William Browder provides a rare insight to the thinking that drives the USD 3.2 billion Hermitage Fund, the world’s largest Russia-dedicated investment fund.
William Browder is Founder and CEO of Hermitage Capital Management Limited, the premier investment advisory firm specializing in Russian equities. The firm’s clients include over 6,000 high net worth individuals and financial institutions from over 30 countries. Hermitage currently manages over USD 4 billion in Russian investments, including the USD 3.2 billion Hermitage Fund, the largest Russia-dedicated investment fund in the world. William is a leading shareholder rights activist in Russia and an outspoken advocate for better corporate governance throughout Russian companies. He and Hermitage have been credited with a number of breakthroughs in improving corporate standards at major Russian companies, including Unified Energy Systems, Sberbank and Gazprom. He also spearheaded radical changes in Russian corporate law, including the creation of pre-emptive rights for all minority shareholders in Russian companies and the introduction of cumulative voting for director elections.
William serves as Chairman of the Russia Task Force for the Institute of International Finance and is a member of the OECD/World Bank Roundtable on Corporate Governance in Russia. He was named a Henry Crown Fellow at the Aspen Institute, was named a 2005 ‘Person to Watch’ by Financial News, and received a 2004 Industry Achievement Award by Global Fund Analysis. William was also named a Young Global Leader by the World Economic Forum in Davos in 2005. Prior to starting Hermitage, William was Vice President at Salomon Brothers where he managed the firm’s proprietary investments in Russia. He received an MBA from Stanford Business School and a BA in Economics with highest honors from the University of Chicago.
HW: What is the background to the fund?
WB: I founded Hermitage in April 1996 with the backing of the late Edmond Safra, who committed USD 25 million in seed capital. Today the Hermitage Fund has USD 3.2 billion under management, making it the world’s largest Russia-dedicated investment fund. Since inception, the Hermitage Fund has produced total shareholder returns of some 2,400%, or about 38% annually. In addition to the Hermitage Fund, we manage about USD 1 billion in managed accounts.
The Fund takes significant positions in large and mid-sized companies that have valuable assets (oil reserves, gas reserves, steel mills, pipelines, power generation capacity, etc.) but that trade at low asset-based and financial valuations compared to international, emerging markets and country peers. In Russia, the reasons for the discounts we see at the company level are often due to management inefficiencies and poor corporate governance practices. Our primary investment approach involves finding these discounted companies with good assets and then executing what amounts to a corporate governance turnaround – using our stake to run for the board, shake up management, raise public awareness of the problems at these companies and otherwise agitate for positive change. Our experience is that the improved corporate governance will ultimately be reflected in the share price and the company’s stock will re-rate. This strategy involves some degree of unique risk in that we may from time to time take a very confrontational approach to management, however, it also offers a sizable potential for significant capital appreciation as the ‘hidden value’ that was obscured by bad management is realized. More often than not, things work out in our favor. In the ten years since inception, the Hermitage Fund has roughly doubled the performance of Russian stock index.
Our geographic focus is currently Russian public equities, but our mandate covers all of Eastern Europe and the Former Soviet Union. W are also free to employ various fixed income and currency strategies in order to diversify our exposure, however, at the moment we have no fixed-income or currency positions.
HW: Who are your service providers?
WB: The offshore manager of the Hermitage Fund is HSBC Management (Guernsey) Limited, which has been our partner since HSBC acquired Edmond Safra’s Republic Bank in 1999. The Hermitage Fund is organized as a unit trust, with the trustee being HSBC Private Bank (Guernsey) Limited. Our auditors in Guernsey are KPMG and the Fund Administrator is Investors Fund Services (Ireland) Limited. We use a variety of law firms in numerous jurisdictions for both regulatory work and well as shareholder rights litigation. We also have several prime brokerage relationships.
HW: How and where do you distribute the fund? What is your current and targeted client base?
WB: Most of the distribution of the Hermitage Fund takes place by word of mouth or one-on-one meetings with potential investors. The large public awareness of Hermitage both in Russia and overseas enables us to attract interest from most investors who are considering an allocation to Russia. We are also on the platforms of most European private banks, which also helps to expand our reach.
HW: What is the investment process of your fund?
WB: Our investment process involves three stages. First, we continually conduct a general screen to identify potentially attractive investments on any number of given metrics or valuations. The second stage involves a more detailed analysis of key valuation drivers, the corporate ownership structure and potential positive and negative triggers for the stock. At this second stage we also begin to see if there are corporate governance issues at the company that are impacting the equity price and – equally importantly, if shareholder activists such as ourselves can play a productive role in resolving them.
