British Prime Minister Winston Churchill once famously described Russia as a riddle wrapped in a mystery inside an enigma. Investors today might feel the same way about the country, given the dichotomy between its enticing growth prospects and the uncertainties raised by the increasing authoritarianism of President Vladimir Putin.

On the one hand, Russia's economy has grown smartly this decade thanks to its booming oil and gas export sector and, more recently, to its growing domestic economy fueled both by infrastructure spending and by rising wages and personal consumption. And some professional investors believe Russia's near-term economic outlook remains bright. Russia's RTS index has skyrocketed more than 1,100% so far this decade, and as of early December it traded at a discount to the other so-called BRIC nations of China, India and Brazil.

On the other hand, the Putin government's heavy-handed tactics have turned Russia's democracy into a de facto one-party state that stymies both opposition parties and the media. Several government critics have died under mysterious circumstances. Russia's growing assertiveness on the geopolitical front has ranged from using energy as a political weapon to increasingly bucking Western interests to planting its flag beneath the North Pole and claiming the region as its own.

"Russia is a big, ugly country going through a tremendously difficult transformation," says Christopher Smart, portfolio manager of the Pioneer Emerging Markets Fund, which is invested roughly 10% in Russia. "Its politics are opaque, its foreign affairs sound more threatening and you have to ask yourself if this is a place where you want to put your money.

"That said, it's also a place of tremendous opportunity," he continues, citing Russia's massive oil and gas revenues that are trickling down and benefiting the overall economy. The combination of capital inflows and rising employment and household income levels are benefiting domestic-oriented sectors ranging from banking and real estate to telecommunications and retail.

"Oil will always be one of the-if not the-most important part of the economy," says Smart. "But Russia is not just an oil story anymore because there is very strong consumer demand that's driving economic growth."

Ruble Rises From The Rubble

Russia has come a long way since its currency crisis in 1998 that devalued the ruble and caused it to default on its government bonds, which helped trigger the notorious implosion of the Wall Street hedge fund Long-Term Capital Management.

Propelled by skyrocketing prices for oil, gas and minerals, the unprecedented global economic growth that began earlier this decade has greatly benefited resource-rich Russia and enabled it to establish the third-largest cash reserves in the world. This massive kitty supports internal growth while insulating Russia somewhat from the global credit crunch.

Russia has grown from the 22nd-largest economy in 1999 to No. 11 in 2006, according to the International Monetary Fund, and it is projected to possibly reach the ninth spot next year. The World Bank reports that Russia's GDP growth has averaged more than 6% annually in recent years, a solid rate that trails those of high-flying China and India (roughly 10% and 9%, respectively) but is about twice that of Brazil.

According to a World Bank report from April, Russia's oil and gas sector accounts for less than 1% of Russian employment but about one-fifth of economic output and almost half of exports. Productivity in the manufacturing sector has been rising, but it hasn't kept pace with rising real wages in recent years due to the appreciation of the ruble, which in turn limits the international competitiveness of Russian manufacturing.

In some ways, Russia differs from others in the BRIC complex. "The population demographic story isn't as spectacular," says Maria Gordon, co-portfolio manager at the Goldman Sachs BRIC fund. Not only is Russia's population approximately one-tenth of those of both China and India, it's also older. "Russia's demographics are closer to Europe," she says. To reverse Russia's population slide, the government is giving 250,000 rubles (about $10,000, a sizable sum in Russia) to women who have a second baby.

And whereas India is privatizing many key industries, Gordon notes that Russia is re-accumulating control over strategic parts of its economy. But Russia is benefiting from some of the same growth drivers as its Asian rivals. "The story of the penetration of services and the build out of infrastructure is probably as interesting as in China and India," says Gordon.

Much of Russia's infrastructure hasn't been upgraded for nearly a quarter century. "Russia is starting to spend money on roads, railroads and power plants," says Gordon. "Capital availability is key with infrastructure-led growth, and Russia clearly has that."

John Connor Jr., manager of the Third Millennium Russia Fund, believes that one of Russia's biggest growth drivers will be the 2014 Winter Olympics in Sochi, a southern resort city on the Black Sea. For starters, he cites Putin's estimate that the Olympics will require a $12 billion investment in infrastructure and facilities. Beyond that, Connor believes that Sochi represents a larger emphasis toward Black Sea resort areas that signal greater development in southern Russia that will benefit industries ranging from concrete and steel makers to telecommunications providers and banks.
Connor notes that Russian consumer disposable income has grown at an average rate of 27% during the past couple of years; this increased spending power has boosted sales at retailers such as X5, Russia's largest food chain, and at Pharmacy Chain 36.6, the top pharmacy and cosmetics operator. It also means more deposits at leading Russian banks such as Sberbank and VTB.

It's A Trust Thing

The Russian market traded at about 13 times estimated forward earnings as of early December. That was slightly lower than Brazil's market multiple of 14 times and significantly cheaper than India (24 times) and China (40 times).

One reason for Russia's below-peer valuation within BRIC is that more than 60% of its market capitalization comprises the energy sector, which took a hit earlier in 2007 from falling oil prices. "Smaller, domestic-oriented companies did well, but the overall market was overwhelmed by the energy sector holding it back," says Robert von Rekowsky, manager of the Fidelity Emerging Markets Fund.

Russia is the world's largest oil exporter after Saudi Arabia, but the industry faces an onerous tax hit of almost 90 cents on the dollar per barrel when oil is priced above $27. Russia's mature oil patches are drying up and new fields in difficult areas such as the Arctic require heavy capital outlays, but the tax structure discourages needed investment.

