Russia Buyers Beware
By ALEXANDER TEMERKO
February 1, 2007

In their enthusiasm for Russian stocks, many Western investors seem to believe that, with a few improvements in disclosure and the addition of some foreign managers and nonexecutive directors, the companies they're investing in will be just like any other. They couldn't be more wrong.

Russian capitalism is not an imperfectly evolved version of that practiced in developed countries. Russia has created a form of capitalism never seen before. Unless you have your own private mole in government, you will never be able to predict your returns with any confidence. Directly or indirectly, corporate authority ultimately rests with the state in Russia.

Take Rosneft, the recently floated oil giant. Attentive readers will recall that I strongly criticized of the Rosneft flotation in this column last May. Some might even think that my warnings were ill-founded, and that the IPO was a great success. Far from it.

With the government's full support, Rosneft strong-armed BP and other strategic investors eager to operate in Russia into buying large blocks of shares. As a consequence, Rosneft has a free float -- i.e. tradable shares not owned by insiders and direct investors -- so thin that, were it a British company, it would be in serious breach of U.K. trading rules.

In the U.K., trading rules require a free float of at least 25%. Yet Rosneft's free float is a fraction of 1%. How can this be? Well, the rules apply only to shares that can be traded in London. In Rosneft's case, and that of nearly all other London-listed Russian stocks, shares traded outside Russia are global depository receipts, which represent only 10% of Rosneft's total shares issued. The 25% rule is applied only against GDRs and, by that meaningless measure, Rosneft passes the test. As a consequence, Rosneft's share price is almost entirely insulated from international investor sentiment. The only shareholders who count are in Russia. And of those, the dominant players are the state-controlled banks, especially Vneshtorgbank and Sberbank.

Daily trading in Rosneft shares since the flotation has seldom exceeded $250,000. But major spikes have occurred, almost like clockwork, in the middle of September (on consecutive days, $500,000 and $550,000), October ($1.2 million one day), November ($1.3 million) and December ($4.85 million). Each drove Rosneft's share price to a new plateau, raising questions about whether the spikes represent organized intervention.

If you had $2 million to play with, you could have a significant impact on Rosneft's market capitalization. And if you devoted just $5 million to the task, you could -- in theory -- hold the company's destiny in your hands, artificially boosting its value at will. But this, of course, would not be permitted. You would quickly find obstacles to your trades. Trading in any stock at this level in Russia requires permission from the Kremlin.

In short, Moscow -- an "insider" to almost any major share transaction in Russia -- can do virtually whatever it chooses to do with share prices. But state involvement does not stop there. Corporate governance is directly supervised by the government, which vets all board and senior management appointments for companies with direct or indirect state ownership. Ministers and leading bureaucrats also serve as executives or board members of the biggest companies under direct or indirect state control, and all are paid supplementary stipends.

Also much overlooked by international investors are the smaller "tasks" that these companies are required to perform. For example, the aluminum company Rusal's generous treatment by the state -- on taxes, electricity tariffs and, occasionally, loans from Sberbank -- is in effect guaranteed by its ownership and maintenance of another large but far less successful business, the auto manufacturer GAZ. GAZ is a major employer in the city of Nizhny Novgorod, east of Moscow. It takes little imagination to spot the "deal" there: You subsidize thousands of jobs in Russia's third-largest city, and we'll protect your core business.

It is impossible for outsiders to predict which state interest or whim might prevail at any given moment. Perhaps the asset you have bought into is one on which insiders are expecting their own capital gain. Or perhaps the insiders will decide to use it for some other purpose, one that will ultimately ruin your investment.

And if the past is any guide, investors cannot rely on international bankers and securities analysts to be prudent in this sorry picture. The deal fees are just too attractive. The canceled Uralkaly flotation last autumn and the postponed IPO of Pharmstandard highlight the problems, as have the worried reactions recently to Severstal's high offering price. Uralkaly, a fertilizer company, acknowledged it had overpriced itself (or, rather, it said the market had failed to value it appropriately). But how many already-completed flotations were based on overvaluations?

Behind all of this lurk any number of fundamental business deficiencies. Did you know, for instance, that Russian oil-industry growth came to a halt in the fourth quarter of 2006? Capital expenditures in the Russian oil industry are at a five-year low. Why is this so? First, the state claims everything above $27 per barrel in taxes. Second, the companies are investing money in purchasing assets that have already been fully developed instead of further developing existing oil and gas fields, or exploring and developing new ones. Given these short-sighted strategies, a decline in production is inevitable.

All this should be of grave concern to international investors. Having raised more than $17 billion in 2006 -- 50% more than was raised over the past five years combined -- Russian companies coming to market in London should have been heralding bigger opportunities. Instead, they represent the ruling elite's bet that Russia Plc can exploit capitalism for its own purposes.

Mr. Temerko, a former vice president of Yukos, is founder and managing director of BST Link in London.