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. Last Updated: 07/27/2016

THE ANALYST: 1997 an Outstanding Year Despite Market Narrowness




It was easy to forget during the last 10 weeks of 1997 how amazing the year actually turned out to be. Despite the well-documented setback, The Moscow Times Index surged by 110 percent for the year, a triumph by any yardstick. While the result is slightly less than 1996's 123 percent return, Russia still managed to take first place among emerging markets for the second year straight. Equally impressive, the market capitalization of the nation's 200 largest companies grew to $130 billion, or 28 percent of gross domestic product (still less than most emerging markets).


Almost without exception, all oil, utility, and telecommunication stocks finished the 12 months with spectacular returns. Basically, investors could do no wrong in 1997. Even Lenenergo, 1996's winner, managed to find another 85 percent, and Rostelekom, which fell out of favor with many analysts over the year, jumped up an admirable 49 percent. Among the 50 stocks listed in the MT Index, the winner for the year was Sakhalinmorneftegaz, which exploded 591 percent. Not far behind was Aeroflot Russian International Airlines with its 548 percent vertical take-off. The year's loser: Red October, the fabled Moscow confectioner, which saw its stock plunge a hefty 16 percent.


Naturally, beneath every boom there is some sort of contradiction. In Russia's case, it can be said that, despite two years of stunning returns, the stock market is extremely narrow. All the action is in a handful of shares. Over one-half of all equity trading in 1997, as reported by the Russian Trading System, was accounted for by three stocks: Unified Energy System, LUKoil and Mosenergo. UES alone accounted for 22 percent of the market's trade volume. Taken together, the top 20 Russian stocks could claim 90 percent of all equity trading last year.


One logical outcome of this "wafer-thin" market is that the top 20 corporations account for 81 percent of total market capitalization (as calculated by ASP General Index, which includes 190 companies). Another is that the aggregate capitalization is skewed toward three sectors: oil and gas, utilities, and telecommunications. Together these three industries account for 92 percent of Russia's $130 billion market capitalization. Oil and gas companies account for two-thirds, utilities 17 percent, and telecom stocks for 8 percent.


Will the market widen? For the time being, almost certainly not. There is every reason to believe that by the end of 1998 we will see roughly the same pattern of a top-heavy stock market. The privatization of Rosneft and Transneft will further solidify the predominance of oil and gas. Undoubtedly the market will acquire some diversity over time, albeit gradually. In order to understand why, one must consider two specific factors, both of which have stunted the growth of Russia's stock market from its conception. First, there is still a need for efficiency. Custody and settlement operations, while much improved over the past two years, still have a way to go; a flawless infrastructure will do wonders for boosting investors' confidence and facilitating new inflows. Market insiders and regulators know what needs to be done, and hopefully they won't lose sight of their ultimate goal.


Second, and by far the most crucial factor, is that corporate directors have to want to develop a secondary market for their companies' stock. All the infrastructure in the world can't bring an ounce of liquidity to the market if directors do not want to have their shares bought and sold freely. More often than not, directors do little more than give lip-service to the ideal of a liquid secondary market for their shares. They smile and shake hands when analysts and potential investors come knocking, but when the tough questions concern financial transparency and corporate governance -- such as accountability -- they start grumbling.


Strangely, the reluctance of many directors to use the stock market to their benefit is a paradox: After all, an overwhelming majority of directors managed to grab sizable portions of equity in their companies during the wild privatization years of 1993 to 1994, usually by buying out swathes of shares with the help of cheap bank loans through a highly abused process known as closed subscription.


Were directors to understand the virtue of shareholder value, they could help make themselves even richer. All they need to do is remember the classic case of Vimpelcom. This quintessential high-tech growth stock, located in one of the largest cities in the world, has been able, just by being transparent and investor-friendly, to push its market cap to $850 million. Soros and Fidelity have purchased large blocks of the stock. Meanwhile, Moscow City Telephone, a telecommunications company that provides service to 98 percent of Moscow households -- compared to VimpelCom's 90,000 subscribers -- has a lowly market cap of $1.3 billion.


Given the jittery world markets and the shallowness of Russia's stock market, the prudent investment advice for 1998 is to stick with liquid blue chips. That will change when Russian directors have a change of heart and give investors a choice. But don't hold your breath.


Gary Peach is the editor of the weekly newsletter Capital Markets Russia.