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. Last Updated: 07/27/2016

Sovlink Looks on the Small-Cap Upside

Sovlink's timing, it seems, could not have been better.

The evening before Moody's investment upgrade Wednesday, the second-tier brokerage launched its Russia Small-Cap Index at a party in Moscow's elite Monolit Club.

The index pools 45 stocks with market capitalization of $50 million to $875 million and at least $10 million in readily traded, or "free float" shares. The exception in the index is TNK, which has a significantly larger market capitalization but only a 3 percent free float.

The oil and gas sector is the best-represented on the new index, with 14 stocks, followed by power (10), telecommunications (9), industrial (4) and nine stocks from the financial, retail, transport, trade and chemical sectors.

"It is probably the first barometer that we've seen of small caps," said Peter Kizenko, small-cap specialist at Brunswick UBS. Most of the second-tier stocks are not listed on the leading RTS index. It will be measured against the benchmark of the "Russia Deep Blue" index, a 16-firm indicator including the "bluest of the blue" RTS stocks, and four more that are traded elsewhere but whose combined capitalization approaches a third of the RTS: Gazprom, Wimm-Bill-Dann, Vimpelcom and MTS. The companies in the deep blue index each have a capitalization of more than $750 million and a free float of at least $100 million.

Sovlink said second tiers are where the upside is. Since the start of the year, the stocks in its small-cap index, which is not weighted by market capitalization, have grown 99.8 percent, against 65.1 percent for the MCAP-weighted deep blue index and approximately 60 percent for the RTS index as of Oct. 1.

Potentially fueling further small-cap growth is excess liquidity, which Sovlink puts at $33.3 billion, a figure it got by totaling funds available in corporate bank accounts. Analysts say this money is finding fewer blue-chip shares on the RTS. The exchange's free float has shrunk to just over 26 percent, said Chris Weafer, chief analyst at Alfa Bank.

Eric Kraus, Sovlink's chief strategist, agreed that a major part of the super-profits have been due to risk associated with nontransparent (and usually more poorly managed) smaller companies with limited liquidity. "If you're buying into the second tier, you're buying in the hope of continuing improvements in corporate governance and transparency in Russia," he said.

But some of the growth could be due to second tiers being more representative of the economy, Kraus said. Less than a third of Sovlink's small-cap index are oil and gas stocks, while a fifth are from the fast-growing and generally more competitive telecommunications sector. Weaver said oil and gas companies account for over two-thirds of the RTS's capitalization, compared with just 10 percent for telecoms.

Kraus also believes the significant growth in individual blue chips this year has been due to one-off events, such as the YukosSibneft merger. "Sibneft is not going to be bought again, so you will not see the same growth," he said.

But does this mean extra cash will head to small caps? It already has, according to most observers. It is difficult to estimate how much money has gone into second-tier stocks, since most of them are traded "off-screen," between dealers. But the process started six to nine months ago, said Dominic Gualtieri, head of equities at Alfa Bank.

No one can say exactly what effect the Moody's upgrade will have on demand for small caps. Kraus said around 90 percent of demand for second-tiers comes from domestic investors.

This is unlikely to change, Troika Dialog equity strategist James Fenkner said. Institutional investors "do not buy assets that do not have a minimum of an ADR status," he said. Anyhow, valuations of second-tiers have already risen steeply, he said.

The most likely scenario, Gualtieri said, is that the upgrade would send larger corporations to foreign credit markets and release domestic money for smaller companies. This would provide them with some much-needed liquidity and help raise their share prices.

Meanwhile, because risks will have fallen, investors will demand less returns and both debt and equity prices will rise, said Martin Skelly, head of equities at United Financial Group.