government-linked”
strategies, trying to define the segments and companies that could benefit from the
rise or fall of a particular minister, a change in government policies, or the allocation
of state funds. We have even seen funds that make holdings of listed SOEs the
cornerstone of their portfolios. Our back-testing, however, shows that these
strategies are misguided and SOEs regularly underperform the market at large; this
may not be immediately evident in a short time span, but in the long term
underperformance can seriously hamper portfolio returns.
We have plotted the performance of 34 major state-owned companies with a total
market capitalisation of $330bn against the RTS Index from the market bottom in
2009 to date. Our back-testing shows that the portfolio of SOEs underperformed the
market by 41% in the period. Moreover, if we exclude Sberbank from our calculations
(as an outlier in the sample), this underperformance widens to 67%.
Figure 11: Government controlled stocks vs the RTS Index, Feb-09 to June-12
Source: Bloomberg, Aton estimates
80
100
120
140
160
180
200
220
240
260
280
300
320
340
360
380
400
420
440
GovCo RTS GovCo excl SBER
9. 9
The underperformance of the SOE portfolio vs the index was mainly driven by the
heavyweights of the Russian market and economy: Gazprom, Rosneft, Gazprom Neft,
RusHydro, Rostelecom and Federal Grid Co. While fundamental factors were also
undoubtedly at play, we would point to the diverging performance of stocks in the
same sector, the best example being that of privately controlled NOVATEK and state-
owned Gazprom. In the last three years, NOVATEK outperformed Gazprom by a
breathtaking 155% and traded at a significant premium to the state-owned gas giant.
Figure 12: NOVATEK vs Gazprom: relative value and P/E differential
Source: Bloomberg, Aton estimates
Business and Legal System: Make Money Locally, Seek Protection Globally
Corporate legislation in Russia provides a relatively wide range of provisions to
help protect shareholder rights, including direct voting rights, low thresholds for
nominating directors, a one-year director’s term, pre-emptive rights in new share
issues, and mandatory buyouts, and disallows limitations on voting rights or anti-
takeover defences. Among BRIC countries, Russia seems to offer the most clearly
defined shareholder rights.
However, Russia’s weak judicial system and the courts’ lack of independence
means that effective enforcement is lacking, whether through the regulator or the
courts. Furthermore, corporate law contains numerous loopholes, particularly in the
area of ownership rights. For example, the loose definition of affiliated and related
entities and limited transparency on beneficial ownership often allows block holders
to avoid mandatory buyouts after accumulating majority stakes. This problem was
seen with particular clarity in the utilities sector, as shareholders in OGK-2, OGK-3,
OGK-6, TGK-1, TGK-2, TGK-4 and TGK-14 can attest. Another weakness of Russian law
is that it allows indirectly held treasury shares to be used for voting at the discretion
of management, as was evident in the recent controversy surrounding the conflict
between the key block holders of Norilsk Nickel. Moreover, disallowing anti-takeover
defences means nothing given that SOEs are usually impregnable to hostile
takeovers, while majority owners at most private companies have the final say on
any potential M&A (and the price agreed for a majority stake could be very different
from the one offered to minorities).
Similarly, existing squeeze-out provisions leave considerable scope for manipulation
of the valuation of the minority stake, as we recently saw in the case of retail chain
Seventh Continent.
0%
100%
200%
300%
400%
500%
600%
700%
0.0
0.5
1.0
1.5
2.0
2.5
3.0
NVTK/GAZP 1Y avg NVTK P/E prem/(disc) (rhs)
10. 1
0
In spite of the reforms of the last ten years, political and legal institutions in Russia
have not replaced cronyism and corrupt corporate practices. The inefficiency of
formal institutions is compensated by a system of personal relationships which
facilitate the functioning of bureaucracy and replace legal enforcement with a set of
informal rules. As John Browne, former CEO of BP, lamented in his memoirs, “The
problem is not the lack of laws, but their selective application. This is what creates
the sense of lawlessness. While bureaucratic legalistic processes are the hallmark of
Russia, you never know whether someone will turn blind eye or whether the laws
will be applied to the hilt.”
The inefficiency and difficulty of enforcing legal contracts in Russia has led to Russian
companies increasingly applying to foreign jurisdictions or courts to register material
transactions. According to a recent survey conducted by local legal partnership
Egorov, Puginsky, Afanasiev & Partners (see Vedomosti from 27 June 2012), 90% of
Russian businesses prefer to apply foreign law, mostly English, to conduct, settle or
enforce material transactions such as mergers and acquisitions, shareholder
agreements, project financing, joint venture agreements, debt restructuring, and
others. They also rely on international arbitration courts to settle legal disputes. In
the most recent high-profile example, two major beneficiaries of the questionable
privatisations of the 1990s, Roman Abramovitch and Boris Berezovski, decided to
settle their legal disputes in a London court in order to avoid dealing with the
Russian legal system, while in the past they might have been expected to exploit its
inefficiencies.
Regulatory Infrastructure Remains Weak and Ineffective
Russian corporate governance regulation is still in its infancy and is fairly limited in
scope and application. Meanwhile, the Federal Financial Markets Service has very
few means of enforcing it. Although Russia’s Corporate Governance Code compares
well in its key aspects with international practice, it is voluntary for all public
companies. Governance regulation directly affects only 33 of roughly 354 companies
listed on the local exchanges (MICEX/RTS) as it only applies to the top A1 and A2
quotation lists. Seventy-six companies that are traded on the lower markets should
adhere to only very basic requirements (e.g., only one independent director, no
requirement for the preparation of IFRS accounts, etc.). A further 245 or so
companies that are traded outside the top lists are virtually unregulated, as are more
than 1,000 stocks that are traded solely over the counter. This is largely a
consequence of the fact that most listed Russian companies became public as a
result of the voucher privatisation of the 1990s and not via IPOs.
In fact, foreign regulations have a bigger impact on the corporate governance
practices of Russian companies than domestic initiatives: as Russian companies go
global and tap international markets for capital, they must increasingly adjust their
corporate governance practices to prevailing regulatory regimes – to paraphrase an
old saying, they have realised that “if you want to be valued as a duck, you have to
quack like a duck”. As of today, over 60 Russian companies are listed on the main or
AIM market of the LSE, and several companies are listed on the NYSE, NASDAQ,
Frankfurt’s XETRA, Stockholm and Hong Kong stock exchanges. About 30 companies
with primary business in Russia trade solely abroad. These companies usually have a
higher quality of corporate governance, at least formally, and should be setting the
tone for the rest of the Russian corporate sector. Once again, we underline that the
most dynamic Russian companies prefer to do business locally but raise money
globally to access a much larger pool of capital than is available domestically, while
enjoying better protection from foreign courts.
