The conflict with Georgia makes Russian stocks cheap — but dangerous.

MANY WESTERN INVESTORS have taken a cavalier attitude toward Russia, figuring that the opportunities in the resource-rich country outweigh the risks stemming from a capricious and increasingly anti-American government led by Prime Minister Vladimir Putin.

Russia’s brutal assault on Georgia offered yet another challenge to that view, although Russian stocks last week recovered much of the initial losses that they suffered on Aug. 8, when Russian troops attacked Georgia. In fact, investors seem more worried about oil prices than about a revival of Soviet-style imperialism.

The invasion of Georgia showed a brutal side of Russia that many Westerners thought was a thing of the past.

The Russian RTS index now is down 23% for the year. The benchmark rose 4% to 1785 last week, after hitting a low of 1722 on Aug. 8. Until its downturn in recent months, Russia’s stock market had been one of the non-Western world’s biggest winners, having tripled since 2005. Bargain hunters are eyeing Russia because its market’s average price/earnings ratio of seven (based on this year’s expected earnings) is one of the world’s lowest.

While the $1 trillion Russian stock market entices some investors, there are better and safer places to invest in the developing world, places where governments have better relations with the West. Brazil’s stock market is valued at 11 times 2008 profits, while Mexico, China and India all trade around 15 times. Western European stocks aren’t much richer than those in Russia, fetching an average of 10 times this year’s earnings.

One reason for Russia’s low P/E multiple is a heavy weighting in energy stocks. Lukoil , the most independent Russian major, has U.S.-listed shares (ticker: LUKOY) that trade for 80, roughly five times projected 2008 profits. That’s a low P/E, but Western oil majors like ExxonMobil (XOM) and Chevron (CVX) trade at about a seven multiple, while Petrobras (PBR), the well-regarded Brazilian oil giant, has a 2008 P/E of 10.

Russia’s pluses include abundant natural resources, some $600 billion in foreign-exchange reserves and a growing consumer economy. The negatives include a 15% inflation rate and the risk of investing in a company that might run afoul of the government. Some investors subscribe to the view of Loews chief investment officer, Joe Rosenberg, who has told Barron’s that it’s tough enough for investors to make money where there is a rule of law, let alone in Russia, “where the rule of law is Putin. Whatever he decides, that’s the law.”

When Russian authorities target a company, there can be dire consequences, such as the 2006 demise of Yukos, a big oil company that was bankrupted on dubious tax charges. Last year, Royal Dutch Shell(RDSB) was strong-armed into ceding control over its Sakhalin oil field to Russian companies and BP (BP) probably faces a similar fate with its Russian joint venture. Recently, a Russian coal company, Mechel(MTL), saw its NYSE-listed shares cut in half, to 26, after Russia began a tax investigation and Putin criticized its pricing policies. Investors fear Yukos-type punitive actions.

“Most hedge funds I know avoid Russia because they’re terrified of the political risk,” says Byron Wien, chief investment strategist at Pequot Capital Management in New York. Wien says that Western investors should get used to Russia’s behavior. “People can’t assume that the Old World, the U.S. and Europe, will continue to call all the political shots. The emerging countries will increasingly want a political voice commensurate with their growing economic power.” Russia clearly sees Georgia as being in its sphere of influence.

For those attracted to Russia, there are several options, including the Market Vector Russia ETF (RSX), the successful ING Russia mutual fund (LETRX) and Russian stocks, some of which are listed in the U.S., including Lukoil, VimpelCom (VIP) a wireless operator, and Wimm-Bill-Dann (WBD), a food company.

JPMorgan’s Russian strategist, Peter Westin, has an Underweight rating on the market, citing oil, high Russian inflation, the Mechel and Georgia situations and the prospect that profit growth will slow to 9% next year, versus almost 50% growth in 2008.

Ian Hague, a partner at Firebird Management, whose firm has about $3.5 billion invested in Russia and nearby countries, says that he’s “starting to see value” in Russian shares. Credit Suisse’s Russian strategist wrote last week that “at a time of increased political risks,” it pays to stick with “state-friendly” stocks, including Gazprom , the natural-gas monopoly, and Sberbank, a large savings bank. Each has significant government ownership, and American depositary shares are traded over the counter, under the respective pink-sheet ticker symbols OGZPY and SBRBF.

Hague warns, however, that the management of state-controlled companies is often weak. He prefers consumer plays like X-5 Retail Group, whose shares (FIVE.U.K.) trade in London, and VimpelCom.

Hague has another play; this one in embattled Georgia. He’s partial to the JSC Bank of Georgia , a commercial bank whose London-listed shares (BGEO) have fallen 25%, to $12, since the Russian attack, far from their 2007 peak of 44. Hague says the bank is well-run, doesn’t suffer from government interference and trades at about 80% of book value. Its stock-market value is $380 million. Firebird is a sizable holder. For those who subscribe to the old adage that the time to invest is “when there is blood in the streets,” the Bank of Georgia is a candidate, albeit with obvious risks.