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. Last Updated: 07/27/2016

Stock Market Bulls Set for Round Two

With the Russian stock market surging through most of this spring, foreign fund managers can now revel in a boom they have spent two years waiting for.

After months of negative returns, they no longer feel so embarrassed about reporting the changes in their Russia funds' net asset values. In 1995, Russian and CIS equity funds scraped the very bottom of industry performance rankings.

From March 19, when the dollar-adjusted MT-Index hit an all-time low of 54.33, to June 24 when it hit a peak of 132.34, the stock market gained an impressive 144 percent in dollar terms, compelling even the most risk-averse emerging markets investors to take a second, and perhaps longer, look at Russia.

Before the second round of the presidential elections, and especially given the political developments of the past week, it would be difficult to predict how much upside the market can sustain over the next few days.

However, should Yeltsin win the second round, the market is likely to immediately react with another strong rally driven primarily by foreign investors.

Initial investor focus will be on the most liquid blue chip stocks but as the summer progresses, the current investor obsession with a few top stocks that offer liquidity is likely to give way to a progressive re-rating of the better-quality second tier stocks, and of the Russian market as a whole.

While it is difficult to estimate the size of the capital flow into Russian equities this spring, average daily trading volumes in May were about $12 million on the Russian Trading System, the electronic market for more than 100 stocks.

According to market sources, the majority of foreign money driving the recent rally came from the smaller, more adventurous hedge, emerging markets, country and private funds that are characterized by a strong appetite for risk and have some experience of investing in Russia.

But blue chip international asset managers such as Fidelity, Mercury and Pictet were all reported to have increased their positions this spring, as were the more aggressive hedge funds like those managed by Soros and Rothschilds Emerging Markets (formerly Croesus).

The universe of emerging markets funds that buy Russia is still relatively limited, observers say. "We are still dealing with a fairly limited audience in the international investor universe who buy Russia," said Graham Marshall, of ING Barings, London.

Most, however, agree that this universe is poised to broaden significantly once the election dust settles and mainstream investors begin to recognize the opportunities that Russia presents for investment.This may already be starting to happen. The International Finance Corporation last week announced it is adding Russia to its daily index coverage of emerging markets as of September. In May, Merrill Lynch went overweight on Russia for the first time as part of its global strategy review, and Morgan Stanley is said to be on the verge of including Russia in its basket of traded emerging markets.

When the boom resumes, attention will center on the large institutional investors -- the mutual funds, insurance companies and pension funds -- from the United States and Europe.

"U.S. insurance companies and pension funds are now beginning to look at Russia because it represents an enormous opportunity," said Yuri Ostrovsky, investment manager of Pictet's First Russian Frontiers Trust, a $68 million fund, in London.

Generally, these institutions may allocate only a tiny slice of their emerging markets allocation to Russian stocks, but in a stock market currently capitalized at just $22 billion by some measures, such sums are meaningful.

"Fifty million dollars may not be a lot in the grand scheme of things, but in Russia it can definitely move the market," said Dan Lubash, managing director of emerging markets at Merrill Lynch in London.

These developments will encourage major global portfolio adjustments, potentially bringing substantial capital inflows into Russia in their wake.

Over the past few months, most market watchers believe, Russia's stock market was mainly propelled by foreign investors' heightened optimism about the prospect of a President Boris Yeltsin victory and their desire to gain exposure ahead of the election.

In February, as Communist Gennady Zyuganov was being feted at the World Economic Forum in Davos, there were serious questions surrounding Yeltsin's ability to campaign effectively. As the election neared, however, Yeltsin's campaign gained momentum and the stock market followed.

"There is no doubt about what investors have focused on," said Lubash. "Overwhelmingly, the main issue for investors in this market rally is whether Yeltsin will win," he said.

Fund managers echo the point that, while there is an increasing appreciation of fundamental value when selecting stocks, the opportunity to make a "quick buck" in what might well prove to be the emerging market rally-of-the-year undoubtedly played a decisive role.

"Some people follow the crowd and invest when others invest," said Pictet's Ostrovsky. "They make a 100 percent profit and get out ... this is what the rally was about."

Politics is important in the boom, but undeniably, the rise in the market is also fuelled by a whole range of factors which relate to subtle improvements in the way shares are traded in Russia and the way Russian companies relate to investors.

