Q:  Would you describe your core beliefs when approaching the Russian market? A: I find Russia a very exciting place for investors to participate. Although it is usually associated with high political risk, I do consider Russia a stable free market. It is a democratic country with a limited number of political parties and policies, which provide real choice. I am also impressed with the highly literate, ambitious, and capable people. They may still lack the discipline of a free market economy, but they are learning really quickly. Overall, the era of cheap Russian stocks is over and the value opportunities that previously existed are gone. But we see tremendous domestically financed growth, similar to the situation in Japan after World War II. There is high liquidity in the economy, and as the Soviet infrastructure has ended its useful life, there is going to be a construction boom in Russia and a lot of capital expenditures. Russia certainly can finance this growth and it has been focused on doing so. The capital flow out has ended as the people realized that you can do better back home at good old mother Russia. The tax system and all the incentives are now running in the right direction so I’m not even sure why it is considered an emerging market anymore. Generally, almost everything’s private. The wireless companies are private start ups; most of the line companies have large public ownership and are being further privatized. The oil industry is about 70% private. Even after the Yukos event, Rosneft held a big IPO. Kremlin has adopted the public-private model and its policy is to partially privatize the biggest state-owned companies. I don’t see a currency risk either. The ruble market is very stable; the Central Bank of Russia has some of the highest reserves in the world and a large budget surplus. There are elections coming up but I don’t think that there will be many surprises. Of course, that doesn’t mean that the Russian market is risk-free. For me the largest risk is the oil price, which is difficult to deal with objectively. Another concern is the systematic risk. Twenty years ago there was no capitalist economy in Russia, so there is lack of experience and expertise. When Russian organizations face questions of first impressions, they don’t always have the experience base to make the best decisions. Q:  How do you handle the risk of the oil price that you perceive? A: Most of our oil holdings don’t have as much upside or downside as people assume because of the windfall profit tax regime in Russia. The government gets most of the upside above $30 a barrel, so in terms of reported earnings, the public companies are not dramatically affected by oil price fluctuations. In the past year I’ve had about 30% in oil and 10% in gas so that’s been a heavily weighted sector. Although Lukoil underperformed the Russian market last year, I consider that stock my bellwether investment and I did very well with a couple of other oil companies. But forward-looking, I’m planning to reduce our exposure in oil. Q:  How do you translate these views into an investment strategy and process? A: When I look for companies to invest in, I first pick the sectors that look promising over the next two years. For example, I stayed out of oil for a couple of years because of the Yukos affair. The oil companies were well managed, but the politics was not in the investor interest and that affected the technical demand for stocks at that time. Once I find sectors of growth, I look for the winners within that sector. So my method is top-down when selecting the sectors and bottom-up when picking the companies based on fundamental performance. That’s where I factor my concerns about issues of first impression and experience. I look for management with investor orientation and with seasoned judgment in their respective industries. I usually visit the companies and I like to see a young IR person making Power Point presentation in English, as well as the top management being available to answer questions. Traditionally, most of my stock picks have been companies with good export dimensions, although recently I’m getting more exposure to the domestic consumer side. I look for seasoned companies with experience around the world and with mature managements. Accounting is another important issue and I’m looking for companies that are fully audited by firms like KPMG, PricewaterhouseCoopers, or Delloitte. Q:  Which sectors do you find attractive? A: Right now we are seeing tremendous growth in consumer disposable income, which is up about 35% a year. The middleclass in Russia today represents about 25% of the population; the GDP per capita has skyrocketed, moving from $8,000 towards $11,000. On the other hand, people don’t spend money on occupancy because the state sold them their apartments cheap. So they have a lot of money to spend on cars, home improvements, and upgrades in the living conditions. More importantly, while the goods used to be imported, now they are more and more domestically produced. For example, consumer products company Kalina is a strong competitor of foreign imports, and is doing very well with Russian women. So the interesting sectors currently are consumer products, real estate, retail, mortgage banking, and cell phone companies. One of my winners last year was Vimpel Communications, whose great performance was a function of the consumer’s disposable income. Another strong trend in Russia is the migration towards the cities. When I was a boy in America, the rural population was 22%, while now it’s down to 2%. Today Russia already has 20 cities of more than one million people, where people have just migrated. In most of those cities you’d be amazed