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Russian stocks may be worth the risk (if done right)

I am doing something ignorant, risky and possibly evil. You may want to join in.

If you do, brace yourself for some blow back. One money-manager friend tells me I'm "dangerously naive." Another says I'm committing an "act of stupidity." A colleague chimes in with the opinion that I'm supporting the forces of oppression.

That's what you get for buying Russian stocks. But I beg to differ with the naysayers. John Templeton, the renowned money manager who bought European stocks at the start of the Second World War, liked to say that the best time to invest was at the moment of maximum pessimism. Right now, that sums up the outlook for Russia.

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Even for the famously downcast homeland of Dostoevsky and Chekhov, today's situation looks dire. The country's economy is verging on recession and its conflict with Ukraine leaves it facing stinging sanctions. If you're looking for a place where expectations have been scraping rock bottom, take a tour of the Moscow stock exchange.

It's cheap, especially at a time when most global markets are in distinctly frothy territory. When I bought my Russian shares, in early May, they were 30 per cent cheaper than they had been two years earlier. Their average price-to-earnings and price-to-book ratios were approximately half that of the S&P 500.

Markets that get beaten down this much tend to bounce back. Mebane Faber of Cambria Quantitative Research has crunched the historical numbers and shown that investors would have produced outstanding results by regularly buying the global stock markets that were cheapest in relation to their 10-year average inflation-adjusted profits.

In recent months, Russian stocks have been among the world's biggest bargains on the basis of that 10-year price-to-earnings ratio. But it's not just their price that suggests them as buys. It's also the revulsion.

Money managers hate situations that can't be modelled on a spreadsheet. Even more, they loathe investments that could suddenly plunge in value and leave them holding a big, career-ending loss. So mutual funds and other investors have been retreating from Moscow faster than Napoleon's army ever dreamed possible. Capital flight out of the country in the first quarter is estimated to be more than $60-billion (U.S.), according to The Economist.

Moving in the opposite direction could spell opportunity to a patient investor. Most of Russia's biggest companies are commodity producers that cater to the European market. It's possible that sanctions could block them from connecting to their natural customers. However, if rational leadership prevails (and Vladimir Putin is the guy who puts the "rat" in "rational"), then it's likely that the conflict in Ukraine will stagger toward a peaceful resolution. Nobody has an obvious interest in sparking a conflict that would hurt both sides.

In the interim, does buying Russian stocks make you a bad person? I don't think so. It seems to me that investing in the Russian stock market is actually a bet on peace. The Moscow stock market will only climb if today's conflicts are settled amicably.

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The challenge in such situations is to keep risk and expectations in check. Russian stocks make up less than 5 per cent of my portfolio. I'm hoping they'll close a third of their valuation gap with U.S. stocks, which would imply a 30 per cent gain from my purchase price, and I'm prepared to wait up to three years for that. When a market is hated this much, even a little good news will send prices soaring.

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About the Author

Ian McGugan is a reporter with The Globe and Mail's Report on Business and has been writing about investing, economics and business for more than 20 years. He joined the Globe and Mail in 2010. He has been executive editor of Canadian Business magazine and founding editor of MoneySense magazine. More

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