11. 1
1
The current parlous state of global equity markets, however, has put a stop to
Russian equity issuances. Moreover, the effective seizure of capital markets should
have a pronounced negative effect on the state of corporate governance because it
reduces the incentives for companies to promote good practices. Unfortunately,
corporate governance is seen by most Russian companies not as part of the value
creation process and business ethics, but as a public relations exercise. This attitude
is likely to persist until the market matures, an equity culture takes hold and the
enforcement of regulations becomes the norm.
Furthermore, there is a restriction on Russian companies that wish to raise capital
abroad: an artificial cap of 25% on the share of listed equity that can be converted
into DRs and floated outside Russia. Although there are plans to remove the cap for
non-strategic enterprises, the timing for relaxing the rules is unclear. However, for
Russian companies there is always the option of moving registration to a foreign
jurisdiction and avoiding the restrictions imposed at home.
Informational Infrastructure – Improvements Driven by International
Capital Raisings
It is unsurprising that companies listed abroad are also the most transparent and
lead the Russian corporate sector in terms of information disclosure. As Russian
companies are increasingly competing for debt or equity capital against
international peers, they have had to drastically improve disclosure standards and
meet at least the basic mandated requirements.
According to our assessment (for a description of methodology and ratings, see page
24; a full ratings breakdown is presented in Fig. 20), Russian companies score an
average 5.9 out of 10 on our Transparency & Disclosure metrics. Utilities and oil and
gas are the worst of the larger sectors; consumer, transportation and metals and
mining are at the top of the range. It is interesting to note that out of 15 companies
scoring above seven points in our rankings, 14 have a foreign listing. Ninety-five out
of 111 (85%) of the companies on our CGS assessment list publish IFRS accounts,
with utilities once again the worst in this respect. Among large companies, the least
transparent is Surgutneftegas.
Disclosure levels are expected to improve and recently introduced rules require all
companies to publish IFRS accounts starting from 2013. However, even though most
of the listed companies already have IFRS accounts, disclosure levels vary widely and
many firms do not go much beyond the minimum disclosure requirements. In
addition, low frequency and delayed publication diminish the usefulness of the
information for investors. Particularly obscure areas include related party
transactions, accounting for affiliates, operating information and ownership
structure. Moreover, a large chunk of companies report according to IFRS only
annually, or at best semi-annually. There is certainly huge room for improvement.
We believe this improvement should happen both naturally and by design, as the
companies are seeking to widen the investor base while the authorities want to
increase the investment appeal of the country’s corporate sector and raise the
international profile of local markets.
12. 1
2
Shareholder Activism is Rising
Among BRIC countries, minority shareholders in general have only limited influence
over the governance practices of public companies. This is partially because of the
relative inactivity of minority shareholders, but also because of large share
concentrations, which prevent market-driven changes in control.
Apart from a few exceptions (such as Hermitage, East Capital and Prosperity Capital),
international institutional investors provide only modest input into corporate
governance despite the fact that these issues greatly affect the corporate sector’s
performance, the end return to beneficiaries and the country’s investment
attractiveness. One possible explanation here is that because such a huge proportion
of portfolio returns now come from overall national economic growth and the
overall return from the market (i.e. beta returns), institutional investors see little
additional return from engaging with companies. This is misguided, in our view, as
our research shows that corporate governance plays a significant role in determining
the long-term returns to a portfolio although in the short term its influence is less
pronounced.
The last decade also saw the emergence of shareholder watchdog associations, the
most prominent being Investor Protection Association (IPA), which defends
investors’ interests mainly by consolidating votes and gaining board appointments. It
is also active in publicising cases of abuse and in educating local companies on the
merits of good corporate governance.
What is more encouraging is the strong domestic grassroots movement that is often
associated with the fight against corruption and is particularly active in defending
minority shareholders in SOEs, such as Rosneft, Gazprom, and VTB. There is,
however, a rising belief that corporate governance problems are closely interlinked
with governance issues at the state level and tackling the problem in earnest
requires major structural and economic reforms in the country.
13. 1
3
Russia Continues to Rank Low in Most Global Governance Surveys
It has become commonplace to refer to global surveys and rankings produced by
international economic institutions such as the World Bank, IMF and World
Economic Forum and non-governmental organisations such as Transparency
International or the Economist Intelligence Unit. These rankings play a significant
role in shaping the views and attitudes of international institutional investors and
Russia’s investment case is not helped by its positioning well below most of its
emerging market peers. This often reflects the fact that improvements in
macroeconomic stability have been counterbalanced by a deterioration in other
important areas, most notably the quality of institutions, investor protection and
corporate governance standards, which are regarded by most observers as the
biggest constraints in Russia’s fight for capital. Along with the strengthening of
institutions, Russia needs to improve its track record in the protection of property
rights, anti-corruption measures and the enforcement of the rule of law.
It is worth noting that in the World Bank’s governance rankings, Russia continues to
score badly with little or no change over the last 14 years. In fact, out of six key
indicators, only Political Stability has improved, while Voice & Accountability
indicators have markedly deteriorated. Given that the latest available data is at least
two years old, we would not be surprised to see a fall in the Political Stability
assessment in the World Bank’s 2011 survey.
Figure 13: World Bank corporate governance: change in indicators from 1996 to
2010 (indicator range: -2.5 to 2.5) and current rank by indicator (out of 213
countries)
Source: World Bank, Aton estimates
Many observers argue that most of the country rankings, particularly those focused
on corruption, ease of doing business, rule of law, etc., are questionable and based
on perception rather than hard data and the results are distorted by biased
portrayals of the country in the business press. If that is true and the level of
corruption, poor quality of institutions and corporate governance, inefficiency and
bureaucracy in Russia are no more than an illusion, then we are dealing either with
one of the biggest PR failures in history or the world has conspired to buy Russian
assets ‘on the cheap’. In any case, we hold the view that given the dependence of
Russian capital markets on foreign funds, we must deal with the perceptions of
foreign investors - and it is not helpful to simply dismiss their views as wrong.