to find the same stores and high-end shops that you’re used to. Nevertheless, once you go outside of Moscow and St. Petersburg, it is pretty bleak. Russia is probably 20 years away from the process that took place in the United States during my lifetime but I expect quite a development. Q:  When would you sell a stock? A: This is generally a buy and hold fund. I would not sell a stock when it reached the target price unless I have a better idea to reinvest in another company. Another reason would be if I found a better company and decide to proportionately increase my position while letting the other holding get smaller. The third reason would be if I lost faith in the company’s ability to perform or in the vision of the management because I believe that companies should have a vision of where they’re going and how to get there. I don’t typically take profits because it is often not in the best interest of my shareholders. An exception would be last year, when due to the big correction and redemptions I took too many profits and had a big dividend payment to the shareholders. It was hard to find a position where we didn’t have a profit, so I didn’t have much choice. Q:  Could you give us some examples of stock picks that illustrate your research process? A: A negative example would be Rostelecom, the long-distance company. I liked the management team, its philosophy, and its performance. But every analyst was telling me that they were going to be hurt by deregulation so I should be selling. I finally sold the stock and it promptly doubled last year. That was a very big miss. On the other end of the spectrum, my best pick over the years was the oil company called Sibneft. United Energy Systems in the early years was a very good pick. That’s the company Anatoly Chubais runs and that holds the electric monopoly throughout the country. They are undergoing reorganization, which takes a long time, but follows a very logical system. United Energy Systems is again a good growth stock because investors see it as the main vehicle for participating in the industry. There was a period with under-utilization of the capacity but now they’ve built new capacity because the Russian economy has picked up so dramatically. They stopped talking about exporting electric power and now they’re worried about having enough capacity to handle the growth. It is definitely a growth business and a well-managed business. Another example is Sberbank, the state monopoly savings bank. I chose the investment because it is extremely well run. The manager reduced the number of branches from 32,000 to 20,000 and got heavily into mortgage banking, helping the individuals to unlock their personal balance sheets. Now it is a highly diversified commercial banking business and a big winner, which has doubled in the past year. But there isn’t much choice in the Russian banking sector because banking and insurance have been overprotected by the government. Q:  How large is the Russian stock market? A: The total market cap is about one trillion, which is roughly the size of the Russian economy. Gazprom is the third or fourth largest company in the world, probably only after Exxon and Microsoft. In my opinion there are about 60 investable companies in Russia, but five years ago there were only 20. Every year there are new IPOs; only last year I’ve bought the IPOs of a sausage company, a gas company, a real estate company, and a gold company. Q:  How do you construct the portfolio? Do you look at any benchmarks? A: We have about 35 stocks and I’m generally biased towards large-cap companies. I can invest in Russia and CIS, or the Commonwealth of Independent States that consists of 11 former Soviet Republics. I have exposure to oil companies in Kazakhstan and I’ve owned a fertilizer company in Ukraine. But I’ve gotten in and out of the Ukrainian market because it is a bit messy. Regarding the benchmarks, there isn’t enough data and investable companies for a proper benchmark. There are many benchmarks around; I read a lot and value the research that I get from my brokers. I get a daily service from the Russian press, usually about 50 articles a day. But I make my own judgments in terms of buying, selling, or holding stocks because I feel that I cannot be constrained by an index. Q:  What is your view on risk management? A: I believe that the greatest moments of peril are the redemption events and when money comes sloshing in. I just read a study that actively managed portfolios underperform index funds only in the periods when money come rushing in and out because they don’t anticipate these events. In the Russian context, there will always be a scare about commodities prices collapsing. Once in a while the speculators are right as this is a highly volatile area but, in general, I have to ignore the latest theory about China having a hard landing or about the demand for Russian steel evaporating. So I have to make my own judgments about when it’s actually happening. The legal ability to hedge is also important for handling risks better. If I had it last spring, I would have hedged the six largest positions in my portfolio. Right now we’re changing the prospectus to provide that ability if I’m fortunate again to have a portfolio that goes up dramatically. Such tremendous rises make me nervous, but I wasn’t in a position to hedge last year. The problem was not that we had the wrong holdings but that the whole market went down. Q:  What was the reason? Was it the interest rate concerns in the US? A: Yes. Whenever the Fed tightens to the tipping point and nobody knows exactly when that’s going to be, you hear a huge sucking sound in the emerging markets and “all the money rushes home to quality.”