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VOL. 38 | NO. 24 | Friday, June 13, 2014

Russia returns but does it have ability to sustain?

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The $2 trillion Russian economy has a problem.

The amount of wealth that can be extracted from the ground distracts attention from otherwise productive economic endeavors. This concentrates economic rewards in the hands of the few and leads to development malaise as labor skills languish.

Hitching your economy to a volatile commodity, prone to depletion, is a risky strategy.

The $2 trillion Russian economy has another problem.

Property rights must exist for individuals to take economic risks. Without property rights, any accumulation of assets just invites looters, so why bother?

Without a foundation of property rights, you paralyze innovation and encourage criminal enterprise.

The $2 trillion Russian economy also has another problem. Vladimir Putin views himself as an imperialist emperor who spontaneously battle-plans. His bellicose activities tempt sanctions and embargoes that could cripple his export-dependent economy. Disconnecting the Russian financial system could also leave investor assets frozen and unrecoverable.

Would you invest in a country dependent on volatile commodity sales devoid of property rights with a throwback ideologue at the switch? Prudence likely dictates that you would not. But should you?

The Russian stock market opened for business in 1995 after the collapse of the Soviet system in 1991. Today, the Moscow Exchange lists 262 tradable equities with a market capitalization of $771 billion.

An investor who invested $100 in the Russian stock market on Dec. 30, 1994, would have $706 today.

An investor who invested $100 in the U.S. stock market on Dec. 30, 1994, would have $426 today.

That’s right, the return since inception of the Russian market, while hugely volatile, outpaced that of the U.S. stock market by 280 percent.

When it comes to long-run investment returns, what really matters is entry point valuation.

Greece seemed like a ludicrous investment destination at the height of the Euro crisis, but since then its stock market has appreciated 250 percent. In June of 2012, Greek stocks were trading below five times earnings. As Greece stepped back from the edge, valuations began a recovery path that proved propulsive.

Applying this logic to Russia. If you throw out all of the political and analytical discourse, and just consider valuation, reversion to the mean alone could deliver 100 percent return to investors. Add to that potential growth in earnings and dividends, and the return opportunities appear significant.

Am I suggesting that you plow your portfolio into Russian equities? No.

You have to have an iron constitution and a great deal of patience to see these returns develop.

I am suggesting, however, that it does make a worthy speculative case for those so inclined.

Bottom Line: Over time, entry point valuations hold the greatest influence over long-term returns.

Entering into markets that look hopeless has historically rewarded investors with extended time horizons.

This is not a strategy for the squeamish by any means, but those seeking high returns should habitually seek out abnormally low valuations and tune out the circumstances.

David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.