168
174
123
130
158
177
-0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6
Voice and Accountability
Political Stability and Absence of
Violence/Terrorism
Government Effectiveness
Regulatory Quality
Rule of Law
Control of Corruption
Rank by indicator, 2010
14. 1
4
Figure 14: Country Governance Indicators, selected countries
World Bank Governance Indicators (213 countries)
S&P Credit
Rating
Total
Governance
Indicators
Rank
Voice and
Accountability
Rank
Political
Stability
and
Absence of
Violence/
Terrorism
Government
Effectiveness
Rank
Regulatory
Quality
Rank
Rule of
Law Rank
Control of
Corruption
Rank
World
Bank Ease
Of Doing
Business
Rank (183
countries)
World Economic
Forum Global
Competitiveness
Index Rank (139
countries)
Transparency
Int
Corruption
Perception
Index (183
countries)
Global VC &
PE Country
Attractiveness
Rank (116
countries)
Global
Financial
Centres Index
Rank (75
cities)
FINLAND AAA 1 7 13 2 3 2 10 11 4 9.4 17 56
SWEDEN AAA 2 3 26 4 8 3 7 14 3 9.3 8 33
DENMARK AAA 2 4 34 3 1 5 4 5 8 9.4 11 46
NORWAY AAA 4 1 15 10 17 4 13 6 16 8.6 13 53
SWITZERLAND AAA 5 2 20 5 13 11 14 26 1 8.8 10 8
AUSTRIA AA+ 6 10 25 6 15 9 20 32 19 7.8 21 43
NETHERLANDS AAA 7 9 44 13 5 8 12 31 7 8.9 12 32
CANADA AAA 7 14 41 8 9 10 9 13 12 8.7 2 9
AUSTRALIA AAA 9 11 55 9 11 12 8 15 20 8.8 7 10
GERMANY AAA 10 16 56 18 14 18 17 19 6 8.0 9 14
BELGIUM AA 11 12 58 15 30 26 24 28 15 7.5 14 41
UK AAA 12 18 90 17 7 13 25 7 10 7.8 3 1
FRANCE AA+ 13 24 63 23 28 22 26 29 18 7.0 15 20
JAPAN AA- 14 38 50 25 41 27 21 20 9 8.0 4 5
USA AA+ 15 28 93 22 21 20 28 4 5 7.1 1 2
CHILE A+ 16 39 70 35 19 28 23 39 31 7.2 27 na
ESTONIA AA- 17 32 69 32 18 36 33 24 33 6.4 40 74
PORTUGAL BB 18 33 65 39 52 37 34 30 45 6.1 31 64
CZECH REP AA- 19 46 39 41 32 44 71 64 38 4.4 37 55
SLOVENIA A+ 20 47 53 40 54 39 47 37 57 5.9 45 na
POLAND A- 21 41 36 58 44 67 57 62 41 5.5 29 59
SPAIN BBB+ 22 31 130 44 34 30 35 44 36 6.2 24 37
HUNGARY BB+ 23 54 62 60 39 59 67 51 48 4.6 41 72
Source: World Bank; World Economic Forum; Transparency International; Economist Intelligence Unit; Z/Yen Group
15. 1
5
Figure 15: Country Governance Indicators (continued)
World Bank Governance Indicators (213 countries)
S&P Credit
Rating
Total
Governance
Indicators
Rank
Voice and
Accountability
Rank
Political
Stability
and
Absence of
Violence/
Terrorism
Government
Effectiveness
Rank
Regulatory
Quality
Rank
Rule of
Law Rank
Control of
Corruption
Rank
World
Bank Ease
Of Doing
Business
Rank (183
countries)
World Economic
Forum Global
Competitiveness
Index Rank (139
countries)
Transparency
Int
Corruption
Perception
Index (183
countries)
Global VC &
PE Country
Attractiveness
Rank (116
countries)
Global
Financial
Centres Index
Rank (75
cities)
LITHUANIA BBB 24 55 67 55 43 61 68 27 44 4.8 48 na
KOREA A 25 66 107 34 45 42 58 8 24 5.4 18 16
LATVIA A- 26 61 80 59 42 57 75 21 64 4.2 59 na
ITALY BBB+ 27 52 81 68 49 81 92 87 43 3.9 30 41
GREECE SD 28 57 128 67 56 72 98 100 90 3.4 66 73
S.AFRICA BBB+ 29 74 119 74 79 91 82 35 50 4.1 26 54
BULGARIA BBB 29 80 91 92 60 101 95 59 74 3.3 58 na
ROMANIA BB+ 31 83 97 105 55 94 94 72 77 3.6 50 na
BRAZIL BBB 32 78 111 91 93 96 87 126 53 3.8 36 44
TURKEY BBB- 33 121 179 72 82 90 89 71 59 4.2 35 71
MEXICO BBB 34 102 165 81 87 142 111 53 58 3.0 38 52
S. ARABIA AA- 35 204 137 100 95 86 86 12 17 4.4 28 70
INDIA BBB- 36 87 190 95 128 98 122 132 56 3.1 32 58
THAILAND BBB+ 37 148 186 88 92 108 108 17 39 3.4 34 19
ARGENTINA B 38 91 117 112 154 144 118 113 85 3.0 51 64
INDONESIA BBB- 39 110 173 110 127 147 146 129 46 3.0 55 63
CHINA AA- 40 201 162 85 116 119 134 91 26 3.6 22 5
KAZAKHSTAN BBB+ 41 183 82 117 122 146 172 47 72 2.7 67 na
EGYPT B 42 184 175 126 112 104 135 110 94 2.9 56 na
UKRAINE B+ 43 119 124 158 142 160 171 152 82 2.3 64 na
RUSSIA BBB 44 168 174 123 130 158 177 120 66 2.4 43 68
AZERBAIJAN BBB- 45 186 141 164 133 167 184 66 55 2.4 na na
Source: World Bank; World Economic Forum; Transparency International; Economist Intelligence Unit; Z/Yen Group
16. 1
6
In our view, we should reject the idea of any idealism or a “failure of perception”
among investors: they are in the business of making money and should be least
susceptible to illusion, particularly over a fairly long time period – markets may be
inefficient but the mispricing of risk has never run for over a decade. To cap it all,
suggesting that the investment environment in Russia is much better than perceived
is akin to saying that the insiders who should know best – Russian businessmen and
ordinary citizens – are all acting irrationally when they channel their newly acquired
wealth abroad instead of deploying it locally. In the markets, the only measure of a
right or wrong decision is the return on investment. In other words, if you are
underperforming you must be wrong somewhere.
