The Kingdom of Saudi Arabia (KSA) has long been the El Dorado of emerging market (EM) investors: a mix of oil economy and traditional EM opportunities so attractive that it must be illusory almost by definition – and, of course, by the very fact of it being off-limits to foreign investors except through swaps.
That now looks set to change in the first half of 2015 as the long-anticipated opening of the Arab world’s largest market to direct investment by foreign funds is finally in the offing. Saudi Arabia’s regulator put out a consultation paper on terms for Qualifying Foreign Investors at the end of August, and it will publish final regulations at the end of the year. What this means for your investment strategy will depend not just on the details (and conditionality) placed on the opening, but on your willingness to dig deep to find value plays in a market that is already more than fairly priced relative to its EM peers.
The Kingdom’s opening will make it far and away the largest investable market in the Middle East and North Africa (MENA) region. Presuming it is classified as EM, will it draw attention away from smaller regional bourses? Or will it finally make the MENA region a well-defined sub-region within the wider EM universe? What plays can you pursue today to capture new upside heading into the anticipated opening of the market in 2015? What long-run themes are most compelling in Saudi Arabia? Are Saudi companies ready to meet the disclosure standards expected by international institutions?
These are among the questions top institutional investors will be putting to C-suite executives at the EFG Hermes London MENA Conference, 15-17 September (inclusive), the largest investment conference focusing on the Arab world to take place annually in the UK with more than 70 companies from 12 countries scheduled to attend this year, including senior management from 14 Saudi Arabian companies.*
Which one of these is not like the others?
Heading into 2015, it is critical that investors realize that Saudi Arabia is not your typical Gulf oil-exporting economy. Unlike its Gulf Cooperation Council (GCC) peers, the Arab world’s largest economy is a large consumer market (c. 30 million residents against an estimated 9 million in the United Arab Emirates (UAE)), is not exceedingly wealthy (per-capita GDP of c. USD24,000 to the UAE’s USD44,600), and the majority of its residents are nationals (70%, versus an estimated 13% in the UAE). What’s more, ongoing labour market reforms mean more Saudi nationals enter the workforce each year, and private-sector credit has plenty of room left to grow in comparison with other GCC economies.
|Saudi Arabia trades more than all other MENA markets combined|
Another key difference: while Saudi Arabia is no less an absolute monarchy than is the UAE, its economy has developed in a far less centrally planned manner – and over a relatively longer period of time. The result, as we will see, is opportunities arising from both fragmentation and market inefficiencies of a type comparatively rare in the UAE.
Anticipation of foreign participation should support market – but KSA is not cheap
We think that the market will continue to anticipate next year’s opening for the rest of this year. We believe the combination of inflows on the back of positive sentiment on the prospective opening to international capital – coupled with early signs of what could prove a durable earnings recovery after four quarters in which companies as a whole missed consensus – means performance is likely to be on-par with MENA markets heading into the final months of 2014.
There are downside risks, of course, particularly when you consider Saudi Arabia is the only major Arab market not to have experienced a correction in the past 52 weeks. Moreover, the Tadawul (the official name of the Saudi Arabian stock market) is presently trading at just over 16x 12-month forward earnings, which represents a premium not just to MENA markets, but 45% above MSCI EM; it is, moreover, a figure close to the developed world market aggregate (MSCI World).
New value won’t be created by passive bid until 2017…
Steep valuations may deter foreign institutional investors from buying heavily when the market opens up in 1H2015: the outlook for several mainstream EMs is improving and foreigners were net sellers in KSA in 2Q2014. We estimate that foreigners already own around USD6 billion in KSA stocks via swaps. If the USD1.1 trillion in actively managed funds that track the MSCI EM index allocate 2% of their funds to Saudi Arabia, we may see additional flows of around USD15 billion. KSA’s eventual MSCI EM weight may range from 1% to 3.2%, depending on foreign ownership limits (FOLs).
