Maintaining our market targets. We are maintaining our targets of 1,950 for the RTS Index and 1,671 for MICEX, which are based on the fundamental valuations of the stocks in each index. This implies upsides of 24% for the former and 13% for the latter. However, because the Russian market is now primarily driven by external rather than domestic events, we are extending the time frame to achieve these targets from end 2010 to end Qtr 1 next year. US quantitative easing may provide a catalyst. The prospects of a global market rally into the end of the year are, however, improving, albeit underlying nervousness persists on all markets. A second round of quantitative easing (QE) in the US could be a trigger. In that case, just as we saw in 1Q10, Russian equities will strongly outperform the global and EM average. We advise investors to stay fully invested in the market (out top stocks picks and best market themes are detailed in this note) from now. A late rush of issuance. Only one international IPO has been placed this year. Five IPOS have been placed in Moscow. The total raised is $2.9 bln, rising to $4.7 bln if SPO volumes are added. Several IPOs are now underway as companies rush to raise equity financing before the year-end. The total for the year may reach $8.5 bln, a long way from the $20 bln originally expected IPOs have been a bad investment. All of the IPOs issued so far in 2010 are currently trading below the issue price, some by more than 50%. That will make potential investors wary and look for even bigger discounts.

Valuation and Stocks

Equities are at a near historic high discount. Equities are, on average, trading at a 35% discount to the EM average based on the Bloomberg consensus for 2011. Minus the more lowly rated oil and gas sector stocks, the market is still trading at a near 25% discount. Before the crisis, the discount was closer to 10%. Banks should be the best performing. The best market themes for the next 12 to 15 months will be in domestic sectors. The budget is focused on increasing social spending which is expected to boost domestic consumer and corporate investment spending. The banks are best placed to benefit most from this.

Economy, Currency & Politics

Economic growth is slower than expected. Economic growth is more sluggish than expected this year because of the effect of the extreme summer weather on the agriculture sector. Inflation will also be higher, but it is unlikely to be high enough, for long enough, to force interest rates to rise. Fiscally, Russia is strong. The budget deficit is expected to be much smaller than forecast and capital outflow this year will be minimal. Ruling tandem is stable. Although there has been an increase in speculation about the stability of the so-called ruling tandem, especially surrounding the dismissal of the Moscow mayor, there is no evidence to suggest anything other than business as usual. Appetite for Russia risk is still evident. Russian equities are viewed by a majority of emerging market portfolio investors as a derivative of the global economic recovery. A majority say (*) that they intend buying more Russia exposure, but only when they have a higher level of conviction about the sustainability of the global recovery. That was the case in the 1Q10, when the MS Russia Index rose 14.3%, while the MS GEM Index gained 5.9% and the S&P added 8.7%. But, despite the setback to the economic recovery caused by the summer drought, the economy and corporate earnings in Russia are in good shape. The story is improving steadily, albeit not spectacularly. Russia funds have been ignored. Since early summer, investors have sidelined Russia as they increase bets in Brazil, Asia and Turkey. Russia content is now neutral (relative to MSCI) in EM Portfolios. Investors are adding more domestic stocks. Investors continue to broaden their Russian holdings by adding more domestic-theme stocks and second tier names. Gazprom is the biggest under-weight with utilities also very under-owned relative to the MSCI Russia Index. Equity Issuance Current snapshot of the investment case. Set out later in this report, we review the main reasons why Russia’s investment credentials are much better than the current valuation and investor approach suggest. We also list the main risks that could change the increasingly favorable picture. We review the main drivers and risks within each of the market sectors and highlight the stocks about which we have the highest conviction. Finally, later in the report, we summarize the current position in the economy, in the fiscal balances, the currency and in political developments before reviewing the year-to-date fund flow activity and IPO/SPO equity issuance. * based on Uralsib Research informal survey

Russia Investment case

Reasons to own more Russia. The most important points that support the investment case for Russian equities include:

• Russia is the best high-beta theme in global markets. Assuming that another round of QE does lift the US and global markets, Russian equities will again lead that rally;
• The government is expected to “allow/facilitate” a higher ruble exchange rate, as its number one priority is inflation control through the winter;
• The 2011 Federal Budget is an election budget, which will help boost domestic consumption and attempt to boost domestic investment rates;
• Russian equities are not overweight in GEM portfolios relative to the MSCI EM Index. Brazil, China and India are overweight currently, while Russia is only at a neutral weight. EM portfolios have more scope to add Russia;
• Russia portfolios are holding a high level of cash. Currently that is estimated at between 6.5% and 7.5%, while a more normal level is closer to 3.0%. So, portfolio managers also have the means to buy more Russia;
• Russian equities are, on average, cheaper than peer EM markets. The discount gap is now at the widest it has been since 2004. Even excluding the (globally) cheap oil & gas sector shares, the remaining market is about 25% cheaper than the rating of Brazil;
• Russia’s economy is fiscally strong. Foreign exchange reserves are again near $500 mln and the budget deficit has been contained so that the balances of the Reserve Fund and Well-Being Fund (approximately $41 bln and $90 bln, respectively) are no longer being dipped into;
• The total sovereign debt to GDP ratio is at 10.5% and may reach 11.0% by year-end;
• The budget deficit is unlikely to exceed the current level of less than 3.0%, despite the overly cautious Finance Ministry forecasts;
• Economic growth in 2010 would have been well in excess of 5%, if not for the effects of the summer drought. It cut at least 1.0% off this year’s growth;
• Inflation will rise higher by year-end because of a number of one-off factors. Next year’s rate should be lower. That should allow the Central Bank to avoid having to raise interest rates;
• The government is much more focused on improving the investment perception of Russia amongst investors. Its development plan is also much more pragmatic than before;
• The first phase of the Finance Ministry’s privatization plan will involve placing equity in already listed state companies (e.g. VTB, Rosneft, Sberbank, Federal Grid Company, etc). Hong Kong listings are very likely. That will improve the liquidity of the shares and expand ownership of Russian equities;
• Russia is, and will remain for the foreseeable future, a stable country with a stable political regime and leadership

Main Risks

Mostly external risk. The main risks to the investment case for Russia are external. These include:

• Escalating currency dispute or trade war between the US and China which would disrupt global economic recovery;
• While another bout of QE will provide a boost for equity markets over the medium term, if this does not result in an accelerated recovery, then the hangover, in terms of market sentiment, will be worse and could drag all valuations even lower;
• A slowdown in Chinese growth that hits demand for imported commodities;
• A slowdown in the modest pace of the US economic recovery;
• An escalation in solvency risks in the Eurozone, as it could cut demand for risk assets elsewhere.

Domestic risks. On the domestic side, the main risks include:

• A slow pick up in confidence that slows the pace of consumer pending and corporate investment;
• Inflation continues to rise toward 10%, which forces the Central Bank to start raising interest rates;
• Rising inflation may result in even more intense pressure from government agencies on consumer sector companies to keep prices as low as possible. That would hit margins in e.g. food manufacturing, food retailing, pharmaceutical and fuel retail/distribution companies;
• Political instability ahead of the election;
• A drop in public support for the United Russia party might lead to even looser fiscal policies in 2011;
• The Finance Ministry’s efforts to attract more taxation will likely focus on even more on the extractive industries. That could mean higher taxes for steel and other materials exporters;
• The International Court of Human Rights is due to rule on the $98 bln claim brought by a Yukos shareholder group against the Russian state. An unfavorable ruling would certainly be appealed but would also generate very bad headlines across the world;
• If the acquisition of a controlling stake by Transneft in Novorossiisk Seaport discriminates against minority shareholder rights, this will undermine the president’s claim that investment conditions are improving;
• If planned IPOs fail (i.e. have to be sold very cheap or are pulled before completion), that could send a very negative signal to investors.
• On the other hand, if market conditions remain favourable for equity issuance, there could be a significant increase in the volume of IPOs/SPOs to that already expected. That would divert a lot of cash from existing equities and slow the rate of overall market appreciation.

Market Valuation

Market cap weighted calculation. The table to the right shows the PE Ratio and EV/EBITDA ratios for the RTS constituents, in aggregate, for this year and the next two. This data is calculated based on the individual financial forecasts for each of the stocks in our coverage universe. The average for the RTS index is calculated using the market capitalization weighting of each stock in the index. Strong earnings recovery expected in 2011 and 2012. Using our analyst forecasts, the PE ratio for the full market drops to 7.3 for next year and to 6.4 for 2012. But almost 50% of the total value of the market is weighted in oil and gas sector shares. Shares in this sector receive the lowest valuations in all world equity markets; hence they cause a distortion to the bottom line valuation for the full market. Stripping out the oil and gas sector shares changes the PE ratio for 2011 to 9.4 and 2012 to 7.9. Russia, excluding oil and gas, is more than 25% cheaper. The table to the right also shows the PE ratio for Russia and other major emerging markets using Bloomberg consensus data. It is assumed that a common methodology is employed across all data points. In this comparison, the 2011 and 2012 valuation for the RTS index is 7.9 and 6.6, respectively, i.e. close to our full market valuation. Compared to the ratios for the other big emerging markets, Russia is almost 40% cheaper. Even excluding the oil and gas sector shares in our model, the 2012 comparison shows that Russian equities are still trading at a 25% discount to the ratings of Brazil and Turkey and with an even bigger discount to the Asian markets. Chris Weafer is the Chief Strategist for Uralsib Group