Bill Robinson: Time to dance with the Bear

Though there is widespread optimism that the world economy is being led safely back into recovery by the US, the financial markets are looking much less robust. Part of the trouble is that valuations are so stretched. UK equities are still priced at around 20 times annual earnings. In the go-go 1980s, UK price-to-earnings (PE) ratios were closer to 10.

The fundamental value of any share is underpinned by its earnings. Expressing the price as a multiple of earnings is a way of wrapping up two key drivers of future value: the expected growth of earnings, and the rate at which future earnings are discounted. In the 1970s era of oil crises and high inflation, expected growth was low and the discount rate was high because equities seemed risky. Since the early 1980s, when the economic climate started to improve, expected growth has increased. But more important, people increasingly downplayed the inherent risk in a stream of equity earnings, and discount rates came down. This led to higher equity market values, reinforcing the perception that shares were not so risky.

It was a nice ride while it lasted, but valuation multiples cannot rise for ever. With yields still low, and the growth in capital values stalled, the risk-reward relationship for UK (or US) equities looks unappealing. Economic growth, which drives the top line, is sluggish, while the bottom line may be further affected by write-offs and other unpleasant surprises. The Enron affair still casts a long shadow.

It's not surprising then that investors are taking a much closer interest in emerging markets. The risks are undeniable. But when companies can be bought on an earnings multiple in the low single figures, the rewards are much more commensurate with the risk.

Russia is a case in point. From a fundamental economic point of view, it must be a candidate for a growth "miracle", like Japan and Germany after the Second World War. Economic growth, typically 2 to 3 per cent a year, is driven by technology. "Miracles" occur when technological change is very rapid, as an educated and stable society catches up with best global practice. Russia certainly has a well-educated population. Their scientific and technological capabilities gave the country superpower status and kept it in the space race. These same capabilities could turn some of its industries into global players over the next half-century. Remember how the Japanese outperformed the West in car manufacturing and electronics after the Second World War? The Russians may have a similar surprise in store for us now.

In some industries, they already have a compelling story. They sit on large reserves of oil and minerals. They have some large farms on fertile land that are potentially very efficient producers of wheat. These industries are interesting to investors because there is a world market price for the outputs. If a Russian producer has some kind of inherent cost advantage, there is pure profit to be made. Extracting the oil, or processing the metal, or buying farm machinery to produce the wheat, requires capital. But if a Russian company can get hold of this, it can provide exceptional returns based on solid economic advantages: low energy and raw material costs, and a high-quality labour force that is still exceptionally cheap.

In principle, then, we are looking at a match made in heaven. Western investors are nervous about the yields on offer in Western markets, which stand on PE ratios of around 20. Russian companies need capital and are offering returns that equate to a PE ratio of four to five. So will we see a wall of Western money going east?

Clearly it is not happening yet, and for obvious reasons. Bank failures and bond defaults scare investors, and memories of the Russian crisis of 1998 are still fresh. There are too many stories about oligarchs and a robber baron culture. So Western cash is not flowing in, and Russian cash is actually flowing out. Russia runs a surplus (driven principally by oil exports) on the current account of its balance of payments. The resulting inflow of money is in effect being used by wealthy Russians to finance the purchase of foreign assets. Capital flows are driven by perceptions and by confidence, and as long as the Russian oligarchs are perceived as lacking confidence in their own economy, Western capital will remain shy.

But things are changing. The most encouraging sign is that the risk premium on Russian government bonds (compared with US government bonds) has fallen dramatically since 1998, from 45 per cent in the immediate aftermath of the crisis to only 3.3 per cent today – a surprisingly small amount to persuade someone to run the risk of another Russian default.

Now consider some numbers. In the UK the average earnings yield is near 5 per cent, remarkably close to the average bond yield. In Russia the conventional wisdom is that new companies can be taken to market on a multiple of four, implying a 25 per cent earnings yield. Yet Russian energy companies can borrow on dollar bonds at a yield of under 10 per cent. So while UK equity yields are only around 2 per cent above those for bonds, in Russia they are some 15 per cent higher.

These calculations suggest UK equities may be over-priced relative to bonds, while Russian equities may be under-priced. Selling UK shares to buy a stake in the Russian economy is clearly a high-risk strategy as political and economic developments remain very hard to call. But at least the investor is well rewarded for running that risk. In Western equity markets, by contrast, the risk to investors appears unacknowledged and under-rewarded.

Bill Robinson is head UK business economist at PricewaterhouseCoopers