Another argument claims that survey findings, particularly those related to
corruption, show that Russia is ‘normal’ for its development level and ‘on trend’ for
improvement with rising GDP per capita. However, putting Russia in the “upper-
middle-income” bracket (under World Bank classifications in its recent Ease of Doing
Business Survey) shows it is in 40
th
place out of 49 countries in the category, while
many lower income countries scored better. In the same survey, Russia ranks 39/49
in the Protecting Investors category among upper-middle-income countries,
highlighting again the need for improvements in corporate governance. At any rate,
arguing that corruption is ‘normal’ for Russia’s level of development is rather like
saying it was worth the melanoma to get the sun tan and indeed akin to degrading
the country and its population, writing off their travails as growing pains that justify
little action to improve the situation.
Figure 16: World Bank Ease of Doing Business score for middle-income countries
Source: World Bank, Aton estimates
Similarly, charting Russia’s position in Transparency International’s Corruption Index
(based on GDP per capita) shows Russia diverging from the trend and scoring worse
than some of its poorer counterparts. Furthermore, while there is no clear link
between the corruption perception index and valuations, Russia looks like an outlier
in Figure 18. All standard valuation metrics show Russia to be very cheap but we feel
that this tremendous value is trapped, at least for the time being.
Thailand
Malaysia
Macedonia
Lithuania
South Africa
Chile
Peru
Colombia
Tunisia
Kazakhstan
Mexico
Bostswana
Antigua
Turkey
Romania
Grenada
Maldives
Albania
Uruguay
China
St.Kitts & Nevis
Jordan
Seychelles
Lebanon
Dominican Rep
Russia
Costa Rica
Brazil
Ecuador
Iran
Algeria
Gabon
Suriname
Venezuela
0
2,000
4,000
6,000
8,000
10,000
12,000
14,000
16,000
18,000
0 10 20 30 40 50 60
PPP GDP per
capita ($)
Ease of Doing Business Rank
17. 1
7
Figure 17: Transparency International’s Corruption Perception Index vs PPP GDP
per capita (from 0-2 – “highly corrupt” to 8-10 – “very clean”)
Source: Bloomberg, Aton estimates
Figure 18: Transparency International Corruption Perception Index vs MSCI Index
valuations by country (based on 12M forward P/E)
Source: Bloomberg, Aton estimates
The State as Part of the Problem
National context plays a significant role in determining the level of investor
protection and in shaping governance practices at the company level. While a firm
may exhibit a high CGS, shareholder rights might not be easy to enforce in a country
with a weak governance profile.
Moreover, a country’s political and economic structure sets the context and
defines the incentives for corporate governance. Companies and industries adjust
their strategies to the prevailing economic and political climate and often mimic
national power structures.
Ukraine
Turkmenistan
China
ThailandBelarus
Bulgaria
Azerbaijan
South Africa
MalaysiaRomania
Venezuela
TurkeyArgentina
Mexico
Latvia
Brazil
Lithuania
Russia
Poland Chile
Uruguay
Hungary
Estonia
2,500
4,500
6,500
8,500
10,500
12,500
14,500
16,500
18,500
0 1 2 3 4 5 6 7 8
PPP GDP per
capita
Corruption Perception Index
Russia Egypt
Hungary
Turkey
China
PolandSouth Korea
Brazil
Czech Rep
South Africa
India
Indonesia
Malaysia
Taiwan
Colombia
Chile
Thailand
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
3.0 5.0 7.0 9.0 11.0 13.0 15.0 17.0
CorruptionPerceptionIndex
Fwd P/E
18. 1
8
The role of a national authority structure, similarly to that of a company, is to
decide who controls cash flows, defines strategy and allocates resources. This
shapes the long-term stability of a country and its economy, prospects for
employment, savings and pensions, and incentives for education, innovation and
development. It deals with hostile actions by foreign countries and competition from
foreign companies and is expected to protect the rights and benefits of all its
stakeholders.
In this context, it is troubling to see that Russia increasingly resembles a huge,
complex and rather inefficient corporation with key managers exhibiting rent-
seeking behaviour with little incentive to change. Thanks to the “vertical of power”,
Russia Inc. has a highly concentrated ownership structure. Meanwhile, elevated
commodity prices continue to provide plentiful cash flows that safeguard the
prevailing political and economic elite and allow them to run the country without
considering the benefits of all of its stakeholders.
Current institutions and power structures allow little accountability from the
country’s key managers. For example, although President Vladimir Putin has
promised to restore direct elections for regional governors, he maintains the final
say in the appointment process. Furthermore, the newly-elected president has
created an unwieldy two-tiered government with a traditional or formal government
led by Dmitry Medvedev (consisting mostly of liberal-minded technocrats) and an
inner cabinet around the president which oversees and controls the work of
Medvedev’s cabinet. There is clearly a mix-up between the branches of power and
given the often diverging views on the reform agenda, there is risk that the
seemingly reformist government may not be able to push through reforms against
strong vested interests. Whatever the president’s reasoning, the current
arrangement sends conflicting signals to the market and confuses investors and
businesses.
The lack of accountability in the government and the absence of a proper system of
checks and balances provides fertile ground for the abuse of corporate governance
principles at the company level. In the end, corporate governance is all about
accountability: who takes the blame for poor performance, the ineffective use of
funds, value destructive acquisitions or corruption.
One of the most striking examples of how government policies can influence
corporate governance quality can be found in the utilities sector. Given its capital-
intensive nature, long-term investment cycle and strong influence on the budgets of
producers and consumers, the sector needs a clear and stable regulatory framework
that ensures a balance between the interests of investors and consumers. In reality,
the utilities sector is currently one of the least predictable in terms of regulation and
government policy, with an uncertain outlook for investment returns and opaque
ownership structures. As a result, the sector has become a playground for financial-
industrial groups, both private and state-controlled. Significant stakeholders in the
segment as well as managers often enhance their returns via corrupt practices,
including murky transactions with related parties or outright asset-stripping, and by
abusing minority rights. This situation represents a significant danger to the sector’s
long-term economics as incentives to invest are diminished by ever-changing
regulation and unclear policies.
