September’s trading was influenced by the higher prices for oil, which approached $60 per barrel, and the appreciating ruble, which was particularly supportive of oil and gas names led by Lukoil and Novatek.

Amongst other tipped names are the old favourites Sberbank and Yandex, both of which are generic plays on Russia’s ongoing economic recovery.

Amongst the most speculative players recommended by Aton are Polyus Gold, which has launched two massive new gold mine projects, and pipemaker TMK, which is another metals player. The steel sector continues to perform on the back of recovering demand, especially in China, and Magnitogorsk Iron and Steel Works (MMK) remains the top pick in the metal sector, according to VTB Capital (VTBC).

Recent rallies in names that include Tinkoff Credit Systems (TCS), Aeroflot, rail company Globaltrans and real estate developer Etalon have led analysts to downgrade them as there is little upside left to these stories, says Aton.

In general the dollar denominated Russia Trading System (RTS) has continued its recovery, but has yet to make back all the index lost early in the year. The RTS Index added 13% in the third quarter of 2017, but is still 2% lower year to date (YTD), holding at 1,127 and remaining the worst EM performer relative to Turkey (+29%), Brazil (+23%) and India (+17%).

“This underperformance seems particularly surprising given the near-record breaking run by EM equities — MSCI EM has risen for almost 20 straight months and has not seen a 10% correction since January 2016. In fact, there has been only one longer winning streak for MSCI EM, in the 1995-97 period,” Gazprombank said in a note.

The Russian price-to-earnings ratio (p/e) discount to EMs has narrowed to 45% vs 52% a quarter ago and is presently in line with the three-year historical average, according to Aton. Currently, the Russian equity market is trading at a p/e of 7.2x vs the 7.0x average for the last two years with a peak of 7.7x achieved in December 2016.

The story is similar to the ruble-based MICEX Index, which added 10% in the third quarter of 2017, but is still down 7% YTD, negatively affected by the selloff in the first half of 2017, which was a result of new US sanctions and ruble appreciation, Aton reports.

Oil and gas (-12%) and financials (-10%) were the worst-performing sectors, with the latter negatively affected by AFK Sistema legal battles with state-owned oil major Rosneft (-49%). The transportation sector is the top performer, adding 22% YTD.

“Overall, we believe the Russian equity market is close to its fair level. We assume the RTS Index may add another 5-7% to 1,200 points, driven by the O&G and financial sectors, while in other sectors the majority of stocks are now trading close to their fair valuations,” Aton said in a recent note.

In the coming quarter dividend payments and changes to the MSCI Russian index may trigger some movements in particular names affected. The dividend story has been one of the biggest drivers of stock gains in the last few years.

“The dividend yield in the Russian market has grown from 4.6% to 5.3% YTD (2.7-9% on the most-liquid names) amid equity underperformance, and remains by far the best dividend story in the EM universe, which yields just 1.5-3.5%. Moreover, Russia’s dividend yield is narrowing the gap between local sovereign bonds, the average yield on which (7.5%) has dropped YTD,” Gazprombank said in a note.

A number of companies will pay interim dividends in the fourth quarter of 2017, including Mobile TeleSystems (MTS) (3.7% dividend yield), Megafon (5%), Norilsk Nickel (2.2%), MMK (2%), Novolipetsk Meatllurgical Kombinat (NLMK) (2.4%), Severstal (3.1%), Unipro (3.3%) and Detsky Mir.

“In November, MSCI Russia Index rebalancing should have a large impact on Russian stocks. Sistema and Rostelecom might be excluded, while Polyus Gold should be included, potentially leading to a stock inflow of up to $150mn. It is also possible that MMK could be included and to a lesser extent, Aeroflot. Sberbank and Novatek will present their new long-term strategies, which should heat up investor interest in these names,” Aton said.

Steel

The steel story continues to return positive results to investors. Steel has had a great first half and the prices for steel products are expected to remain strong in the second half of the year as well. At the same time, the strengthening ruble is also supporting share prices.

Magnitogorsk Iron and Steel Works (MMK) remains the sector’s top pick with VTB Capital (VTBC) giving the name a 12-month target price $12/GDR and a 35% upside to current prices.

“MMK remains cheap on multiples, keeps delivering on promises (higher dividends, shares placement) and has strong triggers ahead,” VTBC said in a note.

