Investing in High-Tech in Russia, Part II: Challenges and Opportunities
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In Part I of this article, I dealt with misconceptions about Russian high tech and Russian markets in general. I now explore investment opportunities outside of the familiar defense, oil, gas, and commodities sectors. I also examine financial and cultural barriers to investing, and macroeconomic considerations.
NONDEFENSE HIGH-TECH SECTORS
Table 1. Russian-Based Registrants of USPTO Patents in 2005–2009 (OECD 2011)
Top 10 Russian-Based Registrants of US Patents
|Registrant||Domicile||Field||Number of US Patents Registered|
||Computers and communications
||Nitto Denko Corp.
Top Three Russian-Domiciled Registrants of US Patents
||Acronis International||Data recovery software
||Quintara||Internet search software
The holding company JSC Atomenergoprom (2012) operates nuclear power plants that generate a total electric power output of over 23 GW, second only to French AREVA, and provides 40% of the world’s uranium enrichment services. Its main potential market is China, which must increase energy production to satisfy its rapidly growing economy.
This sector is small but growing. In 2009, it represented $3.0 billion in exports, less than 1% of total Russian exports, but it had increased sixfold over the previous five years (Crane and Usanov 2010). A distinctive feature of the Russian software sector is the high complexity of its products. In 2008, captive software development (basically, the tailoring of firmware to customers’ needs) constituted 15% of exports, the production of packaged software made up 30%, and offshore programming for third parties amounted to 55%. Alcatel, Ericsson, Google, Intel, AMD, Motorola, Samsung, and Oracle all have established development centers in Russia.
Globally, nanotechnology is more of a promise than actuality. In 1995–2007, Russia ranked sixth in the number of nanotechnology publications, behind the US, China, Japan, Germany, and France; in 2008, it came in third in public spending on nanotechnology projects, trailing the US and Japan (Crane and Usanov 2010).
Unlike defense industry, medical equipment and pharmaceuticals in the USSR consistently lagged behind those of developed nations. Even now, only 8% of college graduates choose biomedical and agricultural sciences, while the share of degrees awarded in science and technology exceeds 60% (OECD 2011). The sector has been growing at a staggering rate (an average of 17% since 2005), but it started at a very low level. Still, given Russia’s size, it constitutes one-third ($17 billion in 2010) of the pharmaceutical markets of Central and Eastern Europe. Domestic industry has been mostly concentrated on generics, but Russia also imports generics from Germany, Slovenia, and Hungary. (At times, East Germany, Yugoslavia, and Hungary were major suppliers of pharmaceuticals to the USSR.) Novartis and AstraZeneca are establishing new factories in St. Petersburg and Kaluga (a city 93 miles southeast of Moscow), respectively. The local government of Kaluga is trying to develop a business park with a cluster of related companies.
Table 2. Select Educational Statistics (OECD 2011)
|Educational expenditures in proportion to GDP
|Proportion of the workforce with college and post-graduate degrees
|Graduates in science and engineering in proportion to total
Note: Accounting for private education in Russia is very difficult. As is the case in some East Asian countries, noncredit private tutoring for qualifying exams in higher education is a veritable industry in itself.
In 2003, the Russian Federation disbanded its Soviet-era state system of railroads and opened railroad freight to competition. The government-owned carrier Russian Railways is in charge of transportation between railroad hubs; regulated municipal monopolies control local passenger traffic. Freight transportation and local and long-range commuter rail services for millions of passengers have been significantly privatized (approximately 60% of the freight stock).
The building of a high-speed rail system presents opportunities for investment in high tech. Today, high-speed connections run among Moscow, Nizhny Novgorod, St. Petersburg, and Helsinki (Finland). The Strategy for Developing Rail Transport to 2030, signed by then–Prime Minster Putin in 2008, includes plans to increase the amount of high-speed rail from 650 KM to 10,887 KM (JSC Russian Railways 2012). European engineering companies are the main competitors for contracts.
FINANCIAL AND CULTURAL IMPEDIMENTS TO INVESTING
The low level of involvement of private companies in R&D is an obstacle to the restructuring of the high-tech sector. More than 60% of R&D funds come from the Russian government; in the US, more than 60% of spending comes from the private sector (OECD 2011). This is a systemic feature that emerged more than a century ago. As their peers did in England and France, but in sharp contrast to the Germans and Americans, business leaders of the late Russian Empire viewed research as extraneous to their business purposes and regarded scientists with disdain. When research was required, they acquired the results of research and development from government research labs and universities. (The loss of British competitiveness on the eve of the twentieth century has been attributed to the slowness of British industry to develop contacts with research universities and government research establishments [Ferguson 2004, 2009]).
