Low Valuations Don't Buffer Russia From JP Morgan Downgrade

Among global investors, one thing that Russian stocks are known are a tendency to trade at valuations that are low compared to the broader emerging markets universe. However, Russia's inexpensive equities were not enough to prevent JP Morgan from downgrading the "R" in the famous BRIC acronym from Neutral to Underweight.

In a report dated April 20, Adrian Mowat, JP Morgan's chief Asia and emerging-market strategist said Russia is vulnerable to foreign outflows, Bloomberg reported. A recent dividend cut announcement by Russian energy OAO Gazprom OGZPY is not helping matters, either.

The Gazprom news comes after the largest Russian company by market value announced in February that it reduced its 2012 dividend to seven to eight rubles per share, down from the payout of 8.97 rubles in 2011. However, at the time Gazprom said its 2013 payout could jump to eight to nine rubles. Instead, the company suggested a 33 percent cut earlier this month.

The Gazprom dividend cut and JP Morgan downgrades are two issues that have the potential to weigh on Russia ETFs and that is saying something. In a year when the largest emerging markets have been dreadful in terms of returns, Russia has been a particularly egregious offender.

Year-to-date, the Market Vectors Russia ETF RSX, the oldest Russia ETF, is down 13.8 percent. That makes RSX by far the worst performer among the four major BRIC ETFs with a loss that is nearly 300 basis points worse than the iShares FTSE China 25 Index Fund FXI. RSX's decline is more than two-and-half times worse than the 5.1 percent year-to-date loss seen on the Vanguard FTSE Emerging Markets ETF VWO, the largest emerging markets ETF by assets.

Declines for Russian equities and the corresponding ETFs indicate investors are not taking the bait on the market's stunningly low valuations. The MSCI Russia Index trades at 4.9 times its estimated 12-month earnings compared to 10 times for the MSCI Emerging Markets Index, according to Bloomberg.

In fact, Russian equities are deeply discounted relative to their historical standards. The average P/E ratio on the MSCI Russia Index over the past decade is almost nine.

At the ETF level, RSX ended March with a P/E below 6.5 and a price-to-book ratio just over one. The iShares MSCI Russia Capped Index Fund ERUS trades for 8.24 times earnings with a 1.76 price-to-book ratio, according to iShares data.

Another way of looking at the near-term scenario for Russian equities is that if investors have not been lured in by cheap valuations, then a dividend cut by Gazprom is not going to do the trick. Actually, Gazprom's dividend reduction poses a risk to Russian stocks on multiple stocks.

First, it flies in the face of the Russian government's efforts to force state-run enterprises there to boost their payouts in a bid to attract more foreign investors. Russian firms are highly profitable and prodigious generators of free cash compared to their equivalents in other emerging markets, but the Gazprom dividend news could dent the country's allure as a dividend destination.

Second, Gazprom is a major holding in Russia ETFs. The shares represent more than 18 percent of the weight in the iShares MSCI Russia Capped Index Fund. Gazprom is RSX's second-largest holding with an allocation of 8.2 percent.

Cheap or not, investors may have more reasons to avoid Russian stocks in the near-term than they have to embrace this volatile market.

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