The other leading names in the sector look less exciting, fairly priced and lacking triggers to move their prices upwards. However, Evraz remains of interest on the back of its rapid deleveraging story; the company has cut debt and paid out dividends recently for the first time in years; VTBC has the name marked to buy with a 39% upside to current prices.

While the environment for steel prices is good at the moment, analysts wonder if the story is about to run out of steam.

“We believe that the current euphoria on the steel markets does not have much fundamental support behind it, apart from re-stocking (in anticipation of winter production cuts) and the real estate market recovery in China. However, we think that the latter might enter a downturn cycle in the near future, following the drop in personal mortgages,” VTBC said in a note.

Steel prices could normalise next year as demand returns to its mean. However, even in a less dynamic market MMK remains cheap, trading at 4.6x 2018 EV/EBITDA, according to VTBC, which is still a 25-30% discount to rivals Novolipetsk Meatllurgical Kombinat (NLMK) and Severstal.

“The company continues to deliver on its improvements in the pipeline: it recently announced a 75% of free cash flow (FCF) dividend for the first half of 2017 and the majority shareholder placed a 3% stake on the market. The latter could improve stock liquidity and increase the chances of MMK being included in the MSCI Russian index already in November which would lead to $140-150m of passive inflows,” VTBC said in a note.

 

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ATON Top picks and key drivers
Company	Ticker	TP	Upside  potential	Key arguments
Sberbank	SBER RX	RUB240	25%	The bank trades at a 2017 P/E of 5.0x and P/BV of 1.1, which is well below EM peers. It enjoys high and sustainable ROE above 20%. Dividend payout ratio can be increased after 2017. The bank will hold a strategy day by end-2017, presenting a new 3Y plan including revised dividend policy. We expect positive news flow from this event. We also note improving lending/investment activity in Russia, where Sberbank is the main beneficiary.
RusHydro	HYDR RX	RUB1.13	32%	RusHydro lagged sector performance as of mid-2017. The stock currently offers circa 8% 2018E dividend yield, particularly since management plans to amend the company's dividend policy to exclude non-cash one-offs from dividend calculations. Fears over Taishet aluminium project participation did not materialise: the company will not have much cash exposure to the project. The deal with VTB was signed at RUB1.0/share, +15% to the market.
LUKOIL	LKOD LI	$67	23%	The company remains focused on the most profitable crude oil barrels, cutting output in Western Siberia to comply with OPEC+ commitments. We see 2017E FCF at $2.3bn, resulting in 6% FCF yield. LUKOIL now offers circa 7% annualised dividend yield (RUB205/share) assuming further dividend hikes to track RUB inflation.
Novatek	NVTK LI	$133	14%	Yamal LNG 1st train launch is imminent (likely in Nov-Dec), which should bring the stock back onto radar screens. The new LT strategy to be presented in December should clarify the company's next growth points, potentially helping smooth the negative reaction after the 2017 production decline. Novatek is currently offering a compelling 9% 2017E FCF yield.
Polyus	PLZL LI	U/R	N/A	Polyus say they are constructive gold, expecting the price to average $1,350/oz in 2018, believing that the North Korean nuclear programme, Trumponomics, Brexit and S&P valuation concerns will continue to fuel market uncertainty and bring inflows into Gold ETFs. We believe Polyus shares provide attractive exposure to gold as the current valuation level of 7.3x 2018E consensus EV/EBITDA looks attractive vs global majors at 9.6x Ð Polyus offers the industry's lowest production cash costs and highest dividends.
TMK	TMKS LI	$6.0	27%	TMK shares fell 15% from August levels after publication of fairly muted 2Q financials. We see this as a buying opportunity as the company is now favourably positioned  for rising oil prices (benefits revenue), while seasonally weaker steel prices should help ease cost pressures. American Division earnings recovery is on track (we expect $106mn EBITDA in FY17 vs $72mn loss in FY16), while valuation (5.7x 2018E EBITDA) offers a substantial discount to direct peers Vallourec (15.2x) and Tenaris (10.9x).
Yandex	YNDX US	U/R	N/A	Yandex benefits from a strong rouble and economic recovery. Seasonally strong 4Q17 results and an increasing market share should be upcoming drivers.
Source: ATON Research