Saudi Aramco did not attract the level of foreign investor interest the government had hoped for, but it has highlighted where the government needs to focus its attention
For a country taking great pains to improve liquidity in its equity markets, endorsing a government buyout of Nasdaq Dubai’s most liquid stock seems an odd move.
In February, DP World and its majority owner Port and Free Zone World FZE (PFZW) made an offer to DP World’s minority shareholders to acquire the outstanding 19.55% of shares for around $2.7 billion. The transaction means that DP World will be delisted, with state-backed PFZW acquiring full ownership. With the offer at a 30% premium to the share price, it is unlikely investors will refuse.
The move is a blow to a market where liquidity is already very thin and seems to contradict the government’s strategy of positioning itself as a destination for international investors.
“It is telling what is happening,” says Matthew Pigott, an assistant fund manager at Jupiter Asset Management. “We have one holding in the Gulf, which has seen a deterioration in liquidity.”
The inclusion of Saudi Arabia in the MSCI Emerging Markets index was a big development. Next we will see Kuwait coming in- Mohamed El Jamal, Waha Capital
The deal sets a worrying precedent for larger companies buying out their smaller subsidiaries with little thought to the impact on the broader market.
“It’s a significant move by the Dubai government,” says Pigott. “It underlines, as we see it, the divergence between price and value in the region.”
It is also a good example of why many international fund managers still stay clear of Gulf equities, despite the inclusion of UAE and Saudi Arabia in the MSCI Emerging Market Indices. In fact, bankers have identified a $70 billion shortfall needed to bring funds up to market weight, even after billions of dollars of passive inflows and the world’s largest IPO.
Saudi Aramco’s offering – billed as the key to accelerating the development of local stock markets and making the region “impossible to ignore” in the words of one banker – has failed to fully convince investors.
The region offers good potential for diversification, as well as price stability and good undervalued investment opportunities. So why is it still proving unpopular?
A lack of understanding about the region, a lack of investible assets and thin liquidity are among the chief concerns. But key regulatory developments in both Saudi Arabia and the UAE should make investing in the Gulf more attractive – even if the DP World trade seems like a move in the wrong direction.
Mohamed El Jamal, Waha Capital
Despite passive inflows of between $13 billion and $14 billion into Gulf equities in 2019, many funds remain structurally underweight in the Gulf Cooperation Council (GCC) region, says Mohamed El Jamal, chief investment officer, public markets at Waha Capital, an Abu Dhabi-based investment firm with $900 million in assets under management.
The weighting of the Middle East and north Africa (MENA) in global emerging market indices has gone from almost nothing to 5.5% over the last five years.
With the upcoming inclusion of Kuwait and the removal of foreign ownership limits across MENA markets, this may go up to 6.5%.
MENA is now impossible to ignore as an investment proposition, says El Jamal. But over the medium term, inflows of $60 billion to $70 billion are needed for global funds to go market weight on the GCC.
“The inclusion of Saudi Arabia in the MSCI Emerging Markets index was a big development,” says El Jamal. “Next we will see Kuwait coming in, which will increase the weighting to 6.5%. Investors can’t ignore the region any longer.”
Foreign ownership in the equity markets remains small however; in Saudi it is in the low single digits.
Jupiter’s Pigott agrees that many international funds are underweight Gulf equities, which are dominated by the UAE and Saudi.
“One of the reasons is the nervousness around the economy of Dubai,” he says. “Dubai has a real-estate overcapacity problem, prices have fallen, and that has weighed heavily on sentiment for the region. However for us, this can create opportunities to buy into some excellent businesses at discounted prices.”
MENA equities are also attractive on a relative value basis, says El Jamal, because they have not been inflated by financial easing.
“In MENA, we actually saw the opposite, which was a shrinkage of the liquidity pool,” he says. “We have seen the opposite of asset-price inflation.”
Part of the issue, says Dino Kronfol, chief investment officer global sukuk and MENA fixed income at Franklin Templeton in Dubai, is the mismatch between the perceived risks of the region and the true risks.
Geopolitical risk has always been part of investing in the Gulf, but earlier this year the US-drone strike on Iranian general Qasem Soleimani prompted fears of a nasty escalation of US-Iranian tensions. Coming a few months after a strike on Saudi Aramco assets that interrupted about 5% of the world’s daily oil supply, the perceived risks associated with investing in the region came to the fore of allocation strategies.
When it comes to climate change and political risk, for example, it is difficult to collect and analyze timely and key data that may help to dispel concerns about those risks, says Kronfol. This perception prevents people from investing.
