Rampant Corruption in Russia Hinders Stocks

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Corruption in Russia is prevalent at all levels from public figures to wealthy oligarchs and especially within the law enforcement sector. For example, in the events leading up to the country’s predetermined election, Mikhail Prokhorov sought to run his campaign by pushing his own agenda (as long as it was not critical of Putin or Medvedev); when his plan deviated from the original arrangement organized by political puppet master Vladislav Surkov, masked police officers immediately raided a bank which was owned by Prokhorov. Interestingly enough, Mikhail was not even running as a possible contender for the presidency, but was merely staged to neutralize the liberal electorate.

Bribery Everywhere

Corruption stems from the public sector into businesses, naturally. Russia, buy a wide margin, has the worst rating on the Bribery Payer’s Index, which ranks the likelihood of businessmen paying bribes. Attempts by the country to curb corruption have been viewed as merely attempts to appease the international community to ensure Russia’s acceptance into the World Trade Organization. The mentality of simply paying for results was also highlighted in the recent Costa Concordia disaster – rich Russians were seen paying crew members to obtain priority spots on life boats.

Bas for Business

A study 2006 by Charles M.C. Lee and David Ng of Cornell University, Corruption and International Valuation: Does Virtue Pay, determined that corporations operating in corrupt countries trade at significantly lower multiples than their international peers.  However, Russia’s rich energy deposits continue to attract foreign direct investment despite the unethical politics involved in setting up joint ventures. BP (NYSE: BP), for example, obtains approximately 10% of its profits from Russia, and thus cannot afford to pull out of the country despite its unfair treatment following the collapse of the catastrophic $16 billion deal with Rosneft. Even following the lawsuits and subsequent raids on the BP offices in Russia, the company concluded that they cannot afford to abandon their operations.

Testing the Hypothesis

A quick analysis of investment multiples reveals that the conclusion reached by Lee and Ng proves to be correct: Mechel (NYSE: MTL) , Russia’s major integrated mining and steel giant, trades at an earnings ratio of 7.12, a sales ratio of 0.37 and a cash flow multiple of 4.72; all of these metrics are well below the average for steel & iron companies trading on the New York Stock Exchange. Likewise, the same trend is observed with Mobile TeleSystems (NYSE: MBT) and CTC Media (NASDAQ: CTCM). MBT is Russian largest mobile operator and CTC Media, which trades on the NASDAQ, operates three Russian television networks. These companies trade at discounts relative to their North American counterparts because they operate in an uncertain political environment which can be subject to arbitrary change.

Looking Forward

Russia has done a respectable job of curbing soaring inflation – although prices were rising by 20% a year at the onset of the millennium, inflation has fallen back to a manageable, yet high, 8%. Furthermore, the country’s current 7.5% unemployment rate is comparable to that of Canada and is actually below the average of the OECD nations, including the U.S. Russia’s strong economic performance, accompanied by several periods of annual budget surpluses, is undoubtedly linked to the rising price of oil, which is forecasted to show moderate growth over the next five years. However, for Russia to emerge as a true economic superpower it must fight corruption and diversify its economy from energy. In order for the latter to occur, the former must first become realized; corruption deters the origination of businesses through presenting an unfavorable business environment and reduces the ability of smaller companies to obtain financing.

Stories of corrupt police officers and multibillion net worth mayors who embezzled tax payer’s money are all too common in the country. Once these issues are properly addressed, only then will Russia realize its true economic potential.

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