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Investing In Russia: Heady Returns But Plenty of Landmines

Russian stocks have posted outstanding returns in the last six years, but market pros say investors may want to pause before jumping headfirst into the maturing economy.

"There are a lot of opportunities there but there are also a lot of landmines you want to avoid, the biggest is political risk," said Kevin Kerr, president of Kerr Trading International. "It's a double-edged sword; you can't tell what's going to happen, investors need to be cognizant of that."

The top 10 performing mutual funds in 2006 were all China-related equities funds except for one, the ING Russia Fund, which managed to sneak past many investors' radar screens on its way to heady gains of 68% last year (Also see: The China Challenge: Guide To Investing).

The handful of individual Russian stocks that trade on U.S. exchanges have performed even better than mutual funds, led by incredible 12-month returns of more than 120% for telecom giant Vimpel Communications and 140% for Wimm-Bill-Dann Foods, a maker of dairy and juice products. Russia's major oil companies such as Gazprom and Lukoil trade in London and have not fared as well, dipping as much as 50% in the last 12 months.

Russia has seen its economy grow every year since 1998 with average annual growth of 6.7%, according to the World Bank. While rising oil prices have been a factor, a rise in consumer demand and increased foreign investments have also played a role.

"The markets have done very well in the last several years but this year has been very disappointing, down about 5%," said Kerr. "It's been consistent since 2000, this is the first year its backed off. With the negative publicity it'll probably cool off even more."

"It's probably not the market to be in right now," he added. "It's a wait-and-see environment, kind of on a weekly basis."

At the Group of Eight Summit meeting in Germany, talks were at times overshadowed by political tensions over a proposed missle radar shield between former Cold War opponents Russia and the United States.

"If you have negative news item after negative news item coming out of the Kremlin as we've seen, at some point you have to question whether foreign investors will be more cautious on the market," said Vladimir Milev, strategist with the Metzler/Payden Emerging Markets Fund .

The strategist said Russian stocks have backed off in 2007 not only because of negative sentiment fueled by heightened geopolitical tensions but also due to lower investor demand following two major banking IPOs, vacillating oil prices and other energy-related commodities.

"The Russian market is pretty heavily weighted in the energy market and you've had a bit of a loss of momentum in those stocks because oil prices haven't exhibited as strong of a trend and traded in a fairly narrow band," he explains.

In addition to having arguably the greatest political risk of any major emerging market, the heavy bias to the oil and gas markets have also turned off some diversification-seeking investors.

The ING Russia Fund currently devotes 34% of its assets to energy stocks, 17% to the financial sector and 13% to telecoms. The fund, despite big gains in 2005 and 2006, has also seen its fair share of drawdowns with double-digit losses in more than 20 three-month periods in the past decade, highlighted by the fund's 83% decline in 1998 following the government's massive default on external debt.

Thinking Long Term

Russia Still a Good Long-Term Bet?

Ian Hague, a fund manager with Firebird Asset Management, remains undeterred by recent political tensions and says Russian stocks could be ready to resume their uptrend.

"We're no strangers to political rhetoric that is a bit over the top," he said. "Political rhetoric in Russia has much less of an impact on the actual conduct of business than you might think. It's not really the same kind of relationship that exists between businesses and government as this country."

Hague, who runs $3 billion in various funds and focuses on the former Soviet Union and Eastern Europe, has been investing in Russia for the last 13 years. He says shares of companies such as oil giants Gazprom and Lukoil are now oversold on a technical basis.

"They are the most liquid stocks in the market and they'll benefit from the change in sentiment," he asserts.

Milev of the Metzler/Payden fund contends that stock market declines as a result of negative sentiment have nothing to do with the long-term growth prospects of the Russian economy, which he says remain healthy.

"If you remember the correction of May/June of last year when emerging markets pulled back on concerns of global monetary policy, stocks sold off to an extent that there was absolutely no regard for fundamentals," said the Bulgarian-born analyst. "We were bottom-fishing during that cycle and picked up very healthy returns. I can envision a similar situation in Russia."

Valuations for Russian stocks now appear cheaper than broad Central European and Eastern European indexes, he added.

But Kevin Kerr said he prefers to invest in former Soviet states with a lot of exposure to Russia such as Estonia, Lithuania and Latvia, which are now part of the European Union.

"We would prefer to put our money where we can go to European court," he says. "It's a lot harder to do that in Russia."

More than Just Oil

Those investors brave enough to withstand a potential step-up in volatility may want to look at Market Vectors Russia, a new exchange-traded fund launched April 30.

RSX tracks the newly formed DAX Global Russia Index, a basket of the 30 most actively traded Russian stocks listed locally as well as in London and New York.

Some of the index's components include energy giants Lukoil, Gazprom and Surgutneftgaz, utility giant Unified Energy Systems, steel manufacturer Mechel Steel and mining outfit Norilsk Nickel.

"We believe in the long-term story there," Milev says. "For an investor who's interested in this region and understands the risk-return profile, they just need to take a long-term outlook on the market."

"It's not just the oil story -- oil has been the story for the last three years -- but before that they were already on the path of greater fiscal responsibility, he adds. "Russia is a very different place since 1998."

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