Russia, China and Iran: Should We Ever Invest in Bad Boys?

15 mins. to read
Russia, China and Iran: Should We Ever Invest in Bad Boys?

As seen in this month’s issue of Master Investor Magazine.

Emerging markets once lured investors with the promise of rich pickings. The BRICs (Brazil, Russia, India and China) were once sure to make us wealthy, or so Jim O’Neil, formerly chairman of Goldman Sachs Asset Management, assured us. When they went off the boil he offered us MINTs (Mexico, Indonesia, Nigeria and Turkey). If you had invested in any of these over the last year or more you would have lost money.

Now I’m not going to offer you the written equivalent of a turgid PowerPoint presentation about why Burundi is a better bet than Malawi, or why the Vietnam stock exchange will outperform Indonesia this year. And, as a fully paid-up member of CASA (the Campaign for the Abolition of Silly Acronyms), I promise not to use any of Jim’s four-letter words again.

I do want to ask if you can ever justify holding a part of your portfolio in bad-boy countries with whom we have poor relations and where people live according to different rules than we do. In particular, I want to focus on three countries: Russia, China and Iran. The first two have been investible for quite some time; but with the nuclear accord between the Big Six and Iran announced on 14 July, the doors of the Tehran Stock Exchange will surely open soon to Western investors.

But first, a health and safety announcement on emerging market investment generally.

The compelling investment logic of the emerging markets, advanced by Jim O’Neil and others, was growth. Developing economies generally grow faster than developed, mature economies. This is principally because they have a younger demographic and have large untapped labour reserves. In China, migration from the rural backwaters to the bright lights of the city is still a potent national theme.

But if economic growth were strongly positively correlated with stock market returns, investment would be easy: in fact anyone could do it. Unfortunately, it isn’t, for all kinds of reasons, over the short to medium term at least.

In fact, GDP growth is only very weakly correlated with stock market returns, even in top-tier developed countries. But in emerging and, still more so frontier, markets there are so many additional layers of risk, like the skins of an onion, in addition to economic risk.

There is exchange rate risk, political risk, regulatory risk, fiscal risk, transaction risk, settlement risk – you get my drift. You might find an outstanding high-tech growth stock in a country with a bad government and even worse corporate governance and never get your money back, thanks to inflation, depreciation, rogue taxes and outright theft (the company has been bought for a song by the President’s wife).

Now what is interesting about Russia, China and Iran is that, unlike many emerging markets, they enjoy (if that is the correct word) a high degree of political stability. Putin is not going anywhere soon; and even if he fell under the proverbial Tomsk omnibus, he would be replaced by Medvedev, who shares his worldview. The Chinese politburo is unlikely to be overthrown by the Chinese equivalent of the storming of the Bastille. And the ruling clique of mullahs and Ayatollahs in Iran still exerts an iron grip on power. Of course, the very lack of transparency in these countries means that we never really know how much diversity of opinion obtains in the corridors of power. Their governments are all, probably, more conflicted than they look from the outside.

Another thing these three have in common is that they are all the modern embodiments of ancient empires. China and Iran have ruled roughly the same central landmasses since early antiquity; Russia by historical comparison is a new kid on the block: having originated in the 11th century, it only came to dominate the Steppes under Ivan the Terrible in the mid sixteenth century.

There’s no space here, but we can’t understand what these countries are today without understanding their long, complex histories and their magnificent cultures. Suffice to say, their imperial experiences, over so many centuries, have bequeathed them not just a sense of their own uniqueness, but an instinctive preference for strong, centralised government (order) over feeble, de-centralised government (chaos). They are also, let us not forget, multi-ethnic: only 80% of Russian citizens are Russians; just 90% of the citizens of the People’s Republic of China are Han Chinese; and only 79% of Iranians speak Farsi dialects, the other 21% being largely Turkic minorities.

Much as we might desire it, none of these great countries is likely to turn into a bushy-tailed liberal democracy overnight. I remember an Economist cover story in the early 1990s entitled Would a rich Russia be a cuddly Russia? There was a cartoon on the cover of a huge genial bear having its tummy tickled by the West. Silly question, I thought.

Let’s look at these three bad boys in turn.

First bad boy, Russia: the only one of these three, I admit, that I know well on the ground. Some killer facts: the biggest country in the world with a land area of 16.4 million square kilometres; a population of 144 million (and falling); its nominal GDP of about US$1.9 trillion is the tenth largest in the world. The market cap of the Moscow Stock Market is about US$770 billion, with 225 or so listings.

Actually, if there is one thing we need to know about Russia it is that its massive territory sits on unimaginable quantities of the world’s most prized natural resources – even if it doesn’t have many manufacturers or service companies whose products are in demand outside its borders.

The major reason for the current contention with Russia is that her government has backed a bloody clandestine war against Ukraine. The current spat erupted with the toppling of President Viktor Yanukovich by pro-Western elements in February last year (the Ukrainian Revolution for Ukrainians). The stated aim of the new Ukrainian government was to join NATO, as well as the EU.

