Martin Delaney discovers that it is the growing middle class and its appetite to consume that drives Russian markets - not just oil and gas

“Oil and gas: that is the only play in town.” This is a common observation from investors eyeing opportunities in Russia. Yet the picture is far more subtle than that.

The Russian consumer is virtually unleveraged. There is very little credit card or personal debt, simply because access to debt has previously been restricted. “Russia is one of the least leveraged economies in the world,” explains Marcus Svedberg, chief economist at East Capital. “Total corporate, household and public debt-to-GDP is 71%, half that of the other BRICS and four to six-times lower than in the largest developed economies.”

In addition, there is just 3.65% mortgage penetration. “If you think about the crunch of housing in Moscow combined with the urbanisation trend, then it is obvious there is simply not enough supply and a need for affordable mid-scale housing,” points out Wahid Chammas, co-portfolio manager of the Janus Emerging Markets Equity fund. “To increase affordability the banks are lending more - whether it is to small and medium-sized enterprises or in the form of credit cards. There is an ongoing overall professionalisation of the banking sector.”

The rise of the banking sector is intertwined with the other great theme at work in the Russian economy: consumption. “Consumption is likely to be the key driver of growth - consumption makes up almost two-thirds of the Russian economy - supported by inflation deep in single digits and interest rates at an all time-low,” says Svedberg.

The Russian consumer has money to spend and now has the wherewithal to borrow more, should they need to. The result? A huge expansion in the Russian middle class, a story familiar to the other emerging markets (Brazil, for example, saw 10m of its 192m people move into the middle class between 2004 and 2008). There are approximately 150m Russians (and another 20m live in neighbouring countries) and Russia is now ranked the eleventh largest country in terms of GDP.

With a financially stable middle class come the same demands other countries take for granted. Televisions, cars, computers - anything consumer-related is currently booming: it is estimated that in 2-3 years’ time Russia’s car sales will outstrip Germany’s. “That is just the beginning,” adds Matthias Siller, co-manager of the Baring Russia fund. “There is a lot of scope for growth in almost any consumer-related sector. They are still underpenetrated and there is no leverage. The best indication of this is the fact that Russian disposable income is now significantly higher in real terms than it was in 2008.”

In a recent country focus note, Raiffeisen Capital Management, stated that “financials and consumer goods companies enjoyed the strongest demand, whereas telecommunications and energy sector players saw sub-average performance”.

It is this consumption boom that is powering the equity markets, says Tom Mundy, head of strategy at Bank Otkritie, a Russian bank. “Russian equity market performance, rather improbably for a country with almost 6% of global oil reserves, and almost 24% of global gas reserves, remains driven by Russian consumption stocks - be they retailers or banks. According to Economist Intelligence Unit estimates, Russian household consumption per head is expected to be roughly three times the size of China’s by 2014. In the absence of meaningful changes to the tax regime, that would benefit minority investors, we expect the market to continue to overweight Russian retailers, such as Magnit and X5, or banks such as Sberbank - even if they look expensive relative to oils.”

Schroders is currently overweight Russia, adds Thomas Wilson, head of EMEA equities. He cites Magnit, the Russian supermarket, as a great structural growth story. “The staples are attractive,” he says. “The retail penetration is very low and there is the potential for them to grow at an annual rate of 20%.”

In addition, Russia itself is relatively wealthy. It sits on a currency reserve estimated at $1.5trnbn (€1.1trn), and, according to the website of the country’s National Welfare Fund and Oil Stabilisation Fund, the combined assets of the former Oil Stabilisation Fund now run to a total of $142.5bn. With state wealth comes consumer confidence, strong equity markets - and a steady flow of companies coming to market.

Yet risks remain, not least liquidity risk, says Hugo Bain, senior investment manager of the Pictet Russian Equities fund. “The number of companies [in our investable universe] has shrunk rather than grown,” he says. “We have seen a number of successful IPOs - [Russian internet company] was one of the most successful - and hopefully over the next three years the depth of the market will improve and the range of this universe will expand significantly.” As he points out, the economy is becoming more diversified: “More people work in hotels and restaurants than do in the oil industry.”

Media companies are also rising in attractiveness. For Schroders’ Wilson, this marks the increasing penetration of western products into a new market that is “keen to have brand awareness”.

But the elephant in the room - the oil and gas sector - should not be wholly discounted. There are corporate governance issues, as the state is too involved in the day-to-day running of the companies, but the sector is just too big to ignore. Tanya Landwehr, chief operating officer at TKB BNP Paribas Investment Partners, details the reasons: “Russia produces 10m barrels of oil a day; it is the main oil producer today. It has 30% of the gas reserves and has vast reserves of coal, timber, minerals and land. It is Europe’s largest retail market, and there are many, many compelling reasons to invest in Russia.”