The third and final screen involves an in-depth forensic analysis of revenues and cost structures with a focus on inefficiencies and management corruption (if applicable) and the potential for improvement through shareholder activism. As part of this screen we conduct due diligence checks on the company’s operations using both traditional and non-traditional public sources of information, including verifying export revenues through statistics released by the Russian Government. In this stage we extend our analysis of the ownership structure and management touched on in the second screen in order to identify the owners’ and managers’ true incentives and to assess the degree to which they are aligned with the shareholders’ interest. This third stage is conducted entirely independently from any sell-side analyst input and focuses on ‘peeling the layers of the onion’ to uncover internal problems or valuation triggers at the company that otherwise wouldn’t be seen.
This three-stage investment process is backed up by three key strengths of the Hermitage team: (1) strong expertise in conducting rigorous forensic financial research, taking into account the specifics of the Russian capital markets; (2) an underlying focus on shareholder activism and promoting good corporate governance; and (3) a deep knowledge and familiarity with the macroeconomic and political drivers of the economy and their implications for the capital markets and equity valuations generally.
HW: How do you generate ideas for your fund?
WB: Ideas are generated through a continual screening of the market universe and the continual and spontaneous sharing of ideas among the members of the investment team. The team also focuses on top-down analytics, such as the identification of catalysts for a sector or particular equities (capex restructurings, consolidations, M&A trends, etc.). Russia is also occasionally prone to indiscriminate sell-offs that present opportunities for managers to get exposure to stocks with good fundamental valuations that have been unfairly punished. Communication and interaction among the investment team is very free-from by design and is intended to encourage the free exchange of all kinds of ideas.
HW: What is your approach to managing risk?
WB: Returns on the Russian market are volatile, but unfortunately the traditional methods of managing risk are either not widely available or do not make economic sense to employ. The Hermitage Fund is currently long-only and is not hedged.
In terms of shorting stock or doing long-short pairs trading, there are only about three stocks – Gazprom, Lukoil and Unified Energy Systems – that one can short in any significant volume in Russia, and we are long each stock. It is possible to borrow less liquid stocks, but not the in kinds of volumes where it would become a meaningful hedge for us. As a result, the traditional long-short pair trade is not really available in the Russian equities market alone, and we are left to consider pairings between a Russian stock and a global peer. Options in Russia are also quite expensive and can meaningfully impact returns. As a result, one needs to consider options on oil, other commodities or other instruments that may be linked with what is happening in the Russian market.
Because the traditional tools of hedging are not available, the important risk management work takes place at the time of purchase, and we conduct a more thorough financial and forensic analysis than most managers prior to the initial purchase. Avoiding mistakes at the purchase stage goes a long way to helping us manage individual risk at the company level throughout the life of an investment. If we know what we are buying and what is going well and what isn’t going well at a given firm, we hope we won’t be surprised later on.
HW: How/against what do you benchmark the performance of your fund?
WB: The Hermitage Fund has no benchmark. The comparative indicator for the Fund’s performance that we include in our monthly reports to investors is the CSFB ROS Index.
HW: What opportunities are you looking at right now?
WB: We continually screen the markets of Russia, Eastern Europe and the Former Soviet Union for investment ideas and opportunities. The potential opportunities on the horizon in the Russian market include the Rosneft IPO, slated for later this year, as well as some anticipated IPOs in the banking sector. We expect banking to be one of the most dynamic sectors in Russia over the next five to ten years. What makes banking particularly exciting for us now is the extreme lack of choice for public equity investors in the banking sector, and the upcoming IPOs will offer more choice beyond the likes of state-controlled Sberbank, which we believe currently trades at a ‘scarcity premium.’ We are also seeing interesting flotations outside Russia.
In addition to getting comfortable with the long-term investment case for a company, the additional factor which makes or breaks our participation in an IPO is pricing, which we don’t know until the few weeks before the offering. Given the popularity of the Russian market today, we often find that IPOs are priced very aggressively by the underwriters. As a matter of policy, we refuse to overpay for IPOs. While it means we don’t participate in every IPO, it means we never overpay for equity exposure.
HW: How will changes/future events impact on your own portfolio?
WB: Oil continues to dominate any analysis of the Russian equities market, and the Hermitage Fund is currently about 90% invested in Russian oil and gas producers, with our largest position being the natural gas giant, Gazprom.
