Ben Aris in Berlin -

International investors' interest in Ukrainian stocks perked up with the promise of rapid integration with the EU following the Orange Revolution in 2006, but few expected the market to have come so far, so fast.

At the start of 2006, the leading PFTS index was hovering around the 300 mark, but since then a flood of investment has sent the index soaring to top an astonishing 1000 on June 14, 2007.

The index got stuck at that point and has made little progress since, thanks to the brouhaha that followed the collapse of the US mortgage market. But while other markets have tumbled, the PFTS has proven to be extremely resilient and was still at around the 1000 mark at the start of this year, making it one of the top-three best performing markets in the world.

The Orange Revolution may have turned the international spotlight on Ukraine, but the PFTS had been outperforming almost all its international peers for several years before then: between October 2004 and October 2007, the average return has been 112.3%, while between January and October last year the PFTS Index surged another 129.9% despite the problems in the US and a hotly contested general election at home.

Impressive as this growth is, a large chunk of the gains is due to the very inadequacies of the market. The economy is poorly represented amongst the listed companies and those shares that are listed have very small free floats - typically 5%. It only takes a relatively small inflow of new money to send the index flying: over 2007, the average trading volumes soared from about $8m a day to $30m a day, says Millennium Capital's Peter Keller, but this pales into insignificance compared with the $2bn-3bn daily volumes seen on Russia's RTS.

Roland Nash, head of research at Renaissance Capital says: "We think that there are two major reasons behind Ukraine's stock market growth. First and foremost, there seems to be a firm investor desire to place more new money in the country. Second, there is a decreasing supply of Ukrainian tradable free float; many funds appear to invest in domestic equities for more than one year, which is evidenced by low daily trading volumes."

Second tier

The youth of the market and the volume of money, albeit comparatively small by emerging-market standards, means the Ukraine market is going through the typical development phases of an emerging equity market at double speed.

Investors are working their way through the various sectors as the different investment stories come into fashion. In 2006, the number of banking mergers and acquisitions exploded and, as a result, bank stocks were the flavour of the year. The banking sector was the most frequently traded sector on the PFTS stock exchange, accounting for a bit more than a quarter of all trades, with Ukrsotsbank and Raiffeisen Bank Aval leading the way.

However, by the start of last year the bank shares were starting to look pricey and the interest shifted to oil and gas, steel and metal, mechanical engineering and utility sector stocks as the main listed companies of the economy. The momentum in these sectors was maintained by many of the companies beginning to restructure and improve their corporate governance, either because they are preparing for privatisation or an IPO, or at least closer integration with Western European markets.

However, by the second half of last year the valuations of these companies were also rising fast, to the point where the Price/Earnings ratios were on a par with similar markets like Russia, or even higher, despite Ukraine still lagging as much as five years behind Russia in terms of its development.

In these conditions, investors typically start to look for value based purely on the numbers and this leads them to foray into the second-tier stocks. Russia's stock market went through this stage after it started to pick up steam in about 2005, but in Ukraine the whole process has been telescoped down to less than 18 months. The second-tier stocks easily outperformed the overall index over the second half of 2007.

Over the first two months of this year, the index has been knocked about by a collapse in confidence amongst international investors, but local analysts are almost universal in saying that once the turbulence dies down, the momentum will return. A raft of IPOs and private placements in the pipeline for 2008 mean the emphasis will probably shift in the second half of 2008 to the consumer story that is increasingly driving the economy, but is poorly represented on the exchange.

Equities run out of room?

After such a long and fast run, Ukraine's equity valuations seemed to be running out of steam by the end of November of 2007 and the question for this year is, how much room is left for the market to grow?

Renaissance Capital's analysts said in a note in November: "Ukrainian equity on the whole is trading above its fundamentally justified levels. From a bottom-up perspective, there are virtually no undervalued stocks left. In fact, within the universe of securities covered by our team, we can find only a few stocks with upsides in excess of 10%. Over the past months, we were already selecting our top picks mostly on the assumption of relative out-performance, rather than absolute targets."

The consensus amongst most of the investment banks like Dragon Capital or Renaissance Capital is that the PFTS will gain about 30% this year, based on valuations at the start of February. However, the key ingredient is the projected earnings growth for the year. Despite the progress made so far, Ukrainian companies remain extremely opaque, even by regional standards. Some argue that if the process of improving corporate governance continues, then much of the hidden revenues will become increasingly visible and so the valuations of companies will surprise on the high side as the year unfolds. "The volumes are small, but the valuations can be justified," says Millennium Capital's Keller. "The increase in corporate earnings is running at 60% a year - probably more if you take into account the size of the black economy. On this basis, Ukrainian equity will not stay expensive for long."

Finally, a new source of money is making itself increasingly felt in the local markets, which could push valuations higher: there was exponential growth in the assets of domestic mutual funds over 2007. The stock market regulator reported that the value of equity holdings held by domestic mutual funds over the first half of 2007 grew almost threefold to $210m, due to both market appreciation and asset growth.

Again this is a drop in the ocean when compared to the PFTS market cap or the size of the Russian mutual fund business (approx $15bn under management). However, like elsewhere in the region, the middle class have woken up to the fast growth of equity valuations and have begun to participate in the country's recovery by investing.

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