These factors go back to November 1994, the last high on the MT Index. After that point, the market turned down disastrously, not just because of political uncertainty but also because it became clear that the infrastructure in the Russian market was shaky.

Only a handful of brokerages were offering Russian shares in 1994. Nor were there any stocks on offer that were backed by accurate company information or dependable registries or that could have been described as liquid.

Investors got scared by the risks and headaches inherent in ineffective share registration procedures, the lack of efficient clearance and settlement facilities, and inadequate depositary and custodial arrangements.

In the worst horror stories, Russian directors, disgruntled at the growing influence of foreign investors, simply struck them off the share register or diluted their shareholding by issuing themselves a lot of free stock.

Some investors argue that infrastructural risks like these are not nearly as significant as many believe.

"For the classic portfolio investor, these issues are of very little concern," said Ostrovsky. "When you hear that people have been struck from a company's share register, there is usually a very specific reason behind it that you tend not to hear about."

He argues that shareholdings held by portfolio investors tend to be small in proportion to a company's total shares outstanding and are often virtually ignored by management.

But it is the response to these internal market concerns, rather than politics, that explains many of the details of the 1996 stock market boom, especially the crucial importance in the last few months of a very few blue chip, liquid stocks, notably Mosenergo, LUKoil, Unified Energy Systems (UES), Norilsk Nickel and Rostelekom.

These five stocks account for around 40 percent of the market's total capitalization and 75 percent of the volumes on the Russian Trading System, the over-the-counter electronic market for 100 Russian stocks.

Investors have also gravitated predominantly towards companies with American Depositary Receipt (ADR) programs -- LUKoil, Mosenergo, Seversky Tube Works, Chernogorneft -- or those with ADR issues planned or in the pipeline, such as Rostelekom, Norilsk Nickel, and UES.

Depositary receipts are surrogate share instruments used by Russian companies wanting to broaden their international investor base. In essence, a foreign bank buys the Russian shares and registers them in its name. But the foreign bank then re-sells a receipt for the shares which can be traded internationally.

The beauty of the system is that it allows foreign investors easy access to the stock via a broker in New York or London, as though they were buying IBM or General Motors. Moreover, with ADRs, the non-Russian depositary ensures it has registered the shares before it issues the receipt, reducing some of the infrastructure risk.

Bank of New York's Chris Kearns, who is responsible for new ADR business in Russia, believes the ADR instrument has brought a considerable amount of new money to the Russian market.

"A lot of new investors have invested in Russia for the first time, as a result of the ADRs," Kearns said.

Having listed ADRs has helped Russian companies to increase the liquidity in their shares dramatically, as evidenced by the share price rises in Mosenergo, LUKoil, Seversky and Chernogorneft. This is not yet true for Inkombank, Tatneft, GUM and Menatep which also have ADRs outstanding, but they have been issued only very recently and are not yet actively traded.

Much of the liquidity is believed to be due to the entry into the market of new investors who cannot buy Russian shares directly, such as regulated U.S. pension and mutual funds, and who therefore buy ADRs.

Depositary receipts, most importantly, overcome a number of domestic regulatory obstacles many U.S. institutions face in purchasing and holding foreign securities.

"For some specific and very large accounts, purchasing an ADR is the only way to gain exposure to Russian securities," said Bank of New York's Kearns. "There is also considerable interest in companies which have indicated they will launch an ADR program in the future." These include Purneftegaz, Norilsk Nickel and Surgutneftegaz.

ADRs are not the only scheme that has partially solved the infrastructure problems of the Russian market. A similar degree of interest on the part of foreign investors was shown in the 16 stocks included in ING Barings' Russian Depository Receipt (RDC) program. The crucial criterion for joining this program is that the companies have an efficient registration system, usually with an independent registrar.

"It pays to be selective about the quality of the registrar," said ING Baring's Marshall. "We always meet with the registrar to ensure that the shareholder information is safely replicated."

The RDC program currently includes 16 stocks and signs are that it too attracts foreign investors. Second-tier companies with RDC programs, such as GUM, Moscow City Telephone Network, Megionneftegaz and Lenenergo, posted significant share price gains throughout the spring.

Another factor contributing to the rising investor interest in selected Russian blue chip and second-tier stocks has been the release of 1995 corporate earnings and other financial data over the past few months, coinciding with annual shareholders' meetings.