19. 1
9
Volatile regulation and unclear government strategy is often the culprit behind
business owners’ emphasis on the short term. This ultimately hurts long-term
prospects and increases corporate governance risks as the majority of owners are
likely to be focused on extracting as much as possible from their companies in a
limited time period – often to the detriment of the company’s future and minority
shareholders’ interests. This makes the economy more sensitive to any economic or
political crisis as rising uncertainty limits the incentives to focus on long-term
shareholder value creation or concerns about corporate governance standards. The
effective temporary seizure of capital markets in crisis times means that there are
fewer incentives to adhere to good management practices: as a rule of thumb, we
should expect ‘cheap’ companies to behave in a ‘nasty’ way during times when no
one is prepared to pay a fair price for their assets. To sum up, shareholders in a
company that demonstrates poor corporate governance standards in stable times
face a double risk when the country hits a recession.
Our observations regarding corporate governance during times of crisis are in line
with a recent global fraud survey conducted by Ernst & Young. The survey found that
corporate standards are more liable to slip when times are tough: 15% of surveyed
firms think cash payments to win business can be justified if they help a firm to
survive an economic downturn, compared to 9% in 2011. One in 20 thinks the same
about misstating a company’s financial performance and a further 24% of
respondents think that bribery and corrupt practices have increased in their
countries of operation because of the economic downturn.
One of the disconcerting trends that illustrates the short-term focus of businesses
and investors and deprives Russia of much-needed investment is high net capital
outflows. True, some of the outflows can be attributed to the increase in the foreign
investments of Russian companies, but this merely highlights the fact that domestic
investors see more opportunities for higher risk-adjusted returns abroad than at
home. As Philip Hanson, professor at the University of Birmingham, Centre for
Russian and East European Studies and associate fellow of Chatham House, said in a
recent report, “Russia, an emerging economy with considerable potential for
investment at home, channels a substantial part of its savings abroad. Poland and
Turkey attract more investment than their savings will finance.” In the last four years
alone, from the start of the on-going global financial crisis, Russia has experienced
net private capital outflow of $308bn and net FDI reversed from a positive figure of
$20.5bn in 2005-08 to a negative $31.2bn in 2009-11.
Figure 19: Net private capital inflows ($bn) Figure 20: Total net FDI ($bn)
Source: Rosstat
81.7
-133.7
-56.9
-33.6
-84.2
-150
-100
-50
0
50
100
2007 2008 2009 2010 2011
1.4
3.63.7
-8.5
2.8
5.9
1.8
-3.9
12.1
-10.1
0.3
6.9
4.7
6.3
5.6
1.2
-4.0
-1.5
2.5
-4.2
-2.3
-2.0
-3.2
-2.2
-0.6
-6.1
0.9
-8.7
-15
-10
-5
0
5
10
15
1Q05 4Q05 3Q06 2Q07 1Q08 4Q08 3Q09 2Q10 1Q11 4Q11
Net
-$31.2bn
Net +$20.5bn
20. 2
0
The Global Entrepreneurship Monitor 2011, produced by Babson College in the US
and the London Business School, concluded that among emerging nations, Russia and
the United Arab Emirates − countries which place a strong emphasis on extractive
resources − exhibit the lowest entrepreneurial intention rates. In contrast,
expectations of starting a business are dramatically higher in some other emerging
economies like China, Chile, India and Brazil.
In Russia, the high concentration of ownership, the dominance of state firms in
several sectors of the economy and restrictions on trade and foreign ownership stifle
competition, while the reliance on extractive industries incentivises rent-seeking
behaviour. Furthermore, the economic and political institutions are structured to
extract resources for the benefit of elite groups, often represented or protected by
the government.
In an excellent book published in Mar 2012, Why Nations Fail: The Origins of Power,
Prosperity, and Poverty written by Daron Acemoglu and James Robinson, the authors
point out that in countries based on extractive economic and political institutions,
elites fail to protect property rights or provide incentives for economic development
and resist change: “Because elites dominating extractive institutions fear creative
destruction they will resist it, and any growth that germinates under extractive
institutions will be ultimately short-lived”. In our view, this could be particularly true
for Russia, where the public sector represents more than 30% of the total workforce
and may be over 40% if we include employees at state-owned enterprises. A large
public sector often incentivises rent-seeking, be it in emerging or developed markets,
and public sector employees resist reform that could ultimately undermine their
position in the food chain. To this should be added the continuous infighting within
the bureaucratic apparatus which further undermines attempts at reform − getting
government agencies to agree to change becomes almost like asking hyenas to share
a steak.
Market Reforms and Privatisation Would be a Pragmatic and Value-
Enhancing Move
Listing the negatives to explain the loss of investor interest and the current low
valuations of the Russian market is not our primary objective. Rather, we are
aiming to show that most governance problems are solvable provided that there is
a clear understanding of the benefits of an improvement and the will to implement
changes at both the macro and micro levels.
Judging by recent government initiatives there appears to be some sense of
urgency in addressing the most pressing aspects of governance in the country.
Among the most notable recent initiatives was the partial removal of government
officials from the boards of SOEs, a new decree on transferring all companies to IFRS
starting from 2013, the first legislation addressing insider dealing and initiatives
aiming at tackling systemic corruption.
There are also a host of financial market-friendly reforms such as the creation of a
Central Depository, the introduction of T+n settlement on the local exchange and a
move to make local financial instruments (initially OFZs and municipal bonds)
Euroclearable, as well as promised pension reform, and the potential removal of
limits on DRs (excluding companies that are deemed strategic). If implemented, all of
these would greatly increase the domestic pool of capital and provide more stability
to the Russian capital markets.
21. 2
1
Many market observers have welcomed the government’s recent drive to establish
minimum dividends payouts at SOEs of 25% of net profit. This is taken as a sign that
the state is aligning its interests with those of minorities. However, we are less
sanguine in this respect. First of all, the government has stated that it will have the
final say on dividends and could grant exemptions to companies with high capex
requirements, therefore immediately removing any stability and certainty from the
dividend policy. Furthermore, although higher dividends payouts should be
welcomed by investors, we hold the view that it is up to companies to decide on the
optimal dividend policy and the key aim for the government should be to reduce its
control over the economy.
