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Frontier markets: Commonwealth of independent states - a wealth of untapped commodity potential

When one thinks of the Russian satellite countries such as Kazakhstan, Uzbekistan and Turkmenistan, revolution and political instability often spring to mind, writes Richard Hemming.

One only has to look back to early April when an interim government took control of Kyrgyzstan after President Kurmanbek Bakiyev was ousted in violent protests.

This highlights why investors must analyse the range of very different political structures and systems of law in the region. For example, Georgia has a transparent and easy-to-understand legal system, while there are big obstacles to bringing assets out of Uzbekistan.

The region's vast untapped wealth nevertheless remains a big draw; Kazakhstan is second only to Saudi Arabia in terms of natural resources per capita, while Ukraine is tipped to become one of the biggest food producers worldwide with crop yields set to increase by 50% in the next five years.

Many investors seem to agree that you need to be able to access the region's potential in commodities, which is why the Kazakhstan-based copper miner Kazakhmys, which is listed on the London Stock Exchange, is a member of the FTSE 100 Index and has a market capitalisation of £6.4 billion.

However, the price of investing in the region's companies listed in London and elsewhere is that they are very expensive. This means that there is a lower expected return for investors due to the higher transparency of their financial and their operational performance.

There are others who are willing to take a riskier approach. One is Marshall Spectrum, which invests close to $100 million in Russian satellite countries. Michael Kart, managing partner of the Moscow-based firm, says that the main reason for his firm's interest in the region is the huge, unrealised potential.

"If you have relatively long holding periods of three years, you can make 300-400% returns. But of course there are big risks," he says, highlighting the need for investors to partner with local experts.

A Kazakhstan bank for example, might trade on a 25% dividend yield and at 0.3% of its book value. In contrast, Barclays trades on a dividend yield of closer to one percent and at one times its book value.

"Sometimes I have no clue what the financials are because the standards of reporting are local and not international," admits Kart. "Companies don't feel obliged to inform minority shareholders and they often won't have an investor relations team."

To overcome this, Kart's team do rigorous due diligence, which involves face to face meetings with shareholders, as well as with the managers of the companies they are looking to invest in. They also meet with brokers and with the banks that have financed the companies. These relationships, he says, are developed over time.

"We try to understand how they think, their general mentality when dealing with outside investors," he says. "It's quite a time consuming process and you can't always be sure that you won't get caught out. But we make sure that we're taking a risk that's appropriate for us."

Jerome Booth, head of research at Ashmore Investment Management, issues a final warning: "We have very few investments in these countries because you have to be very careful investing in failed states," he says. "Aid perpetuates dependency, which creates rent seeking behaviour. Politicians spend their time looking for aid rather than improving the economy."

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