Chapter Eleven

The Big Picture and the Small Picture

A Case Study of Russia

Often the big picture contradicts the small picture.

I can still recall that when I traveled to Russia looking for investments in the early 1990s, the big picture was that the place was dirty, low-down, and dishonest. But the small picture presented isolated pockets of real opportunity. We’re talking macro versus micro views here. Although Russia’s political, economic, social, and financial situations all left a lot to be desired, there were still bargains to be found.

And by correcting the gap between the macro and micro views, you can get a jump ahead of the crowd.

The Bad and the Good

When we first began tentatively sniffing around Russia, the macro picture could not have been more bearish, unless a full-fledged civil war had broken out.

• A besieged Boris Yeltsin had barely staved off a countercoup by shelling the parliament.
• The place was a hotbed of hard-core Communist resistance.
• Inflation was skyrocketing.
• Industrial output had hit rock bottom.
• Capital flight was endemic. Any Russian with a few rubles to his or her name had smuggled the money out of the country and shoved it in some offshore safe haven far removed from the long arm of the Moscow tax collector.
• There were no well-organized stock exchanges.
• There were no balance sheets.
• There were no earnings reports, because there were no earnings.
• The country was deep into what became known as the Great Contraction, when the country’s gross domestic product (GDP) plunged by nearly half in five years.

I could go on; Russia was in a tough spot at the time.

So what attracted us? There was stock to be bought, for nickels and dimes to the share. Companies were being privatized right and left—big ones, small ones, good ones, bad ones, sometimes as many as a dozen a week.

Assets were being auctioned off like excess inventory for pennies on the dollar—or old rubles to new rubles—to sometimes not even the highest but often the only bidder. Entire companies—oil and ore giants, telecoms, energy companies—could be had for peanuts.

So why was the Russian state so determined to conduct a fire sale of its potentially valuable assets? The government desperately needed money. And a lot of individuals—mostly managers—also desperately needed money. So they were skimming and scamming and getting rich in the chaos. This made many ordinary people who were excluded from those deals very angry.

But there was also another, more legitimate reason that things were so cheap in Russia back then: No one could be sure which way the wind would blow—toward a viable conversion to a market economy or toward a civil war between would-be capitalists and ardent counterrevolutionaries.

The ultimate big winners of the second Russian Revolution (to convert to a market economy) were by no means clear. So we foreigners, in effect, had to get paid to take the plunge. Fortunately, those of us willing to take the risk came out smelling like roses—at least for a while, until the expected and probably inevitable deluge.

“Trust Us”

When we first set foot in Russia, registration of shares was a problem. “Who registers the shares?” we would ask, toward the end of nearly every company visit. “Oh, we do,” the company official would smilingly reply. “But what’s our guarantee that if you don’t like our face, you won’t just go and erase our name from the registry?” “Trust us” came the reply. But personally, the lack of a central share registry made me very nervous.

Back in 1994, the Russian Stock Exchange was so primitive that trading began at around three o’clock in the afternoon, give or take an hour or so, when a BMW would pull up to the stock exchange building in Moscow to unload a few million bucks’ worth of cold cash.

Brokers would sit at long tables waiting for workers and ordinary citizens who had been given share vouchers—which could be exchanged for shares in newly privatized Russian companies—to bring them in by the bushel and sell them for a song.

At around six o’clock in the evening, the BMW would return to collect the vouchers that the brokers had bought on the cheap from the gullible workers and citizens. As one veteran of the scene recently recalled, “It really was ‘over the counter.’”

Fast-forward two years. By 1996, the Russian Trading System (RTS), an electronic link between brokers and dealers established under the aegis of the U.S. Agency for International Development (USAID), was trading an average turnover of the equivalent of US$14.2 million daily.

This wasn’t too bad, considering that the vast majority of Russian stocks were still so thinly traded that we had to wait days, or even weeks, to execute a trade.

Five years after we purchased our first Russian stock, the Russian bear boom had entered its second year in high gear. So the same two questions now arose that hover ominously over all runaway booms, at all times, anywhere in the world:

There were, on the macro level, a few things to feel good about and to give us confidence that despite all our misgivings, some real and sustainable growth was taking place that would justify those rising share prices.

After plunging 43% since 1989—the year the Berlin Wall came crashing down on the Communists’ heads and the Iron Curtain opened like a venetian blind—the Russian domestic economy in 1997 actually reported a marginal gain in GDP of a not exactly staggering 0.4%.

This may not sound like a lot to you, but given the amount of money being made that never got booked, it was mighty impressive—particularly since the GDP had risen for two consecutive quarters, the first such back-to-back upswings in five years. It could have been, for all we knew, the beginning of a Great Expansion—or just a minor blip on the screen.

A Welcome Tidal Wave of Privatization

There had been some impressive—and little-noticed—improvements in the results of that tidal wave of privatization. Despite the fact that the program had been highly corrupt and much criticized for being riddled with errors, it had accomplished many of its initial goals.

By year-end 1998, 75% of manufacturing enterprises had been privatized, while 85% of manufacturing output was being generated by privatized companies. More than 80% of industrial workers were employed either in privatized or quasi-privatized firms.

Even more critically, the huge industrial overcapacity that had plagued Russia during the Communist era had been largely squeezed out of the now heavily privatized economy. A burgeoning service industry had been created from scratch, with large and small banks, advertising agencies, and shops thriving on the new opportunities.

Under the old system, the prevailing wisdom had been: “He who doesn’t steal from the state is stealing from his own children.” Another common pearl of workers’ wisdom: “We pretend to work, and they pretend to pay us.” Taken together, it’s not hard to understand why the Soviet system collapsed. In fact, the truly astonishing thing is that it took so long to buckle under its own internal contradictions.