We would single out progress on the privatisation front as a single most important
indicator to watch for gauging the government’s intentions to improve the
investment attractiveness of the Russian market. Privatisation could finally address
the issue of SOEs’ dominance in the market and improve the market’s breadth and
liquidity; it should also have a positive effect on the companies’ transparency and
allow them to focus, first and foremost, on maximising shareholder value.
However, there is still little clarity over how and when the privatisation process will
gain speed. Even if the current plan is put into effect, we would see only a fraction of
the state’s economic interests divested in the next two years, while the major part of
the programme is likely to be delayed well into the future.
In particular, little clarity exists regarding the utility sector’s privatisation, which is, in
the view of our analysts, of paramount importance for the sector’s economics. As
things currently stand, we may first see an effort at consolidating the sector before it
is once again broken down and privatised. Indeed, utilities was one sector where the
process of restructuring never ended and assets were reshuffled several times with
speculators and insiders as the biggest beneficiaries – often at the expense of
minorities.
22. 2
2
Figure 21: Preliminary privatisation plan
Current state stake (%) Stake for sales (%)
Current MktCap
($mn)
State stake’s value ($mn)
First stage (2012-13)
Sberbank 57.6% 5.8% 58,166 3,374
VTB 85.5% 25.0% 18,248 4,562
Alrosa 50.9% 50.9% 5,818 2,962
Aeroflot 51.2% 26.0% 1,530 398
Federal Grid Company 79.1% 4.1% 7,652 314
Total 91,415 11,609
Second stage (to 2016)
Sberbank 57.6% 32.6% 58,166 18,962
VTB 85.5% 85.5% 18,248 15,602
Sovkomflot 100.0% 100.0% 3,100 3,100
Alrosa 50.9% 50.9% 5,818 2,962
Aeroflot 51.2% 51.2% 1,530 783
Federal Grid Company 79.1% 29.1% 7,652 2,227
Rosneft 75.2% 50.2% 59,746 29,992
RusHydro 57.9% 32.9% 7,906 2,601
InterRAO 66.0% 41.0% 8,744 3,585
Transneft 100.0% 25.0% 2,133 533
Total 173,044 80,348
Other unlisted companies
Rosagroleasing 100.0% 100.0% na na
Rosnano 100.0% 100% na na
Rosselkhozbank 100.0% 100% na na
Russian Railways 100.0% 100% na na
Aeroport Sheremetyevo 100.0% 100% na na
United Grain Company 100.0% 100% na na
Murmansk Sea Port 100.0% 100% na na
Arkhangelsk Sea Port 100.0% 100% na na
Vanono Sea Port 100.0% 100% na na
Zarubezhneft 100.0% 100% na na
Source: Government publications, Vedomosti, Bloomberg, Aton estimates
At the Russian Economic Forum in St Petersburg on 21 June, President Putin
presented a policy platform with strong liberal overtones. In short, Putin said:
The crisis in Europe is spreading to the emerging world and Russia needs to
take immediate steps to limit its impact. Russia will support European efforts to
deal with the crisis.
Russia’s priority is to maintain its macroeconomic stability
The Russian economy needs to be diversified and the government must cut the
“dangerous” non-oil deficit, thereby reducing the fiscal dependency on oil
Russia will not impose capital controls and the CBR will maintain a flexible
exchange rate policy
Russia must raise the domestic investment level to 27% of GDP by 2018
(currently it is around 20% of GDP)
Russia will work to improve the climate for long-term foreign direct
investments
Russia is committed to privatising state assets. The process will be honest and
competitive and accessible to foreign investors. Privatisation should not create
private monopolies.
The Russian people are tired of entrenched corruption and anti-corruption
measures will be adopted
Russia needs to reform its pension system
Russia is not aiming to build state capitalism and a strong civil society is needed
for building a modern economy
23. 2
3
From the viewpoint of investors, both foreign and domestic, Putin’s speech hit all the
right notes. At the same time, presidential speeches at previous forums have been
strikingly similar, pointing to the same institutional and structural deficiencies in
Russia, as well as the actions needed to tackle them. It remains to be seen whether
history will repeat itself or if the new government will step up to the challenges
besetting Russia.
Conclusion
The combination of large-scale direct government involvement in the economy and
persistent state corruption remains a major obstacle to improving corporate
governance. This is why, among the most pressing needs, we would single out
privatisation as an issue that should have the most profound impact on corporate
governance quality in Russia. True, the current markets are not particularly
accommodative to new share issues and asset sales, but all investors need at the
moment is a strong government commitment and a clear policy regarding
privatisation. In our view, privatisation should be designed, first and foremost, to
address structural issues rather than simply helping the government to raise
additional budget revenues. Given that the state is a major shareholder in a number
of the largest Russian companies − and is likely to remain in control even after it
reduces its stakes via the privatisation programme – the overall improvement of
governance standards in the country should ultimately be driven by the state, which
is likely to play the role of trend-setter for the corporate sector.
The president and the government continue to hold the view that Russia should
safeguard control of the natural resources sector from foreigners and limit the
extent of privatisation in this segment at least until Russia has found a niche in other
sectors of the global market. Even if we see an increase in private domestic
ownership in this area, the government would remain the largest shareholder in
resource companies for years to come. Therefore, in our view it would be naïve to
expect more than marginal improvements in CGS in these sectors unless the changes
are led by the government itself.
For now, Russia is falling behind DM and many of its EM counterparts on issues of
corporate governance quality, market infrastructure, rule of law and investor
protection. International investors seem to be increasingly cautious about Russia,
which manifests itself in a substantial market discount to peers. In our view, Russia's
discount offers potentially outsized gains, but only if and when substantial structural
reform gains momentum. Just by halving the discount to EM markets (all else
remaining equal), Russia’s market capitalisation has the potential to jump by 1.5
times, on our calculations. Of course, CG risk is not the only factor depressing
Russian valuations, but it is a significant one and Russia’s leaders should take a
pragmatic view of the issue or abandon attempts to attract international capital in
sufficient quantities. Without change, Russia risks being stuck in a vicious circle of
half-baked reforms, ineffectual regulation and economic policies, poor corporate
governance and value-destroying corruption and could forever remain the land of
unrealised opportunities.