In the Soviet Union, R&D functions were concentrated in specialized research institutions, similar to national labs in the US. Higher education was mainly geared toward the training of cadres and had little research intensity, and plants and factories were focused on production. Rather than attributing this system entirely to Stalin’s will, perceptive researchers view these measures in part as necessary for the industrialization of an empire overwhelmingly made up of peasants (Barber and Harrison 2000). Of course, now this attitude toward R&D is completely outmoded. The problem today is more cultural than financial. Breaking the mold of the new private industrialists is an important government task.
The Russian government also provides seed money for venture capital endeavors, although the penetration of venture capital through the R&D system is low. We must keep in mind that the relatively easy availability of venture capital is a unique feature of the US system, which Germany and Japan have failed to imitate despite no lack of trying. Again, cultural factors are probably more important than money.
As investors in emerging markets know, if one waits until all the laws and regulations are straightened out, there will be little left to acquire. One significant difference between Russia and other BRICs is that, as in EU nations, there is no net growth of the workforce. Russia is one of the largest net importers of unskilled workers. The number of guest workers, mostly from poorer nations of the former USSR but also from Southeast Asia, is estimated at 6–7 million, comparable on a per capita basis to that in the US (which has 11–12 million). (The number of migrants is difficult to research because anti-immigration lobbies tend to exaggerate the number of illegal workers and social-service providers to reduce it. Migrants also fall into different categories: documented migrant workers, undocumented migrant workers, refugees from war zones, etc.) The data are compiled from Russian Wikipedia (2012) and Goskomstat (2012).
Hence, when comparing Russia’s (and Brazil’s) annual growth of 4–7% in the 2000s to the 8–10% typical of India and China, we must keep in mind that all growth in Russia has to come from increased productivity, because there is no reserve of unskilled agrarian workers who could be moved into the more intensive urban economy—a major economic driver of other BRICs. On the positive side, Russia does not have a large agrarian proletariat, historically the major reservoir for crime, as we have seen in Columbia and Mexico.
It is easy to see how different the outlook of a macroeconomist would be from a financial analyst’s. From the macroeconomic point of view, extremely low (2–3%) unemployment in Russia’s major cities is a positive indicator. The Economist (2012) lists total unemployment in Russia at 6.6%, which is low by European standards. Furthermore, this figure, already revised upward from the official Russian data (Goskomstat 2012), may be exaggerated because many individual entrepreneurs and small traders benefit from registering as unemployed, according to my impressions from Russian media broadcasts. The main reason for incorporation in the US—namely, tax treatment—is absent in Russia, which has a flat income tax of 13%. However, low unemployment means that establishing local production is difficult because employers have to pay top wages and the loyalty of the workforce is low. There is an increasing tendency to establish new production facilities outside of Moscow and St. Petersburg, as in the case of AstraZeneca cited above.
Despite the low tax and relative easiness of profit repatriation, which contrast with the extensive capital controls in Malaysia and other Asian tigers, there are difficulties. Investing in Russia’s high tech through mutual funds is problematic in that the funds’ portfolios are highly correlated and concentrated too much in energy commodities (see Tables 3 and 4).
Table 3. Select Mutual Funds That Invest in Russian Stock—Annual Performance of the Five Largest Holdings for the Period 05/23/2011-05/23/2012 (Yahoo! Finance 2012)
|JPMorgan Russia C
Note: In bold are stocks that are part of the MMVB or RTS or both.
Table 4. Select Mutual Funds That Invest in Russian Stock—Regression of Daily Returns with the RTS Index for the Period 05/23/2011–05/23/2012 (RTS 2012)
Note: Returns of all three funds are highly correlated with the return of the Russian stock index.
Litigation is heavily politicized. Western courts and regulatory agencies almost never rule in favor of Russian business interests, even in patently frivolous lawsuits—and the Russian government has to retaliate. For instance, there are few exhibits of art from Russian museums in the US, and none in Texas, because of a judgment in Texas against Russia requiring it to compensate losses to a German piano maker dating back to World War I. (New York Times 2012). Outsiders typically confuse these political undercurrents with unfairness and corruption in the courts.
