Foreign investors dominate Baltic capital market

The Baltics occupy a specific place in the dynamic and sometimes heart-breaking capital markets of Eastern and Central Europe. Their small size with market capitalization of $4.4 billion as of July 1998, low liquidity, shallow nature and use of only basic financial instruments, make them less attractive for the big players in the global financial game. At the same time, the generally strong fundamentals, strategic geographical position and overall stable environment are difficult to neglect, which makes them the perfect place to niche foreign players and ambitious local houses.

Due to the small size of the local investor base in the three Baltic states, foreign investors have traditionally been the driving force behind the largest equity trading volumes. Foreign investors hold around half of the traded Baltic equities. However, as good as this might sound, high foreign participation in equity ownership leads to sensitivity to changes in other emerging markets, and the Baltics sometimes react blindly to "emerging markets crisis" or "emerging markets boom" with no solid underlying reasons.
Comparing the debt and equity markets in the Baltics, we get a completely different picture. Since the domestic debt markets are too shallow to attract significant foreign participation, they mainly remain a risk free harbor for excess domestic bank liquidity. In the environment of decreasing inflation, the risk/return profit for T-bills is not attractive for foreigners, whilst the increasing fears of devaluation widens the spreads on FX swaps and forwards.

Prospects forlocal investors

The main strengths and advantages of the local investment houses are their presence on the ground, good local network, flexibility and speed of execution. However, since there are virtually no domestic institutional investors in Lithuania and Latvia (and in Estonian the number is rather small), local houses have limited placing power. It is almost impossible to manage sizable primary market transactions without foreign co-leads, and locals alone are able to manage only small deals that can be absorbed by the local investor base.
This limits the role of the local investment banks to mainly being local advisors or arrangers. Even though this process should be seen as a normal evolution, the growth potential of the local houses is limited because of the small size of the markets, and the lack of economies of scale hamper future development.

Against this background it is not surprising that the importance of larger local banks in the investment banking area is constantly increasing, cornering small independent firms to specialised products or oblivion.

The local investor base remains very weak. It's comprised mainly of a high number of small and unpredictable retail investors. There are no strong institutional investors with banks and insurance companies either are not being allowed to invest like in Lithuania or have had bad experiences in speculating. The first investment funds in Latvia and Lithuania to be founded by early 1999 will slowly change the situation as domestic "fund manager - investment bank" relationship should develop.

Stock picking among price anomalies

The small liquidity and inefficiency of the markets create price anomalies that tend to persist for long periods. Finding "real value" requires a top-down approach, identifying promising sectors and picking out the long term sector leaders. There is also a substantial imbalance between underlying macroeconomic strength and the capital markets. For example, in Lithuania the fundamentals are quite strong whilst the capital markets are very weak.

This makes the Baltic equity market look more like a private equity/venture capital experience rather than a liquid stock market. In such an environment it becomes crucial to focus on value creating factors because just buying "undervalued" assets does not guarantee capital gains - very often chip assets remain "undervalued" for a long time. Liquidity to continue to command premium as blue chips offer a more easy exit; the less liquid the stock, the more arbitrage opportunities exist due to the time lag between a corporate event and its reflection on the stock price.

However, there remain good, undiscovered and attractive "investment stories" in all three markets. Bringing these "jewels" to the markets requires focused promotion, in-depth research, communicating the story to the market and continued informational coverage. Since the company would most likely be a novice in the capital markets, the investment houses need to "coach" the companies on required transparency, relations with investors and market psychology as well as improving the company's management.

Key issues for investors

Liquidity remains a problem, but future developments of the capital markets and the disappearance of the disparity between the macro economy and capital markets should hopefully increase trading volume and market liquidity. However, no sustainable liquidity will develop before strong local institutional investors appear. Also, urgent legislative reforms should be implemented in this area.

The small local markets also limit the growth potential of the companies. The profit expropriation is sometimes still a big problem for investors. Continued research coverage is becoming more available although its quality is sometimes questionable. But demand for quality research is expected to grow substantially.

Key issues for issuers

Probably the single most important factor for a successful primary market deal is the selection of the lead managers willing and able to provide overall sponsorship and commitment. Raising the required capital is not enough any more as companies need assistance in positioning and presenting their company to investors, continuos funding support as well as comprehensive corporate broking, including post-issue research coverage, trading commitment and communications with investors.

(Ivo Gueorguiev is a deputy chairman of Hermis Bank.)