24. 2
4
Ranking Russian Companies by Corporate Governance Score
This report follows in the footsteps of work previously published by our strategy
team (see Price & Prejudice, 1 Nov 2010 and Keep It Simple: Focus on Good
Corporate Governance, 30 June 2011) but attempts to refine our methodology and
develop a more objective and detailed assessment of corporate governance
standards in Russian corporations. As a result, most of the company ratings have
undergone significant revisions and, we believe, now better reflect the reality of
the corporate governance record of the companies under our coverage.
To assess the quality of the corporate governance standards of the companies in our
sample, we broadly followed methodology developed by Standard & Poor’s. This was
known as the Corporate Governance Score and later transformed into GAMMA. It
employs an in-depth, multifaceted analytical and scoring model which rests on four
pillars (each of which is further broken down into components):
Ownership structure and external influence (30% weighting)
Shareholder rights and stakeholder relations (15% weighting)
Transparency, disclosure and audit (20% weighting)
Board structure and effectiveness (35% weighting)
S&P’s methodology presumes the extensive use of non-public information which is
collected through a series of interviews with top management and board members
and by studying confidential internal documents. As external analysts we do not have
access to privileged data and have had to use only publicly available sources,
including materials published by the companies and other sources that we deem
reliable. A proper discussion of corporate governance presumes a highly detailed
analysis of company operations and its full description deserves a separate report.
For the purpose of the current report, each of our sector analysts assessed the
companies under their coverage using a set of 144 questions divided into four sub-
components, as described above.
The final score is achieved by summing up the scores for each of the four
components and weighting them in accordance with their influence on the overall
quality of corporate governance.
Figure 22: S&P corporate governance score scale
9-10 Very strong CGS processes and practices overall
7-9 Strong CG processes and practices with some weaknesses in certain major areas of governance analysis
5-7 Moderate CG processes and practices overall with visible weaknesses in several major areas of governance analysis
3-5 Weak CG processes and practices overall with significant weaknesses in a number of major areas of governance analysis
1-3 Very weak CG processes and practices with significant weaknesses in most of the major areas of analysis
Source: S&P GAMMA Scores, Criteria & Definitions
While we strove to be as objective as possible in our assessment, these rankings
inevitably involve a degree of subjectivity and our work may be far less than perfect.
However, it represents an honest attempt to tackle the corporate governance issue
in Russia in a systematic and consistent manner.
25. 2
5
The average CG score of our sample of Russian public companies reaches 5.5, which
can be interpreted as “Moderate” under S&P methodology. We see this as a fair
assessment of the current stage of the market’s development. Unfortunately we
have no global benchmarks for comparison, only an absolute scale. For the purpose
of progress monitoring, we would consider Russia to have entered the ranks of
world-class corporate governance if the average score rose closer to 7. The country
score weighted by market capitalisation produces an average of 6, highlighting the
fact that larger companies tend to exhibit better quality corporate governance
standards as they are more often in spotlight. However, only nine companies scored
higher than 7 in our ratings, which is closer to the S&P definition of strong CG.
On the basis of our assessment we divided our sample into four quartiles with stocks
in the first two quartiles representing companies with moderate to strong corporate
governance and those in the third and fourth with weak to moderate CG.
Figure 23: Stocks divided into quartiles according to CGS
1st
Quartile 2nd
Quartile
Company Ticker
MktCap
($mn)
CGScore Company Ticker
MktCap
($mn)
CGScore
VimpelCom VIP 12,570 7.3 HMS Group HMSG 539 6.3
NLMK NLMK 10,380 7.3 Sistema SSA 8,603 6.3
Magnit MGNT LI 12,305 7.3 E.On Russia EONR 5,024 6.3
M.Video MVID RX 1,226 7.2 Global Ports GLPR 2,264 6.3
X5 Retail Group FIVE LI 6,029 7.2 LUKOIL LKOH 41,961 6.2
CTC Media CTCM 1,318 7.2 Acron AKRN RU 1,474 6.2
MTS MBT 17,399 7.2 Kuzbasskaya Toplivnaya KBTK 428 6.1
MMK MMK 3,091 7.0 Mechel MTL 2,696 6.1
Evraz EVR 5,686 7.0 Rusagro AGRO LI 711 6.1
Severstal SVST 12,384 6.9 Rosneft ROSN 59,746 6.1
Petropavlovsk POG 1,459 6.8 Rosinter ROST RX 67 6.1
C.A.T. Oil O2C 313 6.8 Polyus Gold PLGL 9,096 6.1
NOMOS NMOS 1,994 6.8 Rostelecom RTKM 9,944 6.0
NOVATEK NVTK 31,327 6.8 Bank St Petersburg BSPB 496 6.0
Mail.RU MAIL 6,742 6.7 Highland Gold HGM 515 6.0
Yandex YNDX 5,775 6.7 Aeroflot AFLT 1,530 6.0
Vozrozhdenie VZRZ 365 6.7 FESCO FESH 825 6.0
Polymetal PMTL 6,321 6.6 TMK TMKS 720 6.0
LSR LSRG 1,723 6.6 Enel OGK-5 OGKE 1,797 6.0
EDC EDCL 3,745 6.6 Gazprom Neft SIBN 21,093 6.0
Sollers SVAV RU 441 6.6 Protek PRTK RX 396 6.0
TNK-BP TNBP 33,756 6.6 NCSP NCSP 1,631 5.9
BASHTEK BANE 9,867 6.6 Cherkizovo CHE LI 710 5.9
Sberbank SBER 58,166 6.6 Dixy Group DIXY RX 1,289 5.9
Transcontainer TRCN 1,389 6.5 PIK PIKG 1,093 5.9
Globaltrans GLTR 2,807 6.4 Pharmstandard PHST LI 2,246 5.8
Integra INTE 272 6.4 O'Key Group OKEY LI 1,999 5.8
Uralkali URKA RU 22,968 6.3 Raspadskaya RASP 1,851 5.7
1st
quartile total/avg 271,819 6.8 2nd
quartile total/avg 180,744 6.0
Source: Aton estimates
26. 2
6
3rd
Quartile 4th
Quartile
Company Ticker