Many countries, including Russia, view American corporations in a negative light. In the common perception, these companies are too prone to lobbying, demand changes in tax and other laws even before they have made a significant investment, and are heavily influenced by political swings in Washington. A Russian proposal to GM to rescue Swedish SAAB was shot down by the US State Department. In the end, the remnants of SAAB were acquired by Chinese investors who did not come through on their promises, and the Swedish plant was shut down (Telegraph 2011).
Now that the two main Russian exchanges, RTS and MICEX, have completed their merger, we can expect a convergence of stock market indices; however, for the time being they are separately quoted. Like the Dow, the MMVB 30 is a nonweighted index of the 30 largest publicly traded companies (with some weighting rules for companies with more than one listed stock). The RTS 50, a weighted index of 50 representative companies, is similar to the S&P 500. As seen in Figures 1 and 2, energy and utilities constitute a large portion of the indices, but they are only about 40% of them by name. (For exact definitions, see RTS . I used my own judgment in classifying diversified conglomerates.)
Figure 1. Composition of the MMVB 50 by Industry (RTS 2012)
Figure 2. Composition of the RTS 50 by Industry (RTS 2012)
In conclusion, I summarize a few most pertinent observations of the high-tech sector in Russia.
- Russian high-tech sector suffers not so much from a lack of funding—though more developed capital markets would help—as because of the lack of good projects. As elsewhere in Continental Europe (Germany, France) and Japan, there is a heavy bias in favor of large companies.
- In contrast to most emerging markets where technology typically comes from the West to exploit existing distribution systems and marketing infrastructure, in Russia, the direction is usually the opposite. Russian partners in many cases possess necessary technological expertise and need access to marketing and distribution channels of their Western partners.
- There is no general rule as to whether government help or laissez-faire approach is efficient in a particular industry. Russian oil and gas industries were restructured through heavy government interference. Yet it has not produced comparable results in aerospace and defense sectors. On the contrary, metallurgy, retail, and agriculture flourished in the conditions of benign neglect by the government. However, relative lack of government interference did not result in modernization of pharmaceuticals, medical devices, or municipal services sectors.
Finally, the outlook of an investment manager is fundamentally different from that of a political scientist or a macroeconomist. The task of the investment manager is to uncover sources of value for his or her investors, rather than to pass judgment on a political process or to review the macroeconomic situation. I’m not advising you to rush to invest in Russia’s high-tech sector, nor to liquidate all holdings and run for the exit. If your business has Russian exposure or plans to have it in the near future, I hope that my column will be of some help.
Barber, John, and Mark Harrison, eds. 2000. The Soviet Defense-Industry Complex from Stalin to Khrushchev. London, England: Macmillan.
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.
Economist. June 16–22, 2012. “Economic and Financial Indicators.”
Ferguson, Niall. 2004. Empire: The Rise and Demise of the British World Order and the Lessons for Global Power. New York, NY: Basic Books.
Ferguson, Niall. 2009. The Ascent of Money: A Financial History of the World. New York, NY: Penguin.
Goskomstat. Russian Federation Federal State Statistics Service. 2012. http://www.gks.ru/wps/wcm/connect/rosstat/rosstatsite.eng/.
JSC Atomenergoprom. 2012. “Our Company.” http://www.atomenergoprom.ru/en/corp/.
JSC Russian Railways. 2012. http://eng.rzd.ru/.
OECD. June 2011. OECD Reviews of Innovation Policy: Russian Federation. http://www.oecd.org/document/58/0,3746,en_2649_34273_48088442_1_1_1_1,00.html.
RTS. 2012. http://www.rts.ru/en/.
Telegraph. December 19, 2011. “Saab Heads for the Scrapheap: Timeline.” http://www.telegraph.co.uk/finance/newsbysector/transport/8965840/Saab-heads-for-the-scrapheap-timeline.html.
Wikipedia (Russian). 2012. http://ru.wikipedia.org/wiki/Миграционная_ситуация_в_России.
Yahoo! Finance. 2012. http://finance.yahoo.com/.
–Peter Lerner, PhD, MBA is a semi-retired financial researcher who lives in Ithaca, NY.
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