[Editor’s note: University of Houston professor Craig Pirrong has graciously contributed the attached blog entry to the RA blog. Craig maintains an excellent blog at www.streetwiseprofessor.com.] Buyer Beware, Indeed By Craig Pirrong In a provocative article published last week in the Wall Street Journal, Alexander Temerko identifies the precise problem facing anyone foolhardy enough to invest in Russian equities, especially “strategic” sectors such as energy:
Unless you have your own private mole in government, you will never be able to predict your returns with any confidence. Directly or indirectly, corporate authority ultimately rests with the state in Russia.
The dominance of the state has two serious consequences. First, the Russian state is notoriously opaque. This translates into corporate opacity for Russian companies. Insiders possess far superior information about the factors—notably the political factors and deals—that will affect a Russian company’s fortunes. Lacking “moles,” outside investors are at a severe information disadvantage relative to insiders and their favored tippees. Severe informational asymmetry has a predictable effect—a pronounced lack of liquidity. Who wants to trade in a stock when there is a high likelihood that the party on the other side of the transaction has much better information? The laughably small daily trading turnover in an immense flotation such as Rosneft that Temerko notes is the inevitable consequence of the informational disparity between outsiders and insiders who face no sanction from trading on their superior information. Such stocks are the financial equivalent of Roach Motels—you can check in, but you can’t check out. Moreover, severe illiquidity can facilitate certain manipulative strategies that can result in mysterious stock price movements. The second implication of state dominance is a severe separation of ownership and control, and a misalignment of the interests of formal owners and those effectively in control. The potential for diversion of corporate assets by the state’s creatures is extreme. As Temerko states, diversion of one company’s assets to support other politically favored companies is inevitable in these circumstances. Furthermore, traditional investor protections from such conduct are completely lacking. Shareholder suits? Surely you jest. And corporate control transactions—such as hostile takeovers—that can sometimes discipline management in the US and Britain are unimaginable in “modern” Russia. So why, pray tell, have investors plunged handsome sums into Russian equities? In some cases, notably Rosneft, investors have had to pay to play; Russia conditioned some companies’ ability to invest in Russian energy projects on their participation in the public offerings. This has proved cruelly ironic, as those that have “won” the right to invest in Russian projects have in fact won only the right to be fleeced a second time by having their capital expropriated on whatever pretext (environmental violations, failure to meet production targets) the Kremlin finds convenient (or perhaps just amusing). The only mildly surprising aspect of this is the extremely short interval that elapsed between the day some companies paid through the nose for an IPO and the time that the expropriation threat loomed large—a matter of mere months for BP, for instance. Vladimir Putin is indeed a man in a hurry, but that is a story for another day. In the meantime, would be investors, follow Mr. Tomerko’s advice: Beware!