* Head of The Boston Consulting Group’s Representative Office in Moscow

The past year was a quite successful one for the Russian stock market. The total volume of funds raised by Russian enterprises via stocks and bonds is estimated at about $11 billion, including around $3 billion on the Russian market. The market as a whole has grown by nearly 60%, which makes Russia one the world’s top markets in terms of capitalization growth.
The P/E ratio, reflecting the extent to which a company is under- or overvalued, has risen for Russian companies from 7.33 in early 2003 to 10.4 this December. In other words, investors have begun to estimate Russian enterprises at a higher value.
However, despite the positive trends of the past few years, the Russian stock market is still performing poorly as it doesn’t ensure the efficient flow of capital from investors to businesses in the real economy. Russian companies issue a minute amount of stock to finance concrete projects. Only two IPOs have been made on the Russian market in five years, which is of course trifling compared to the size of the Russian economy. At the same time, the bulk of portfolio investments are focused on stock from companies whose assets were accumulated in the Soviet era. Thus, the stock market serves as a mechanism for the secondary re-distribution of property rather than as a source of establishing and developing new projects and companies. Today, we can state that despite a fairly well-developed infrastructure, the market is not yet ready for the next stage of development, the large-scale entrance of retail investors. For these investors, the Russian market is still terra incognita: they know little about it, and it is opaque and inefficient in respect to transaction costs.
The most acute problem for the Russian stock market is that it fails to meet portfolio investors’ growing demand for high-quality securities.

The Russian market is highly concentrated: the ten largest issuers account for 78% of the market capitalization and about 98% of all trading.
The status of these top-ten traded companies is of interest. First of all, these companies can hardly be expected to see any considerable long-term increase in profits and, accordingly, any increase in the value of their stock. Secondly, some of them may, for a variety of reasons, eventually abandon the stock market altogether.

The top ten traded issuers include:

• The four major oil companies: YUKOS, LUKoil, Surgutneftegaz, and Sibneft. These companies apparently have no potential for rapid growth in the short term. Oil production and world oil prices influence these companies’ financial status, and they are already close to their all-time highs. Company growth due to expansion overseas is extremely underutilized for the time being, making it unlikely in the immediate future. Increased profits due to cost reduction are likely, but this growth will be hampered by ruble appreciation;
• The four Russian infrastructure companies: Gazprom, Rostelekom, EES Rossiya and Mosenergo. Price increases for their products and services are capped by the state, which restricts their growth potential;
• Sberbank and Norilsk Nickel are the two companies that perhaps have the highest potential for business growth.

Some of the most attractive issuers may soon leave the market for a variety of reasons. Among them is EES. It will cease to exist as a single company after reforms, and today it accounts for more than half of all trading on the market. The major oil companies’ stock could also disappear from the market if they are purchased by a transnational oil company or if they merge. Thus, the highly concentrated and therefore high-risk market may get into quite a fix. Suffice it to recall the YUKOS Affair, when the market as a whole lost around 10%.
Thus, when buying Russian stock, investors demand discounts compared to similar companies in other countries.
The second distinctive feature of the Russian market is that percentage of stock in free circulation is extremely low. By this index (about 27% for the Russian market), Russia lags significantly behind the US and France, where it is about 80% and 90% respectively. In 2003, this index fell as strategic investors bought up EES and regional energy company stock, and YUKOS, Surgutneftegaz and others bought back their own stock.
The third factor restricting supply is the limited amount of liquid securities. Specifically, while the Russian stock markets deal with the registered stock of about 250 issuers (few of them are traded every day), in France stocks number over 800 and in the US, over 7,000. The share of derivatives in the total trade volume is another area where Russia falls behind. In Russia, this figure runs around 5%, whereas in Poland and France, it constitutes more than half.
All this leads to a situation in which investors ready to invest in the Russian market encounter insufficient choice of securities and higher risks as a result of high market concentration, portfolio investors’ weak influence, and limited capacity for hedging.

Nevertheless, the demand for Russian stocks and bonds from both Russian and foreign investors is very high, thanks to companies’ big profits and revenue growth rates. The rapid growth rates for the economy as a whole stand out in contrast to the decreasing appeal of other emerging markets.
Over the last 1.5-2 years, large domestic corporations began to purchase Russian stocks actively. The large revenues of many Russian industries, as well as the relatively undervalued nature of Russian issuers’ assets on the stock market, have attracted some of the funds of major Russian corporations. Individual Russian investors have also increased their participation in the stock market, although their share is still very insignificant. This trend can be explained by a general increase in household income, increased confidence in the financial system, and the return of capital from abroad. In addition, the emergence of new technologies, which make access to the market cheaper and simpler, and the enviable activity of Internet brokers have brought household incomes to the stock market.
Foreign investors continue to play an important role on the market despite their reduced share in total market capitalization. Their free float share has stayed around 50%, since they are trading their portfolios more actively than strategic investors from Russian enterprises.
The demand for stock market instruments will continue to rise due to several key factors.
First of all, pension reforms will increase demand. By our estimates, the increase in investment owing to pension funds alone will amount to about $5 billion in the next five years.
Secondly, life insurance had begun to develop in Russia. As the insurance business in general and life insurance in particular develop, insurance companies will need instruments for long-term investment.
Finally, we cannot forget that some exported capital has come back to Russia. This trend is gathering momentum. Many banks note that wealthy Russians are withdrawing funds from their accounts in Switzerland, the UK, and other countries where current interest rates are close to zero. As confidence in the Russian financial system grows, these individuals are placing ever greater portions of their savings in Russian assets.
However, in order to meet growing demand, the Russian stock market infrastructure needs to become more efficient. At present, it is a complex and costly system, mainly because of the large number of settlement centers in existence. In addition, more effort must be made to increase the number of IPOs in the next 2-3 years. Businesses should be encouraged to finance their development by attracting outside shareholders. This implies the creation of favorable conditions for increasing the number of issuers and removing administrative obstacles. Some changes are already taking place now. For example, we believe that a surge of IPOs will happen in the next 2-3 years. More than 30 companies, whose total revenue exceeds $10 billion, have already announced their plans to enter the Russian stock market in the next few years.

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