Portfolio Update: Russia

I have been horrified watching the evil and unprovoked war unfolding in Ukraine over the last month. It is a brutal reminder for many of us how lucky we are to live where we take the safety of our family for granted. My heart goes out to the Ukrainians affected and I hope for sustainable peace as soon as possible.

As Superfluous Value readers will be aware, I have owned several Russian companies at times and currently hold two- Gazprom and Lukoil, purchased in 2018 and 2020 respectively, and not added to recently.

I would gladly see them both go to zero if it meant a good outcome for the Ukrainian people. However, as there are more knowledgeable and able commentators covering the war and championing their cause, I will direct these brief comments towards my portfolio- sticking to the subject of this blog, as trivial as it is.

I know this is a controversial topic for many, so please reach out if you have strong feelings either way and wish to discuss.

The damage

I have been covering my mistakes a lot this year. My rule for only calculating my exact returns six-monthly is specifically for rough patches like this, so I can’t give a precise performance number, but Gazprom and Lukoil were initiated in at 4% and 6% positions respectively and made up around 13% of the portfolio at the start of 2022.

It is reasonable to carry these at zero for the time being and adding in pain in UK equities (mostly Lloyds) and my seperate Saipem shocker, it is fair to say I am comfortably in a double-digit drawdown year-to-date. Cameco being my largest position as well as core positions in Antero, Petrobras and Barrick have hedged the pain somewhat, but it hasn’t been pretty.

After a very strong 2021, it is particularly annoying to give so much of it back, but that’s the game. My portfolio will recover, but it is important to keep things in perspective, as many are suffering so much more than poor financial performance in Ukraine currently.

Sleep-walking into geo-political disaster

When I bought Russian equities, I believed old fashioned, “Cold War” thinking was obstructing western perceptions, causing some of the best-reserved, lowest-cost commodity producers to sell far too cheaply. I championed Gazprom with the world’s largest gas reserves, as I believed that higher natural gas adoption is one of the best immediate options we have to reduce global carbon emissions.

I also imagined Russia’s economy was set to flourish and stabilise on the back of recovering commodity prices, post pandemic. At a company level, this may have had some merit, but the fact that it could be over-ridden by the choices of a despotic expansionist rules the analysis dead wrong.

I have to now acknowledge that the discount applied to Russian stocks was entirely justified. Possibly there are alternate worlds where these investments worked out, but not in this (ie. the real) one.

I am not the only one who has been caught completely off-guard and have watched shell-shocked, assuming things would de-escalate at many steps along the way, only to see Putin double down again and again. I considered buying more early in the Donbas stage of the outbreak, but thankfully with both conscience and financial hindsight, I passed. Even then, erring on the side of patience and trying to avoid rash decisions (by not panic-selling and sitting tight in what I already owned) has hurt the portfolio badly here.

Both companies are now strong chances of a wipeout, with the Moscow Exchange shut for the last month and trading halted in London and New York.

I have been asked how I feel ethically about owning these businesses at the present time. I feel sickened by what is going on- but I see little point in selling at pennies in the dollar to market-makers or Putin-connected buyers and don’t believe this would help anyone in Ukraine. I am simply locked in place for now and hoping for the best humanitarian outcome.

While there are links between Putin and all companies in Russia (especially Gazprom), there is reason to believe ordinary Russians don’t support the invasion and are suffering shortages and being fed misinformation themselves. Europe itself has also acknowledged Gazprom’s role in keeping the lights (and heaters) on, through its continued acceptance of Russian energy.

Portfolio implications

As much as I would like to believe Russia leaping off the geo-political deep end was a black swan event, this just isn’t the case. Smart friends have expressed scepticism towards my Russian investments in the past and a large risk-premium was built into these companies- arguably not high enough.

This was a real risk I naively ignored and even if there is some future recovery, my decisions can only be labelled a huge mistake, as I have allowed my capital’s fate out of my hands and to the mercy of macro events.

The lessons for the portfolio are numerous and profound. Readers will know I have made investments in several other jurisdictions with questionable leadership, including Brazil, Chile, China and the Philippines. I don’t want to be Nassim Taleb’s turkey again, collecting my dividends, unaware Christmas is coming, or more correctly, I want to make sure any such damage is minimised.

While cutting all exposure to risky geographies is tempting, I think it would be a mistake and limiting position and geographical sizing is a more optimal solution. I haven’t come up with hard rules along these lines yet, but the process is ongoing.

In terms of diversification, I am obviously running a fairly concentrated book and having more Russian investments across smaller positions wouldn’t have helped in this case, as I tactically let the positions run and was happy to have my country allocation as high as it was.

Where to from here

There have been reports the MOEX will re-open this week and may have done so by the time I publish this. There will likely be waves of forced selling in the short-term, but if de-listing (by the west) and nationalisation (by Russia) don’t occur (a big if), a recovery is not completely out of the question over time.

There have been hopeful reports of eagerness to negotiate by both sides in recent days. The state of the Russian military is very hard to ascertain, due to conflicting stories, but Russia walking back its peace demands is a logical sign of a deteriorating position.

Obviously, a near-term peace deal would spare the most lives, but the Ukrainians couldn’t be blamed for seeking to prolong the fighting and press for a crushing victory, if they sense weakness. They owe Putin no favours and revenge would be a natural emotion at this point. The strategic stance of the US will be highly influential in this regard.

Whatever the best outcome for the Ukrainians is deemed to be, I hope it is achieved. Although, as much as he deserves punishment, the western leadership may be wary of a possibly unstable Putin at the command of his nuclear arsenal and want to avoid a humiliated despot with nothing-to-lose. It would be horrifically unjust for him to walk away from his evil campaign unscathed, but I will leave that to foreign policy experts.

For those interested, this fascinating piece from Dr Pippa Malgrem expands on what she calls a “Dead Man’s Switch” and why the balanced approach may be the most productive and safe course.

Summing up

I have no idea how this will play out and, perversely, being locked in halted shares at least gives me one less decision to make- I have to ride this out for the time being.

In terms of the company specifics, I hope sanctions play their part in pressuring Putin, but I don’t believe they will have any long-term effects on either of my companies. Gazprom and Lukoil gain the vast bulk of their value from their massive reserves in the ground and sanctions or missed dividends can only make a small dent in that value.

Both sell energy the world desperately needs for now and are likely to continue doing so for some time.

The best result for all involved is a quick resolution and I will be cheering for this from a humanitarian standpoint, first and foremost.

I own all the companies mentioned in this article.

Guy

Please don’t take this as financial advice. Do your own due diligence and consult a professional advisor, if unsure about your finances.