After just a few years of free-market policies, employee morale had sharply improved. “It’s become more difficult to steal from new owners than to steal from the state,” a Russian oil and gas analyst told the Wall Street Journal. This fellow attributed the 1.3% rise in oil production in 1998 (not very much but still the first increase since 1988) to the fact that: “Management has become more motivated.” In his industry, newly invigorated, financially incentivized managers were “overhauling oil wells, installing new technology, and investing more wisely.”

Thank God a few things were going right. From the standpoint of cultural values, the country was in the midst of a major turnaround. A once-insular country, which out of ideological distaste had shunned foreign trade, became a major player in international commerce.

Still, judging by my own personal experience, in too many of these promptly privatized firms, the same old sad socialist sacks were still running the show. This meant, more often than not, running their companies straight into the ground. Five years of high-pressure, full-speed-ahead privatization and economic shock therapy had failed to bring fresh blood into the ranks of too many senior management teams.

If anything, the prospect of getting rich off privatization had encouraged many over-the-hill managers to stay put, hoping to cash in their chips before heading out. As a result, threatened and paranoid managers tended to adopt, in desperation, a passive survival mentality.

This lose-lose strategy involved:

• Lowering output.
• Cutting employment and wages.
• Running up massive arrears to suppliers and the federal budget.

It’s Okay to Sell the Crown Jewels

Something, sooner or later, would have to give. The basket of blue-chip stocks held by our Russia Fund had done well. But the investments were getting expensive. The Fund’s strategy in Russia in the second year of its boom was the same one that I employ during all booms anywhere and everywhere: Move down the list from the big, large-cap stocks, which have gotten expensive, and look for second-tier companies with small market capitalizations and big growth potential.

Take a good, hard look at your portfolio. Find all the stocks that have gone up 100% or more in one year or less, where the earnings have not risen as much and the five-year projection is not good, and consider dumping them.

What? Am I nuts? Why sell stocks that are your crown jewels? Because your crown jewel stocks can be your most dangerous stocks. Sure, you feel loyal to them because they’ve done well by you, and you by them. But watch out. They can be deadly. Let’s take a quick look at the situation.

Here it was, a splendid collection of Russian blue chips, nearly every one of which had gone right through the roof—not altogether surprising, in a market that had tripled in value in a mere 18 months. The Fund had a good chunk of:

• The oil giant Lukoil (up 184% in one year).
• Vimpelcom, Russia’s number-two cellular phone company (up 154%).
• GUM Trading House (up 132% in one year), the wonderful old department store in Moscow housed in a dramatic location right off Red Square.
• Rostelekom, the huge phone monopoly, and St. Petersburg City Telephone Network, two of the brightest telecom investments available, both well up in the triple digits in the past year.

So I had hit all the sectors and picked up the cream of the crop. I should have been happy, proud as punch. Instead, I was running scared. You don’t maintain high performance by holding on to old blue chips that are no longer blue. Find the next batch of blue chips before they turn blue.

The fine, seasoned stocks in our portfolio weren’t priceless oils, guaranteed to appreciate forever. They were more like prime steaks, capable of going bad if you held on to them for too long.

As I advised our Russia Fund shareholders after our second successful year in operation: “It’s difficult to imagine just how big Russia is. If you fly eastward from Moscow, it takes nine hours to reach Vladivostok, on Russia’s Pacific coast.” Like the United States, Brazil, and China, Russia’s size is intrinsic to its character.

Even after being shorn of many of its Soviet-era and tsarist imperial possessions (and pretensions), Russia is still the largest country in the world, as measured by land mass. It covers nine time zones, stretches nearly halfway across the globe, and contains just about every conceivable form of landscape on earth, from snowy mountains to hot, sandy deserts, from fertile lowlands to dry grasslands, from endless tracts of tundra to lush forests.

Its natural resources are staggering:

• It’s the world’s largest producer of palladium.
• It’s the second-largest producer of platinum after South Africa.
• It’s the second-largest producer of diamonds after Botswana.
• It’s one of the largest producers of nickel, gold, oil, and natural gas in the world.

On the upside, a big country is a place where companies can grow to fit the landscape. Where the potential domestic markets are huge, companies don’t have to rely so much on export-driven strategies to succeed. They don’t have to rely on a global strategy to succeed. If they can become category killers in their own country, they’re halfway there. And having conquered their own territory (assuming that it’s big and diversified enough), moving on to the rest of the world doesn’t seem like such a quantum leap.

On the downside, large countries’ problems are often tailored to their size. They’re not nimble. They’re not quick. Unlike a small car or a small country, a big market can’t easily turn, or be turned around, on a dime.

One time, I visited a company in Vladivostok, an industrial port city on the Sea of Japan. The firm was struggling, with less than 10% of its potential capacity being utilized. Just three years before, the producer of radio and TV components had been struggling to keep up with orders, because it had enjoyed a solid share of the Russian domestic market.

But no longer. With fierce competition from cheaper Asian imports (many originating in countries located not far from Vladivostok by plane), this company’s electronics business was distinctly endangered.

Industry Characteristics Aren’t the Be-All, End-All

But the electronic components manufacturer’s attitude was positive. The company had established ties with U.S., South Korean, and European firms, and although these alliances had not produced much business—let alone hard cash—the managing director radiated hope, optimism, and confidence.

He was excited, he said, about a contract he hoped to sign soon with a South Korean company that might increase production by 50%. Because his business was fundamentally linked to the global economy, the electronic components manufacturer had been forced to engage with the new global realities. Objectively, in some ways, he was in a difficult place. But subjectively, he was miles ahead of the curve. Another, equally important lesson to be learned from not-so-random encounters is: A strictly industry study of a company’s situation can be misleading. A visit on the ground can make the difference.