Russia: Seeing The Wood For The Trees – Prosperity Capital Management
It is now twenty years since the launch of the Russian Prosperity Fund and twenty-three years since I first started investing in Russia. Often, people ask me how the outcome compares with the expectations I held when we started. It is, of course, not entirely easy to remember what I thought then of what would happen but, perhaps somewhat surprisingly, it was not so far from the reality is. We expected Russia to become a modern country, much more similar to developed counties, and for the companies in which we invested to become more efficient and profitable. Often, we heard Russians say that they wanted Russia to become a ‘normal’ country. It is not fully clear what that means, but it is very clear that they have come a long way toward this goal. I lived in Moscow for seven years raising my children in the city over that time – and have visited more than one hundred times since I moved away. I still well remember the chaotic, but exciting place that we moved to in those early years, where nothing and everything worked. When we arrived there was only one modern food store in the whole country, very limited communications, no real taxis, the airlines and hotels were not for sensitive travelers. The companies had next to no transparency, share transactions had to be re-registered manually – often in Siberia – and share quotes were faxed amongst brokers. Most exporters also exported their profits to offshore sister companies. It was not always easy to either live in Moscow or to invest in Russian companies.
Now, Moscow is a very welcoming city with all of her amenities and attractions. Regional cities are not far behind. Every conceivable consumer good is available and everything is digitalised for convenience. There are high-quality restaurants and hotels at reasonable prices and service levels are comparable with any major city. Russian companies are now arguably more transparent
than their western counterparts and the stock exchange works as smoothly as any in the world. Russia has come a long way.
What is driving all of this? What does it mean and where will we go from here? There are many contributors, but most important is clearly productivity. The link between productivity and prosperity is so close that one can almost say that it is the same thing. Productivity is, however, one of the most difficult things to measure correctly. It was easy when all one needed was to calculate factory output, but as services have become the mainstay of most economies it has become trickier – particularly with public services. Whatever measure one chooses, it is very clear that a major shift has happened in the world economy when it comes to productivity. Twenty years ago, the world was much simpler. The developed world had high productivity and was wealthy and the emerging world had low productivity and was largely poor. The latter category certainly included Russia, even if Russia – as opposed to many other emerging countries – was industrialised, urbanised and generally well-educated. Since then, the West has essentially no productivity growth and no real GDP growth outside of population growth. Real GDP per capita has been stagnant for the last eight years. Policy makers have tried to rely on unprecedented monetary stimulus in an attempt to generate economic growth in the absence of real productivity growth. It has not worked.
On the other hand, in emerging countries, including Russia, one has seen striking productivity growth. As mentioned, it is not always easy to measure productivity, but looking around one can clearly tell that more is being produced in terms of both goods and services. This absolute and relative productivity growth is the core of the story that we are trying to tell.
One can often read stories in the press about how Russia is in decline, on the precipice of some collapse and facing a dead-end. At the end of this Prosperity Newsletter, I enclose a rebuttal of such an article. I chose the one that I have not because it is much worse than others, but because the author, Thomas Friedman, is very highly regarded. It is loaded with manipulated and misleading ‘data’. I still find it hard to fully understand why otherwise reputable journalists, like Friedman, would willingly mislead their readers. Perhaps my argument is harshly formulated, but the data can very easily be checked and there is no doubt about who is right and wrong in this case.
There are many different aspects of the improvements that we have seen over the last twenty years and it would be easy to focus on corporate profitability and dividends, which are, naturally, our main interests as investors. Many investors, however, are also concerned with broader issues and have some difficulty reconciling the picture that we paint with impressions relating to political factors. We generally try to stay out of political discussions, but still seek to explain how things look from the Russian side. Later on in this Prosperity Newsletter we have shared our thoughts on geopolitics over the last twenty years and now.
On the domestic political front, there are a number of things that may help to explain the current standing. Putin’s popularity has three legs. Most have focused on the most obvious one; the Russian people are much better off now than when he came to power. US dollar salaries are more than ten times what they were and there is hardly any unemployment. Most commentators have not come further than this and are surprised that Putin is not less popular now, as things have been a bit tougher of late with two recessions in the last eight years.
