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07/31/2012

Investing in High-Tech in Russia, Part I: From Italy with Love...for Russia


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In June 2011, I attended the 18th annual conference of the Multinational Finance Society. My hotel, located in a prosperous section of Rome, did not have hot water running, and the air conditioning didn’t work—conditions that seemed incongruous with the surroundings. But I was pleased to discover that the TV had 20 international channels, including five Russian ones, two Chinese, and several Arabic. I found the most interesting channel to be Bloomberg Europe, where I caught a conversation about investment in Russia.

Discussions about investment in Russia usually center on oil and gas, but the leader of the Bloomberg panel shifted the subject to high tech. While “Russian high tech” seems like an oxymoron thanks to our mainstream media, the perceptions of Russian high tech, and of Russian markets in general, are very different from reality.

MISUNDERSTANDINGS ABOUT RUSSIAN BUSINESS

One peculiarity of the Russian stock market are the low price-earnings (P/E) ratios of Russian companies. (P/E for the Russian stock market is typically 5–7, compared with 7–8 for China, 10–11 for Brazil, and over 15 for India.) The participants in the Bloomberg program attributed these complaints to Western media’s tendency to see the glass as half empty where Russia is concerned. I note that even scholars view what are essentially the same tendencies in China and Russia through opposite lenses. For example, Tai Ming Cheung (2006) regards the centralization of previously fragmented research and development (R&D), the development of public-private partnerships, and cooperation with foreign entities as signs of increasing Chinese competence and self-assurance. In the case of Russia, Keith Crane and Artur Usanov (2010) cite these as example of incompetence and mismanagement.

The discussion leader dismissed notions that corruption is more prevalent in Russia than in his native India as nonsensical. We also have to ask how clean US businesses were in times of breakneck industrial expansion, as vividly depicted in films such as Oklahoma Crude and There Will Be Blood and the cable-TV program Boardwalk Empire.

Local businesspeople frequently cite imperfect laws, conflicts between federal and provincial legislation, and outdated copyright and trademark protection systems as much more pressing problems than corruption and crime. Violent crime in Russia is high by European standards, but it is not very different from the type seen in the US in the 1980s, and is certainly less pervasive than in Brazil or South Africa.

Many legal difficulties result from the rapidity with which the business environment is changing. For instance, banking legislation, which 10 years ago roughly corresponded to the level of development of the financial sector—with commercial banking itself being only about a decade old at that point—now looks hopelessly outdated. Again, how nimble were the SEC and Federal Reserve in the first decade of this century in spotting imbalances and outright abuse in the mortgage-backed securities (MBS) derivatives market? The meltdown of 2008 occurred in spite of our 250-year history of financial legislation.

In the matter of intellectual property law in the digital era, Russia has no obvious model to emulate. Recent showings by the Pirate Party in German state and municipal elections suggest that Western standards are becoming obsolete and need to be replaced with more workable models.

The renationalization of some oil producing and refining assets in the early 2000s is often misunderstood. Generally speaking, the usual targets of nationalization are strategic but distressed assets or highly valuable pieces of national property. In the first case, the government subsidizes the industry in question, usually for the sake of jobs; in the second, it uses the profits to fund other projects. We’ve seen both motives at work in the world markets: the former in the US bailouts of the banks and the automobile industry, and the latter in the Argentinean and Venezuelan nationalizations of their oil industries. The Russian government had neither of these goals (Chernykh 2011). Its purpose was purely political—to remove an alternative concentration of political power—and very limited in scope.

MISCONCEPTIONS ABOUT HIGH TECH

Not all companies that are seen as high tech actually are, as I learned in my business school days. In the late 1990s, I abandoned my research in physics for the greener pastures—or so I thought—of finance, and entered business school along with students half my age. I asked my professors, who came out of the Chicago school, why the companies with which we did business in everyday life—appliance and electronics retailers, say, or airlines—seemed to subtract value, and why value creation only happened in banks and Internet boondoggles. Did we think that in the 2000s we would live in digital cities and travel via the Internet? They answered that the markets must have known something that we didn’t.

I remember the jolly times of the dot-com bubble, when many starry-eyed Wall Streeters held undergraduate degrees in public communication or political science from Ivy League schools. For them, “high tech” comprised a few scary lines of code, and “materials science” meant something about bricks. Indeed, the label “dotcom” sometimes concealed a very traditional or totally unsustainable business model. Princeton economics professor Burton Malkiel (2011, 64) writes, “And if one of the ‘ungentlemanly’ security analysts (somebody from City College of New York rather than Harvard Business School) had the nerve to ask how you can get 15 or 20 percent growth from a foundry or a meat packer, he was told...that profit margins could be easily tripled within two years.”

“After all,” Malkiel (2011, 90) says, sarcastically, “the New Economy stocks were a breed apart—they should certainly not be held to the fuddy-duddy old-fashioned standards such as price-earnings multiples that had been used to value traditional old-economy companies.”

The defense industry is in fact medium to high tech, and the Soviet Union had a defense industrial complex that was larger than the entire defense sector of Western Europe. Its cumulative arms exports in the 1980s exceeded $100 billion in contemporary dollars (Stockholm International Peace Research Institute 1990, 1991, 1992, 1993, 1994). Even now, Russia is the largest exporter after the US, although in a much diminished global arms market.