Russia responded by seizing Crimea, then annexing it; and then launching a guerrilla war, amongst whose victims included the 298 unfortunate passengers and crew of Malaysia Airlines Flight 17 who perished on 17 July last year. Eastern Ukrainian cities such as Donetsk and Lugansk are now under de facto Russian control.

The Russians believe that Ukraine, which means edge in Russian, and which was always termed Little Russia in czarist times, was the birthplace of the Russian state, and that she is Russia’s twin sister in the Slavic, Orthodox world. One senior Russian banker asked me last year: How would the English feel if Scotland broke away and then opened negotiations with Russia to establish nuclear bases at Gretna Green? It’s political; and it’s emotional.

The real issue is that Ukraine is really two countries: the Western part, known as Galicia, centred on Lviv is entirely Ukrainian speaking, but the area east of the river Dnieper is overwhelmingly Russian-speaking.

Crimea, by the way, was a province of Russia from 1783 until 1954 when Khrushchev signed it over to Ukraine. (Russians will tell you he was out of his mind on vodka at the time.) According to the BBC’s John Simpson, most people who live in Crimea, where Russian is the predominant language, seem happy about reunification with Russia.

I am not saying that we should award Mr Putin the Nobel Peace Prize. But there are two sides to this argument. In time, a political solution will emerge, though at present the necessary goodwill for that outcome is absent.

Let’s consider also that most Russians do not feel that they are living under tyranny; in fact many feel freer and more prosperous than at any time in their history. Unlike China and Iran, there are very few judicial executions in Russia; and most Russians think that the Pussy Riot protestors were treated leniently. Mr Putin was elected.

What of Russia’s investment potential? Investible Russian stocks are relatively few; they are all commodities-based; some of them are incredible cash cows, and they are going cheap. Gazprom, which is said to control 15% of known global reserves of natural gas, has a net profit margin of nearly 30% and a return on equity of 13%, is currently trading on a multiple of 20. Compare that with BP’s multiple of 40. Or, Norilsk Nickel, the world’s largest producer of strategically vital platinum group metals (PGMs) and which is sitting on about 40% of the world’s nickel reserves, is trading on a multiple of just 15.

There are plenty of Russia funds available. One is the JP Morgan Russia Securities PLC Investment Trust (JRS), run by Oleg Biryulyov, who is based in Moscow. He has created a kind of Russian market tracker fund. The top six holdings are the top stocks of the Russian market, led by Lukoil, Sberbank, Magnit, Novatek, Norilsk Nickel and Gazprom. Many of the underlying holdings, like Lukoil, are already listed on the London market, so a high degree of transparency is assured.

Second bad boy: China. For now (India is catching up) China is the most populous nation in the world with 1.36 billion inhabitants within a land mass of 9.4 million square kilometres (a whisker bigger than the USA). As everybody knows, China’s is the second largest economy in the world. It will have a nominal GDP of $11.2 trillion this year. Some people will tell you that on a purchasing power parity (PPP) basis China’s economy is already bigger than America’s, though, personally, I am sceptical. (There are methodological problems.)

The Shanghai Stock Market is currently the fifth largest in the world with a market cap of around $4 trillion and with over one thousand listings. Many predict that it will overtake the NYSE in a few years. The Shenzhen (Guangdong province) Stock Exchange is the eighth largest in the world with a market cap of $2.2 trillion with nearly fifteen hundred listings. (Not forgetting the Hong Kong market which has a market cap of $3.3 trillion.)

It is one of the greatest paradoxes of modern times that the most in-your-face capitalist economy on the planet, which has racked up near double digit growth for the last three decades, is run by a political party which is still theoretically Marxist. China is a one-party state with no commitment to human rights. Quite apart from its suppression of ethnic and religious minorities, of which Chinese rule in Tibet is a case in point, China is beginning to throw its weight about in its own back yard. China’s construction of bases in the Spratly Islands in the South China Sea (which are claimed by other countries, not least the Philippines) betokens a more aggressive stance.

The real reason why we in the West fear China is that it is the only country that might be able to challenge America’s military and economic pre-eminence in world affairs by the middle of this century. We can’t really imagine what a world with China at the top might be like, but we suspect it would be inimical to our interests. China is already winning the race to shore up the world’s major resources, agricultural and manufacturing, with the astonishing penetration of the African continent by its major companies, mining firms at the forefront.

But actually, China has never committed an act of aggression against a western power – she fought alongside the allies in WWII – though she has often been violated by us westerners. We shall draw a veil over the Opium War (1839-42), the Anglo-French expedition to China which culminated in the burning of the Summer Palace (1860), and the alliance of eight western powers which suppressed the Boxer Rebellion (1900). As China sees it, she has pursued her interests peacefully since the foundation of the People’s Republic in 1949, never deploying the People’s Liberation Army outside China’s historic borders.