The second leg of Putin’s popularity is probably even more important than the first. The Russian society now functions far better than it did. The 1995 were chaotic and many suffered greatly. Public services declined dramatically. In the last sixteen years, all of this has turned around. It is hard to measure productivity and efficiency in healthcare and education, but it is very clear that things are now improving. One dramatic measure would be infant mortality; we have seen infant mortality decline by 65 percent – this does not happen by chance. It happens because the healthcare system works better and parents are better able to care for their children. The average lifespan has increased by more than six years in the last twelve years. These are very striking numbers and this rate of improvement is very unusual globally.
We also see other signs. There has been a real drive toward e-government and on the Ease of Doing Business measures. Russia has improved on all sorts of rankings, as can be seen from the below listed examples. Education has increasingly been taken online, with each school and pupil now having their own online portal. All of these things add to the sense of wellbeing for the Russian population. Anyone who has regularly visited Moscow will also have noted the clear improvements in the cityscape. Roads, parks, pedestrian areas, sports facilities and much more have improved. Many other Russian cities have seen similar moves forward and those falling behind are increasingly getting into trouble. One of the most pervasive remaining problems is corruption and this is often mentioned in rankings of peoples’ complaints. In the last few years we have seen real action on this also and the list of people caught including high ranking ones – is steadily getting longer. By now, people are probably concerned enough to change their behavior. This is still a work in progress and we will see what the outcome will be.
Russia is moving up the rankings
Ease of Doing Business Report
From 112th place in 2013 to 51st in 2015
The Global Competitiveness Report
From 64th place in 2011 to 45th in 2015
The Human Capital Report
From 51st place in 2013 to 26th in 2015
Bloomberg Innovation Index
From 18th place in 2013 to 12th in 2015
The third leg of Putin’s popularity is related to Russia’s standing in the world. Many Russians felt humiliated when the Soviet Union collapsed. They resented that the Russian point of View was not taken into consideration and that President Yeltsin became a punch line around the world. I will not dwell on the merits of the Russian foreign policy at this time, but many Russians feel that they are now at least being taken seriously. I must say that some people even seem to take Russia too seriously.Just last week, a retiring UK four star general issued a parting letter where he worried that the UK would not be able to withstand an all out Russian assault- as if this was even remotely possible. Maybe a lot of people want their Cold War back.
Having said all of this, most of the productivity gains achieved in Russia have come from the private sector. Sometimes productivity gains are incremental and may be hard to discern, but often we see dramatic improvements in just a few years. Prosperity are micro- focused investors and it is our View that all macro is just an aggregation of the micro. We see our job as understanding what drives a specific company to become more efficient and productive. We seek to understand the competence and attitudes of corporate management as they work to make their companies more profitable.
Russian companies are now amongst the most competitive in several industries, primarily commodity-related ones. The Russian oil industry actually has higher margins this year than it had in 2014, when the oil price was more than twice its current level.
We have also observed a very significant broadening of the Russian economy. The World Bank calculates that ‘natural resource rent’ as a share of GDP has declined from nearly 43.5 percent in 2000 16.2 percent in 2014. No doubt this process has continued since. What has taken its place is primarily a growth in services. We have seen retail, communications and entertainment develop rapidly. There are now also alternatives to public services such as private schooling and healthcare providers. Most of these new businesses operate with higher efficiency than most legacy businesses. We are also seeing far better use of technology, both in terms of its implementation in existing businesses, such as oil or retailing and also in specific technology companies.
We are closing in on the real driver for all of these improvements. All of this is made possible by the very strong human capital that Russia has. This is her hidden commodity – and one that not enough investors focus upon. The general population is very well-educated and the best can measure themselves with anyone in the world. As an example, in the latest world programming championship for universities there were five Russian and one Ukrainian university amongst the top twelve. It is the quality of human capital that makes us convinced that the progress made in the last twenty years will be followed by many more years of success to come. Commodity prices may fluctuate and politics is hard to predict, but strong human capital is a driver we can rely upon.
Over the years, commentators have written Russia off a number of times; in 1994, with the default of 1998, at the time of the Yukos affair in 2004, in the global financial crisis of 2008 and, most recently, in 2014. Each time, Russia has recovered, our companies have emerged stronger, more efficient and profitable and, each time, it has been a great entry-point for investors. We are convinced that the Russian society and economy will continue to improve and that the intrinsic value of our companies will continue to grow.