MktCap
($mn)
CGScore Company Ticker
MktCap
($mn)
CGScore
GAZ Group GAZA RU 481 5.7 OGK-1 OGKA 1,205 4.6
Armada ARMD 96 5.6 MRSK Center and Volga MRKP 410 4.5
UTair UTAR 345 5.6 MRSK Volga MRKV 334 4.4
Tatneft TATN 12,147 5.6 MOESK MSRS 2,019 4.4
Mostotrest MSTT 1,561 5.5 Lenenergo LSNG 311 4.4
RBC RBCM 165 5.5 MRSK Holding MRKH 2,830 4.4
Gazprom GAZP 111,058 5.5 OGK-2 OGKB 858 4.3
Norilsk Nickel GMKN 30,143 5.5 MRSK Siberia MRKS 247 4.3
KAMAZ KMAZ RU 988 5.4 MRSK Urals MRKU 501 4.3
RusHydro HYDR 7,906 5.4 Quadra TGKD 281 4.3
High River HRG 1,012 5.4 Vyksa Steel VSMZ 2,125 4.3
Veropharm VRPH RX 217 5.4 TGK-14 TGKN 46 4.2
Rusgrain RUGR RX 36 5.3 MRSK South MRKY 84 4.2
AvtoVAZ AVAZ RU 692 5.3 TGK-9 TGKI 365 4.2
Black Earth Farming BEFSDB SS 152 5.2 TGK-7 TGKG 1,372 4.2
VTB VTB 18,248 5.1 Krasnoyarsk HPP KRSG 1,089 4.2
Chelyabinsk Zinc CHZN 109 5.0 Mosenergosbyt MSSB 350 4.1
IBS IBSG 500 5.0 PIMCU PGHO 256 4.1
Alrosa ALRS 5,818 4.9 Kubanenergo KUBE 317 4.1
MRSK Center MRKC 601 4.9 Irkutskenergo IRGZ 2,068 4.1
Federal Grid Company FEES 7,652 4.9 SurgutNG SNGS 29,627 4.0
TGK-1 TGKA 836 4.8 Elemash MASZ 188 4.0
TGK-11 TGKK 230 4.7 TGK-5 TGKE 150 4.0
Mosenergo MSNG 1,798 4.7 TGK-6 TGKF 205 4.0
MRSK North-West MRKZ 210 4.6 MRSK North Caucasus MRKK 102 3.6
Pharmacy Chain 36.6 APTK RX 100 4.6 Kuzbassrazrezugol KZRU 1,889 3.2
OGK-3 OGKC 1,397 4.6 TGK-2 TGKB 92 2.9
Razgulay GRAZ RX 90 4.59
3rd
quartile total/avg 204,589 5.1 4th
quartile total/avg 49,321 4.1
Source: Aton estimates
As can be seen from the tables above, utilities is one of the worst-performing sectors
in terms of corporate governance, followed by agriculture, infrastructure, the nuclear
fuel industry and automakers. The poor performance of these sectors also partly
explains the below-average rating of SOEs as a group – our sample of 34 state-
controlled companies scores only 5 on average (see Fig 25) with 24 state-owned
stocks in the bottom quartile. Out of 27 stocks in the 4
th
quartile, 22 are utilities;
among the ten worst companies, utilities occupy six places.
It is interesting to note that in the top quartile we see only one state-owned stock:
Sberbank. We feel it is no coincidence that more than half of the best-governed
companies in our sample represent businesses created from scratch with little or no
connection to legacy assets. These mainly involve companies in the TMT, consumer,
financial and oilfield services sectors, which floated in the last decade. All bar four of
them have a foreign listing.
27. 2
7
It may not be immediately obvious that higher quality corporate governance
structures and processes boost business and share performances. However, it would
be fair to say that even in the best-performing businesses, the absence of good
corporate governance increases the risk that minority shareholders may not fully
benefit from the economic value created, and in the worst cases the assets may be
hijacked and the stock annihilated. In other words, it may be hard to see how good
corporate governance can lead to enhanced share performance, except when it
suddenly does so.
While at the individual stock level it is difficult to find a strong correlation between
good CG and share performance, it has a more pronounced impact at the portfolio
level: our back-testing shows that longer term, portfolios of better-governed
companies outperform the market by a significant margin. We are not talking
pennies (or kopeks) here: on our calculations the stocks in the top quartile of our CGS
rankings outperformed the lower-ranked stocks by a substantial 60-90%, and the RTS
Index by over 55% over the last three years. What is more, this outperformance
seems to be consistent throughout different periods in the recent history of the
Russian market. Of course, not all of this outperformance can be directly attributed
to good corporate governance, but in our view it is fair to say that stocks with better
CG outperform because their managers are more strongly focused on shareholder
value creation.
Figure 24: 3Y performance of stocks by CGS quartile vs RTSI$ index
Source: Bloomberg, Aton estimates
Figure 25: Stock performance by quartile
6M 1Y 3Y 5Y
From low
of 2009
From high
of 2008
1st Q -6.2% -26.7% 80.2% -14.0% 276.9% -33.7%
2nd Q -8.1% -25.0% 19.1% -27.5% 234.7% -34.4%
3rd Q -7.0% -37.5% 5.2% -48.6% 104.2% -47.6%
4th Q -13.9% -34.8% -10.4% -51.6% 91.4% -63.6%
RTSI$ -10.6% -31.9% 24.6% -30.0% 152.5% -47.1%
Source: Bloomberg, Aton estimates
0.0
0.5
1.0
1.5
2.0
2.5
Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12
1Q 2Q 3Q 4Q RTSI$
28. 2
8
We note that the top-rated companies in our rankings not only fell less than others
during market downturns; they also generated nearly double the returns of the RTS
Index when investors came back strongly in 2009 after a tumultuous 2008. The
market clearly shows a preference for better CG stocks at the early stages of an
uptrend, when the overall economic outlook is still unclear.
Our findings suggest that focussing on corporate governance as one of the integral
parts of stock assessment pays off, particularly over the long term. Investors who
ignore CG do so at their peril, although the dangers may not be immediately obvious
and only become clear after a failure of corporate governance leads to value
destruction. It is also clear that country context and the overall governance
environment in a country play a significant role in the aggregate market valuation –
the overall effect from pockets of poor governance is risk contamination.
Finally, we believe that the performance figures of the higher-rated stocks in our
rankings should be of great interest to the companies themselves, as it emphasises
the potential growth in shareholder value that arises from efforts to maintain best
management practices.