However, we do not expect a strong passive bid for Saudi Arabian stocks until 2017, the earliest we believe it likely the Kingdom will earn benchmark EM status from FTSE and MSCI. In other words, we do not expect (in the short term, at least) the type of surge we saw before the elevation of the UAE and Qatar to EM status in mid-2014.
|Saudi Arabia now at a premium to developed markets|
…but rather by domestic institutionalization and private savings
If international investors were net sellers just in 2Q 2014, domestic retail investors have been in that category since October 2008, although they still account for c. 90% of daily turnover. In that period, the market has been supported by a consistent bid from local institutions, both from direct buying by state institutions and by the government mandate that private-sector asset managers invest government funds in local equities. Increasingly, professional and sophisticated family-office structures have also played a role, and a large build-up in domestic savings over the past decade could further pump liquidity into the Tadawul.
It’s all in the details
The Capital Market Authority has published draft regulations for ‘qualified foreign investors’ (QFIs), its second draft after an initial consultation in 2011. This has kicked off a three-month consultation period that will culminate in the release of final rules for QFIs by year’s end and, we expect, set a date for market opening in the first half of 2015.
Among the market access rules on which we’re keeping a close eye are:
● Minimum prop or third-party AUM (USD5 billion in the 2014 draft, potentially falling to USD3 billion)
● Total foreign ownership limits (49% in the 2014 draft)
● Limits on ownership of any QFI in a single stock (mooted as 5%)
● 10% limit on foreign portfolio ownership of KSA market cap, directly or indirectly
● Potential ownership restrictions on companies with assets in Mecca and Medina and / or on companies in strategic industries such as petrochemicals.
● Potential changes to the current T+0 settlement cycle preferred by a vast majority of the retail investors who account for 90% of the market today. This, alongside non-overlapping workweeks, is a prime concern for foreign investors.
Who are we tipping?
Our list of the top 20 stocks in the MENA region includes six Saudi shares. We recently added large-caps SABIC (diversified chemicals, fertilizers, polymers and metals) and Savola (food commodities and products, food retail, and restaurants) to the list. SABIC, one of the world’s leading chemical producers, has jumped in response to news that the market will open up, and 2H2014 earnings will be supportive. In the longer run, the stock will be buoyed by ethylene market dynamics. Savola trades at a premium to the market, but ongoing corporate restructuring and long-running MENA consumer trends should help drive the stock higher.
Indeed, the restructuring of both companies and markets is, alongside KSA’s enduring EM-style consumer story, among the themes that most attract us to Saudi Arabia in the medium-to-long term. Originally revolving around the entrepreneurial efforts of business founders now two-, three- and even four-generations removed from current family owner-managers, KSA is dotted with powerful, diversified business groups. The result is fragmentation, and we see consolidation as being a powerful theme driving growth throughout the economic cycle, led by retail and construction.
Consider, for example, the retail food market, where the top nine operators together control just 22% of a market in which leading player (and Savola subsidiary) Panda (at 11% market share) is nearly triple the size of the next-largest contender, Al-Othaim, which is also on our MENA top 20 list. Larger companies are better able to manage the challenges of labour market reforms, another factor supporting consolidation.
The banking sector is also worth watching. Although already relatively competitive, growth could be driven by future interest-rate moves in a sector with ample room for margin expansion at institutions with substantial non-interest-bearing deposits. We currently like Saudi Hollandi Bank, one of the stronger conventional banks.
All eyes on KSA
Regardless of which sectors investors are watching, we head into the final months of the year knowing that markets across the region are paying close attention to developments in the Kingdom. The sheer size of the Tadawul and the diversity of opportunities on offer – blending those of both traditional EM and oil-based economies – will spark concerns on smaller bourses that investors may neglect them in favor of Saudi opportunities.
However this plays out, KSA’s opening will ramp-up the competitive metabolisms of markets from the UAE (with its restrictive IPO rules) to Qatar (low FOLs) and Egypt (which needs to both encourage new listings and improve the broader investment environment). The ultimate beneficiaries will be investors, both foreign and domestic.
* Institutional Investors interested in learning more about the 4th London MENA Conference, held on 15-17 September 2014 at the Emirates Arsenal Stadium in London, should please contact us at londonMENA@efghermes.com.