"Oil companies have been lobbying the government for changes," says von Rekowsky, "but the government has been loathe to do anything before the elections." That said, he adds that the government extended a tax holiday in eastern Siberia on a pipeline project to China and eastern Asia, and he believes further tax changes to offset rising labor and steel costs are likely after Russia's current election season is over next spring.

The so-called political discount stemming from Russia's parliamentary elections in early December and the upcoming presidential election in March has also crimped Russia's market valuation. Putin's popularity at home remains high as his eight-year run as president draws to a close, thanks to rising oil revenue that has provided sustained economic growth and improved living standards. The Putin-backed United Russia party won 64% of the vote in the recent parliamentary elections (the second-place Communist Party garnered only 11%; critics complained of electoral foul play by the government), a convincing victory that pundits believe could reshape the political landscape and enable Putin to remain the most powerful man in Russia after his second four-year term ends. In December, Putin chose his first deputy prime minister, Dmitry Medvedev, as the candidate he'll back for president in the March election, virtually assuring Medvedev's ascension. In turn, Medvedev said that if elected he'd ask Putin to be prime minister.

Putin's populist electoral message and increasingly confident domestic and foreign policy stances that espouse Russia's role as a world power play well in Peoria, or in this case, Petrovsk, but not on Wall Street. Investors wonder about the next Russian leader and what economic role the future government will take, particularly in light of Russia's recent efforts to wrest greater control from western oil companies engaged in the offshore Sakhalin Island oil projects in the Russian Far East.

"One of the big concerns I see . . . is having an understanding that the government is competent and will take Russia forward," says von Rekowsky, who remains bullish on Russia. His Fidelity fund, which has an average annual return of nearly 39% over the last 5 years, is slightly overweight Russia versus his benchmark, the MSCI Emerging Markets Free Index. All told, Russian companies comprise about 10% of the fund.

After a recent trip to Russia, von Rekowsky concluded that the government's three-year budget realistically accounts for oil price cyclicality and is appropriately tied to non-oil revenue and to domestic spending. "I came away more confident that things are a lot more solid domestically, and that will get them past the upcoming elections," he says.

Perception Is Reality

Russia's collective thin skin, exemplified by Putin's frequently vituperative pronouncements, doesn't score points with foreign investors. "Russia's public relations is pathetic," says Connor from the Third Millennium Russia Fund. "When they get provoked they tend to overreact, and that's not professional. And they don't have a paid lobbyist in Washington to help craft their message. Perception is reality, and that's one reason why Russia's stock market hasn't been great in 2007."

The RTS index was up a respectable 22% as of early December versus 142% for the Dow Jones/CBN China 600 index and a 42% gain both for the Brazilian Bovespa and Indian Sensex indexes.

Connor, who previously lived and worked in Russia as an attorney for New York-based law firm Cravath, Swaine & Moore, before starting his fund in 1998, believes that Russia needs to overcome its culture of negativity. During a recent trip to Russia, he attended an economic panel where Russians lambasted their own markets. A western investor got up and defended the Russian market as well-regulated and transparent. "The Russians seemed surprised," says Connor, who recalls a conversation he had with a Russian lawyer who dumped on the country's 14-year-old constitution even though he never read it. "And this is somebody who reads documents for a living," he says with a sense of amazement.

Connor sees hope for mindset improvement in the cadre of mostly young business executives running some of Russia's most dynamic companies, including those in the steel sector. He notes that Russia has six major steel companies, and four have operations in the U.S. "They're run by positive, professional young people who do PowerPoint presentations and expect performance," says Connor. "I think the new rich, or whatever you want to call these young professionals, have a shot to change the culture."

Seeking Clarity

The bluest of Russia's blue chips include Lukoil Company and Gazprom in energy, Norilsk Nickel in minerals, Savings Bank of the Russian Federation (Sberbank), and telecom provider Vimpel-Communications. But Connor, whose fund's five-year average annual return is 39%, is also excited by companies that stand to benefit from expected development in southern Russia such as steel makers Evraz Group and Mechel, concrete producer Evrocement Group, food retailer Magnit, and Southern Telecom.

Smart of the Pioneer Emerging Markets Fund, which sports an average five-year return of 38%, believes a possible U.S. recession could impact oil revenue flowing into Russia, but on the whole wouldn't greatly impact the country because it trades less with the U.S. than with Europe. "A recession in Europe would hurt more, but this is a country driven more now by its domestic demand."

One of the biggest issues dogging Russia is concern over corporate transparency and government interference in the economy. The saga of Yukos Oil Company makes it a poster child for Russia's past murky dealings-billionaire CEO Mikhail Khodorkovsky remains in prison for tax evasion and the country impounded the company's assets, but many people feel that he and his company were targeted mainly because of his plans to politically oppose Putin. A Russian court eventually declared Yukos bankrupt in 2006, and its assets have been auctioned to Gazprom and others.

Maria Gordon, the co-manager of the Goldman Sachs BRIC fund, believes that transparency issues aren't a major concern because most publicly traded Russian companies are dually listed, domestically and in either New York or London, subjecting them to international accounting standards. "Accounting issues are taking a back seat among investor concerns in Russia," she says.

Gordon's fund, which started trading in 2006 and last year returned more than 57% through early December, has a 19% stake in her native Russia. "The trend for a more assertive Russia is a long-term trend," she says, "but its relevance to the market is perhaps limited because it's self-financing its growth, and the growth picture is more robust than ever."