Now in recent weeks we have lived through the Great Fall of China as the Shanghai market lost 30% or so of its mid-June value, having gained 140% in the previous twelve months. It is now back roughly to where it was in March. But most commentators think this is a market correction which could be a buying opportunity before China’s bull market resumes.

Investing in Chinese equities is complicated by different share classes. There are restrictions on foreign investors buying “A” shares, which are listed directly on Chinese bourses. But one fund which has one third of its exposure in A shares is Fidelity China Special Situations (FCSS). This fund has performed well under the management of Dave Nichols.

Our third bad boy, Iran, is a country that was perhaps better known to our grandparents’ generation than to ours because it has been in relative isolation since the Islamic Revolution of 1979.

Iran is big, though not vast like the other two, with land mass of 1.6 million square kilometres and a population of just under 80 million. This year its nominal GDP is expected to be US$437 billion (half the size of Turkey’s), making it the world’s 27th largest economy. The market cap of the Tehran Stock Exchange (TSE) is about US$170 billion with 339 listings.

Iran has been standing on the international naughty step for so long now that it is worth recalling why they were put there. Iran has been a compulsive backer of terrorist groups since the foundation of the Islamic Republic. Hezbollah, based in Lebanon, an implacable opponent of Israel, is backed by Iran. Iran has played an active and sinister role in the Syrian civil war.

Although not an Arab state, the Islamic Republic became Israel’s most intractable enemy. Iran’s virulently anti-Israeli rhetoric reached a fever-pitch under President Ahmadinejad, although it has abated since his departure in August 2013.

But Iran’s greatest crime in American eyes was to aspire to the possession of nuclear weapons. This would have represented an existential threat to Israel and would have triggered an arms race across the region. There is still the risk that Saudi Arabia will make a bid to become a nuclear power, in which case the Iranians might decide that the recent accord no longer suits them.

The other point of contention is that Iran has a dismal human rights record. They persecute minorities (like followers of the Baha’i faith), imprison suspected subversives, torture people, and they even execute gays. The media is rigidly controlled. A theocracy, the Iranian regime brooks no opposition since it believes that it is divinely inspired. The millennial aspects of forms of Shia Islam – they await the return of the Mahdi, the last imam – also gives rise to extremist ideas about geopolitics (America and Israel as Satanic, and so on).

And yet it calls itself a democracy because it holds elections. Iranians say that they have been demonised for defying the imperialists. The British occupied Iran during WWII. Then, the popular, reformist Prime Minister Mohammed Mosaddegh was overthrown by an Anglo-American inspired coup in 1953 because he nationalised the Anglo-Persian Oil Company.

The fundamental reason for Washington’s willingness to mend fences with Iran is that both countries, for very different reasons, share a determination to exterminate the so-called Islamic State. So long as that threat exists, we can expect a normalisation of relations with Iran which will inevitably include foreign funds finding their way to the TSE.

Turquoise Partners in Tehran publishes Iran Investment Monthly[i]. Mehrafarin Brokerage Company became the first Iranian broker to open an office in London last year. An outfit called ACL Limited in London says it plans to launch an Iran fund when sanctions are lifted. The rumour mill reports that a stream of hedge fund managers has been heading down to Tehran this year.

Moralists argue that one should never support wicked regimes and that trade and investment equals support. Pragmatists retort that only by maintaining a dialogue with one’s opponents can one have any hope of influencing them to change their behaviour for the better. Trade and investment stimulate dialogue.

Historically, the pragmatists usually win: though the sanctions regime against Apartheid South Africa was an example of where the moralists held sway. It is arguable that sanctions were the critical factor in the fall of Apartheid. It is also doubtful if the sanctions against Iran actually succeeded; or whether the current regime of half-heated sanctions against Putin’s Russia has had any meaningful impact.

These three empires are geopolitical constants. Their histories and political cultures incline them towards authoritarianism and it is unlikely that they will ever correspond to our model of liberal democracy, though they may well become more open. Moreover, their geographies, as they see it, require them to meddle in the affairs of their neighbours. That is unlikely to change. And they all bear historical grudges against the Western powers (particularly America, but also Britain) who have tried to intervene in their internal affairs, and those of their close neighbours, usually with negative consequences.

I am not saying that we should turn a blind eye to their shortcomings. On the contrary, we should keep them under the closest scrutiny and feed a constant stream of information about what is going on in their countries back to them – something the UK, with superlative soft power, can do. The BBC’s Persian (Farsi) language service apparently has more listeners than any other foreign language service – millions listening in defiance of their masters. Russians still devour books by British authors. Young, affluent Chinese come to British universities in record numbers.

But we should manage our expectations. We’ll never change them with disapproval alone. Diplomacy, trade and cross-border investment are the three legs of the tripod on which the fragile edifice of our new world order is perched. Kick one leg out and the tripod tumbles.

And one day you might kick yourself if you don’t keep these three bad boys on the radar. Should we ever invest in bad boys? Of course we should, but with eyes wide open.

[i] Access at:

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