Forget This BRIC Nation, Once And For All

#-ad_banner-#With certain types of investments, you just know you’re in for a wild ride. But there’s no sense in assuming extra risk without a reasonable chance of a proportional reward.

This is why I encourage investors to think twice about getting involved with Russian stocks.

As anyone who follows emerging markets knows, Russian equities are exceptionally dangerous. Typically more than twice as volatile as U.S. stocks, they often vacillate between massive gains and dismal losses.

However, investors willing to endure the extreme volatility haven’t gotten nearly enough in return.

While they have done well lately, long-term investors have been pummeled. The largest exchange-traded fund to track Russian stocks, Market Vectors Russia ETF (NYSE: RSX), has gained nearly 25% year to date, but RSX has lost nearly half its value since inception in April 2007.

And the problem isn’t fund-specific. Templeton Russia & Eastern Europe (NYSE: TRF), a closed-end mutual fund that focuses on Russia, plunged by more than 60% during the same eight-year period.

Such data might trigger a Pavlovian response in contrarians, who often view deep pullbacks as buying opportunities. And with a forward price-to-earnings (P/E) ratio of around five, the Russian market does look awfully cheap next to the U.S. market’s forward P/E of 18.

Trouble is, Russia still displays the same issues that have made it a hazard since day one. The biggest shortcoming for this market (and economy) is an extreme overdependence on commodities, especially its two main exports, oil and gas. At present, the energy sector accounts for about a quarter of gross domestic product, two-thirds of exports and nearly a third of government budget revenue.

The deficiency is greatly magnified when energy prices are low, as is currently the case. With oil and gas both still well off last year’s peaks and only tepidly recovering, Russia’s GDP is set to contract by 3% this year and mostly tread water in 2016, suggest growth estimates by the Organization for Economic Cooperation and Development.

The country’s over-reliance on energy isn’t likely to be resolved anytime soon. During his 16-year tenure, President Vladimir Putin hasn’t placed nearly enough emphasis on economic diversification, leaving the nation well behind the eight ball in that respect.

And there always seems to be disincentives to diversify. For example, the high energy prices that persisted for years before the latest downturn reduced the need for industrial diversification. Simply put, Russia didn’t bother much with economic reforms when so much oil and gas money was flowing in. A return to high prices would likely throw a wrench into any future reforms.

The latest distraction from diversification, Russia’s political and military involvement in the Ukraine, has drawn tough sanctions that are reportedly causing substantial economic harm in Russia and Western Europe, with some ripple effects on the United States. The economic woes could worsen, especially for energy-dependent Russia, if oil and gas prices revert to the lows seen earlier this year, as some analysts predict.

Russia has always been criticized for widespread corruption, which appears to be as entrenched as ever. A key red flag: many of the nation’s largest companies are state-owned or have close ties to government officials and thus receive preferential treatment when it comes to regulatory compliance and financial assistance. When rendering aid, the government often blatantly favors companies that support its political agenda.

In some parts of the country, extortion of smaller businesses by local magistrates is common. Overall, Russia consistently ranks poorly on the World Bank’s “Doing Business Survey,” particularly in the “ease of doing business” category.

In a brief but fascinating article that appeared in Fortune magazine earlier this year, hedge fund manager Bill Browder described his tumultuous experience with Russia. For years, Browder was one of the country’s largest foreign investors and a prominent opponent of corruption. But in 2005, he was expelled by President Putin, who declared him a threat to national security once Browder’s anti-corruption efforts no longer melded with the President’s political interests.

Today, Browder takes a dim view of Russia as an investment, predicting that the government will eventually resort to nationalizing and even seizing companies, among other draconian measures. “In the meantime, don’t be fooled by the likely dead cat bounces,” he warns. “Russia is a sucker’s market, and one that you shouldn’t touch with a barge pole.”

Risks To Consider: Although it began converting to capitalism more than two decades ago, Russia no longer seems committed to having a reasonably functional free market system. In fact, it’s backsliding and may never successfully make the transformation.

Action To Take –> Russia may be one of the world’s largest economies, but I agree with Bill Browder. It’s no place to risk your capital. Consider completely avoiding individual Russian equities, as well as the types of Russia-focused funds that I mentioned earlier.

To thoroughly purge their portfolios of Russian stocks, investors will also need to dump emerging markets funds that contain such stocks, as many typically do in substantial quantities. One international fund that has zero Russian exposure: the iShares MSCI Emerging Markets Minimum Volatility ETF (NYSE: EEMV).

As the chart above indicates, Russian stocks have been rallying in what could be one of the dead cat bounces Browder cautions about. For risk takers, this may be an opportunity to short a Russia-focused fund like RSX.

Just because Russia is a dangerous investment doesn’t mean other countries should be ignored. In fact, 75% of the world’s highest-yielding stocks are overseas. And High-Yield International is your best source for investing trends, opportunities and sky-high yields abroad. For more information about international investing, click here.