Another misconception concerning technology occurs when we judge technical complexity and R&D intensity only by the finished product and ignore the underlying production technology. Energy exports are traditionally viewed as low tech, but what if a nation exports electricity from nationally built nuclear power plants? Call centers are classified as “computer services,” yet few of them involve anything but off-the-shelf technology and basic training of personnel. History provides many similar lessons: for example, a Viking longship was a much better seafaring vessel than a contemporary Portuguese or Italian cargo cog (Braudel 1996). However, the former could be built only as large as the largest suitable tree. Vikings made it to continental North American shores, but European colonization started with Columbus.

Russia possesses several high-tech assets that only the US and a handful of other countries have. Among these are GLONASS (an analogue of US GPS, with European and Chinese systems being works in progress), a nuclear-powered navy (also possessed by the US, the UK, France, and China), supersonic jets (the US, the EU, and China), and space launch vehicles (with the retirement of NASA’s space shuttle fleet, only Russia currently has the capability to launch a manned spacecraft). However, unlike its oil, gas, metallurgy, and agricultural sectors, Russia’s high-tech sector is fragmented. Ownership structures are vague and inefficient. Many productive assets are locked in nontransparent government enterprises (FGUPs) or in mixed private-state ventures. (It is a common mistake to describe Russian companies such as Gazprom and Aeroflot as part of the government. Closer analogues would be AT&T and Western Union in their monopolistic periods. In fact, the famous Bell Labs were, for all practical purposes, a government-sponsored defense research establishment with tenuous connections to the business of telephony [Gertner 2012].)

The state corporation Rostechnologii exemplifies the recent shift toward privatization. It specializes in avionics, explosives, and composite materials. Other assets include AvtoVAZ, an automobile manufacturer that adapted the Italian Fiat 124 into the Lada, a Soviet-era “people’s car” and VSMPO-AVISMA, one of the largest world producers of titanium. Now, after government rescue, AvtoVAZ is being modernized by the French company Peugeot. Some of Rostechnologii’s assets, including VSMPO-AVISMA, are listed on the exchange as public companies. On May 18, President Putin asked the new government to consider privatizing many assets of this and other government holding companies and shedding noncore businesses. However, because of adverse market conditions, heavy truck–maker KAMAZ, another holding of Rostechnologii, recently canceled its IPO. We can expect that with changes in the market, IPOs of privately held companies will eventually go forward.

Capital restructuring of this sector can provide rich investment opportunities, but the current rules of the game are murky.

Part II of this article will explore promising high-tech sectors in Russia, financial and cultural impediments to investing, and macroeconomic considerations.

REFERENCES

Braudel, Fernand. 1996. The Mediterranean and the Mediterranean World in the Age of Philip II. Trans. Siân Reynolds. 3 vols. Berkeley, CA: University of California Press.

Cheung, Tai Ming. December 29, 2006. “Leaping Tiger, Hybrid Dragon: The Search for Technological Innovation and Civil-Military Integration in the Chinese Defense Economy.” PhD diss. Department of War Studies, Kings College, University of London.

Chernykh, Lucy. November 12, 2009. "Profit or Politics? Understanding Renationalizations in Russia." Journal of Corporate Finance, Forthcoming. Available at SSRN: http://ssrn.com/abstract=1562047

Crane, Keith, and Artur Usanov. 2010. “Role of High-Technology Industries.” In Russia after the Global Economic Crisis, ed. Anders Åslund, Sergei Guriev, and Andrew Kuchins, 95–123. Washington, DC: Peterson Institute for International Economics. www.piie.com/publications/chapters_preview/4976/05iie4976.pdf.

Gertner, Jon. 2012. The Idea Factory: Bell Labs and the Great Age of American Innovation. New York, NY: Penguin Press.

Malkiel, Burton G. 2011. A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing. Rev. ed. New York, NY: W. W. Norton & Company.

Stockholm International Peace Research Institute. 1989–1994. http://www.sipri.org/yearbook.

–Peter Lerner, PhD, MBA

Peter Lerner is a semi-retired financial researcher who lives in Ithaca, NY.


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Comments

Dear Peter, thank you very much for your great thoughts and deep insights into Russian economy. In fact, it's the most profound account I met during two days of desperate search in the Internet for Russian-Western hi-tech cooperation. I was frustrated finding endless posts on energy, gas and oil cooperation. It seems that the West regards Russia exceptionally as a bottomless oil well. I'd like to add only one more note to your brilliant analysis. A lop-sided view of Russia's economic affairs is also reinforces by some Russian analysts which unfortunately have gained popularity in the West.

I would like to comment on the following part, since the title inappropriately refers to Italy:

"My hotel, located in a prosperous section of Rome, did not have hot water running, and the air conditioning didn’t work—conditions that seemed incongruous with the surroundings".

- If the author stayed at a hotel rated at least 2 stars in Rome and in ordinary conditions, then what he wrote is simply not true.
- Otherwise, either he went to a cheap hotel (you get what you pay for, right?), or the situation was just not ordinary.

Conclusion: Either way, the premises are flawed.

Dear Mario,

The passage you criticize inadvertently changed its meaning due to copyediting. After the first copyedit I commented on the fields of my manuscript:

"The reader can get an idea that all hotels in Rome lack air conditioning and hot water. This is an exception rather than the rule. But sometimes plumbers and electricians decide that they urgently need to go to the Mass or visit family, especially on holidays. I am not here to besmirch a hotel industry of a wonderful country, Italy. In a day I moved to the hotel with functioning utilities."

But it would be impractical for the authors to fight with editors for every word--so it remained in the same form. I hope this message reassures you in my continuing love for Italy, its people and Rome specifically, which I was happy to visit after 22 years hiatus,

Yours Sincerely,

Peter Lerner

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