There is a broad recognition among Russian corporates that in order to raise capital in the international capital markets, they must move in the direction of internationally accepted accounting standards, according to analysts.

"The driving force is an understanding by companies of capital markets requirements," said Gavin Rankin, director of research at Troika Dialog in Moscow. "Those companies that are serious about raising capital in the international markets are moving in this direction ... but it cannot be done overnight."

Most Russian public companies whose share prices have risen dramatically reported exceptionally strong earnings figures for 1995. Purneftegaz reported dollar-adjusted 1995 earnings of seven times the previous year's level, Irkutskenergo reported a tripling of earnings, MGTS and St. Petersburg Telephone saw earnings double, while the major blue chips LUKoil and Mosenergo reported increases of 48 and 37 percent, respectively.

By and large, these figures, based on Russian accounting standards, are often exaggerated and a poor indication of the company's true earnings potential.

"Another problem is that these companies are not producing consolidated results," said Rankin. "What they are showing is simply the results of the holding, without the subsidiaries."

Nevertheless, all major Moscow-based brokerages emphasized the importance of earnings data for the positive recent share price performances.

Of course, given the rather uncritical acceptance of these numbers by most brokerages, investors may be in store for some unexpected earnings surprises in the years to come as corporate financials are adjusted to internationally-accepted standards.

In fact, no Russian company has yet completed a full-blown international audit of its accounts. "LUKoil is perhaps the furthest along the way," said Stephen O'Sullivan, an oil industry expert at MC Securities. "A Western style consolidated balance sheet for its western Siberian subsidiaries is expected in the summer." LUKoil's audit is being performed by KPMG.

Other Russian corporates which have engaged Western auditing companies and whose audits are underway are Gazprom (Price Waterhouse), YUKOS (Coopers & Lybrand) and Rostelecom (Coopers & Lybrand).

One future trend to look out for is that while the boom has so far focused on traditional blue chip, interest could start to spread to other stocks.

In fact, the market rally started to broaden in the spring, spreading to the Top 21 stocks in the RTS Index, with the result that second-tier stocks have done quite well. This is particularly true of those that announced liquidity-enhancement programs or whose ADRs are pending, such as FESCO, Yuganskneftegaz, Irkutskenergo, and Surgutneftegaz.

Other smaller, illiquid stocks -- such as Nizhny Novgorod Svyazinform -- have also benefitted from the rally.

In fact, these non-blue chip stocks are all poised to benefit further on the expectation by investors of increased liquidity and a broader international investor base.

"Some sectors, such as shipping and cement, you can't get exposure to except through the second-tier stocks," said Coast Sullenger, head of sales and trading at Pioneer Securities, which specializes in second-tier stocks. "Although investors can expect a longer-term holding, it's a very good way to diversify."

Fund managers, particularly those with a longer-term investment horizon or those not obsessed with liquidity criteria, agree. According to Liz Hebert, who manages the Flemings Russian Securities Fund out of Moscow, what is broadly defined as the second or even third tier contains some of the more interesting stock picks.

"Flemings has about 30 percent of its portfolio in illiquid second tier stocks," Hebert said.

Another good tendency for the future is that new equity offerings by Russian companies are likely to become a major focus of activity for investors once the presidential election is out of the way.

Several private placements of equity by untraded Russian companies and, quite possibly, a small number of initial public offerings (IPOs) by private Russian companies may well reach the international market during the remainder of the year.

In addition, investors can expect some major public stock offerings from blue chip quoted companies in the international markets. LUKoil, for instance, recently announced it would seek a listing on the New York Stock Exchange in conjunction with an international equity offering via a Level-3 ADR issue. This would allow it to raise fresh capital from U.S. investors directly but will require much higher standards of financial reporting than the Level-1 ADR it already offers.

"The large number of mainstream institutional investors who have not yet made a significant investment in Russia will fuel the market for both international private placements and public offerings," said Alan Apter, a director in Renaissance Capital's investment banking group.

Bankers agree however that it will take some time before private companies attain the size required and establish a track record worthy of going public.

Tina Podplatnik is editor of The Moscow Times weekly newsletter, Capital Markets Russia, formerly Capital Markets Report. Sergei Skatershchikov is general manager of Skate Consulting.