An oil price above USD 70 per barrel, as we have seen throughout this spring, is well above any Wall Street analyst estimates for either the short term or the long term. If oil prices stay anywhere near present levels, Russian oil companies’ earnings will surprise significantly to the upside going forward. At the moment, Wall Street’s consensus oil price for 2006 is USD 60 per barrel. If this were raised to USD 70 per barrel, Lukoil’s earnings would increase by 23% and Surgutneftegas’ by 15% – both are large private Russian oil companies in which we have significant holdings. Of course, predicting oil prices is a notoriously tricky game that nearly all the experts have got wrong for a long time. If one ignores the experts, however, and looks instead at oil futures, that market is saying that oil will be USD 70 per barrel in 2008, USD 69 in 2010 and USD 68 in 2012.
The situation is even more positive if we look at the effect of a change in long term oil price forecasts on equity valuations. The long term oil price estimates used by investors and analysts are even more pessimistic than the short term numbers. If one entered today’s share price of Lukoil and Surgutneftegas into a discounted cash flow model to determine the oil price assumed by current market valuations, the model would produce a long term oil price of around USD 40 per barrel. By changing the assumption of long term oil prices from USD 40 to USD 50, Lukoil’s fair valuation rises by 36% and Surgutneftegas’ increases 17%. If one used USD 70 per barrel, the upside would be 110% and 54% for Lukoil and Surgutneftegas, respectively. The difference between the current price of oil and the price assumed by oil company shares is about USD 25, which is the largest nominal difference between these two variables in the last 10 years. In the past, there has been some variation between the spot price of oil and the price implied by oil company valuations, but the long-term historical average has rarely exceeded USD 10 per barrel. Either the current market price for oil is stretched on the upside or the analysts are being too cautious on the downside – or both. I think it is reasonable to expect that many analysts over the next few months will upgrade their forecasts for long term oil prices, resulting in strong support for Russian oil stocks as this process unfolds.
Moreover, Russian oil and gas companies remain priced at severe discounts to their western peers on an asset basis. Major Russian oil and gas companies such as TNK-BP, Lukoil and Gazprom trade at USD 5.80, USD 4.00 and USD 2.30 (in market capitalization), respectively, per barrel of hydrocarbon reserves, while ExxonMobil, BP and Chevron trade at USD 18.00, USD 16.90 and USD 11.30, respectively. These discounts persist despite the fact that Russian oil companies are among the few in the world that are actually growing production; Lukoil grew production 4% in the first nine months of 2005, while ExxonMobil’s production shrunk 5% in the same period. At the same time, Lukoil’s costs average USD 1.40 per barrel while Chevron and ExxonMobil spend USD 6.60 and USD 5.80 in finding costs per barrel, respectively. Operating costs at the same firms also range from USD 4.60 per barrel for Lukoil compared to USD 7.10 for both Chevron and ExxonMobil. These internal economic advantages will likely be borne out in the operating results of these companies over time and will factor into the stock performance as the equities of the Russian oils are compared more and more with the global oil majors. Russian oils will also benefit from the ‘land grab’ for energy assets that is playing out across the world. 2005 saw a number of headline deals where Western, Chinese and Indian oil majors acquired smaller producers and fields at large premiums. The Chinese state oil company, CNPC, paid USD 11.20 per barrel of proven reserves in its acquisition of Petrokazakhstan. Given the high oil and gas prices worldwide, there is a scramble underway by both companies and states to secure the rights of energy assets as soon as possible.
In addition to oil, the second major catalyst for the Russian market is domestic money supply driven by the repatriation of strong export earnings. Money supply in Russia has more than doubled since January 2003 as a result of record export earnings. This has enormous implications for the Russian equities market. In particular, Hermitage has identified a 90% correlation between money supply growth and the Russian RTS equities index from 2003 to 2005. Increases in money supply are highly correlated with an increase in equity values in Russia. Interestingly, the stock market has recently become more sensitive to changes in money supply then it was in the past. While the correlation has always been high (between 85% and 95%), the slope of the correlation line (i.e. the impact of new money on the market) has recently increased. For example, in 2004 there was a 1:1 relationship between money supply and the stock market (a 10% change in money supply would lead to a 10% change in the stock market). Now there appears to be nearly a 4:1 relationship. New money supply is having a much greater impact on the stock market.
HW: What differentiates you from other managers in your sector?
WB: Our ability to conduct forensic audits and really dig in and research companies to find out what is going on and how it is impacting shareholder value is unparalleled. We then use this information as activists to fight for good corporate governance and to create value and drive returns for our investors.
HW: Do you have any plans for similar/other product launches in the near future?
WB: We offer one primary product, the Hermitage Fund, and have no plans to provide an additional product at the present time. We also continue to provide clients who wish to establish significant exposure to a strategy outside the scope of the Hermitage Fund the opportunity to open a managed account.
(William Browder was interviewed on15 May 2006; the interview was revised on 30 May 2006
