Russian equities are trading at an average price-earnings ratio of 6.5, compared with the emerging-markets average of 12.5. There are good reasons for the discount. Russia’s economy is under severe pressure because of weaker oil prices and the effect of international economic sanctions imposed as a result of its role in the conflict in Ukraine. The ruble has plunged versus the U.S. dollar, inflation has shot up, and Russia’s gross domestic product is shrinking. Ordinary Russians have felt the pinch in the form of declining real incomes.
Against such a backdrop, even the most contrarian investor needs to tread very cautiously before venturing into Russian stocks. That said, we at AllianceBernstein believe selected large Russian food retailers represent a compelling opportunity for investors, given the long-term modernization and consolidation of Russia’s food retail industry.
The country’s grocery segment is potentially massive. Russia’s population is nearly large as Germany’s and France’s combined, yet there are relatively few modern supermarket chains, and the industry is still highly fragmented. Collectively, Russia’s biggest retail chains have rolled out more than 2,000 new stores in each of the past five years, but they still have lots of room to expand and win greater market share. The largest modern chains are relatively young companies, having emerged in the 1990s following the dissolution of the Soviet Union and gone public during the past decade, but they’ve fast gained size and reach.
This growth potential doesn’t seem to be priced into the big Russian food retailers’ valuations, which look cheap compared with many of their emerging-markets peers.
This disparity is particularly surprising because they’re highly profitable. In other countries, intense competitive pressures have resulted in price wars, driving down profitability industrywide. In Russia these pressures are kept in check because the country’s vast geography and harsh climate pose significant logistical barriers to entry for new competitors. Western food retailers have largely decided to stay away, dissuaded by a challenging business environment, economic sanctions and their unfamiliarity with the local market.
Declining wages and soaring prices could curb Russian spending on food. Retailers are also pressured by government restrictions on food imports from countries that have imposed sanctions in protest of Russia’s role in the Ukraine conflict. The big chains are proving more successful in finding alternative sources for banned foodstuffs and, given economies of scale, offer lower prices than can smaller chains and stand-alone stores — a tempting proposition for Russian consumers looking for value for money in tough economic times.
Russia’s economic woes have driven down both labor and real estate costs, the big players’ two largest operating expenses. These factors should help make expansion a less costly undertaking. Nonetheless, aggressive expansion runs the risk of eating into profit margins. Given the significant increase in capital invested by the big retailers over the past five years or so, their returns could have come under pressure. In fact, economies of scale have ensured that their returns on capital have actually improved as they’ve deployed more capital.
Russia isn’t an obvious investment target in these difficult times. But because many investors are steering clear of the region, the grocery segment is a good place for investors to shop for bargains that should benefit from structural change during current economic and political uncertainties, as well as when — one hopes, in the long run — the conflict is resolved.
Henry D’Auria is chief investment officer of emerging-markets value equities, and Justin Moreau is a research associate for value equities, both at AllianceBernstein in New York.
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