“This region is misunderstood to a certain extent and evokes a number of emotive comments,” he says. “It prevents people from investing, they perceive this as a very high-risk region.”
A lot of companies in Saudi became well bid very quickly. When we look at individual companies, valuations tend to be the sticking point- Matthew Pigott, Jupiter Asset Management
Banks and corporates are becoming more focused on investor education, with reports of increased coverage of MENA on the banking side, as well as more investors visiting the region.
El Jamal says: “On trips to corporates, we are seeing more investors from the US and Asia.”
A Saudi-based banker tells Euromoney that demand for investor-relations personnel in Saudi Arabia is extremely high as corporates look to make themselves more investor friendly.
In addition, debt management offices (DMOs) are thinking more about how to position themselves to international investors.
Kronfol says that the issue of misperception also impacts the debt markets: “It is a high-quality segment in the EM universe [and offers] lower volatility and greater diversification.
“Adding GCC debt actually reduces portfolio risk, but it is very difficult to get people to overcome their bias because in their minds investing in GCC bonds means you are taking on all this oil price and governance risk.”
But Sailesh Lad, a London-based portfolio manager at Axa Investment Managers, argues that the investment community already sees the region as a diversification play. Flare ups in Argentina and Lebanon last year saw investors buy MENA debt as a safe-haven play.
“A lot of people are structurally overweight MENA bonds because of last year,” he says, “and as the year wore on, high-yield underperformed relative to investment-grade [in emerging markets] – and a lot of that came from the Middle East.”
Lack of inventory
Another reason funds remain underweight is the lack of inventory in both debt and equity markets.
Saudi’s inclusion in the MSCI saw a flood of money come into the Tadawul stock exchange, but that quickly dried up as the few listed companies became overvalued.
“A lot of companies in Saudi became well bid very quickly,” says Pigott. “When we look at individual companies, valuations tend to be the sticking point.”
Atiq Rehman, Citi
Saudi’s Tadawul has set the pace as a clear channel for foreign portfolio money, says Atiq Rehman, chief executive of EMEA emerging markets at Citi, adding that the speed of change in Saudi Arabia’s markets is impressive.
“The way the Capital Markets Authority has changed is remarkable,” he says. “How they have prepared the CMA to deal with $25 billion to $30 billion of inflows that came from foreign investors and deregulated with credibility the sector, and are now looking at a lot of new products and services… These things are not quick and easy.”
The success of the Aramco deal sets the tone for the future sale of government-owned stakes in Saudi companies, but for the Saudi government the next focus will be on both inventory and liquidity. Aramco may not have attracted the level of foreign investor interest the government had hoped for, but it has highlighted where the government needs to focus its attention.
The Saudi government still owns big chunks of unlisted assets in the country and it is the gradual sale of these stakes that will open up the country’s economy and help the transition from local to international ownership. To do this, it will have to work on attracting more foreign investors as the government will not be able to keep returning to the same, largely retail and domestic, investor base.
In the debt markets, inventory is also low. Despite the big bond deals printed in the last three years, Saudi Arabia is still a long way off inclusion in the World Government Bond Indices, which require a minimum of $250 million of paper outstanding.
A diverse stock of investible assets is even more important in a pegged currency environment because the Gulf does not offer the attractiveness of certain rates or currency plays.
Sector concentration can also be off-putting, says Pigott. It is very high in both the UAE and Saudi: financials make up 60% of the Gulf index, while materials and energy represent another 20%.
“Stock markets reflect the lack of diversity in the wider economy,” says Pigott. “This can be a problem for attracting new investors.”
Matthew Pigott, assistant fund manager at Jupiter Asset Management
Both the UAE and Saudi governments are trying hard to improve the diversity of companies on offer however. Last year, the UAE and Saudi Arabia relaxed foreign ownership restrictions for businesses, an important development in increasing the stock of investible assets in both countries.
In the UAE, the government allowed for up to 100% foreign ownership of some 122 business activities in the manufacturing, agricultural and services sectors when it issued a new foreign direct investment law in September 2018.
Saudi Arabia meanwhile relaxed a 49% limit for foreign strategic investors in shares of listed companies, having opened to foreign investors in 2015.
Invest Saudi reported 54% annual growth in new foreign investor licenses versus 2018 in its winter 2020 report.
GCC pension funds may reach $40 billion over the next five years, which is a significant pool of assets. They will look to invest inside and outside of the region, too- Dino Kronfol, Franklin Templeton
More recently, the UAE has inked a draft law encouraging family-owned businesses to list on its domestic exchanges, a move that is expected to improve the diversity and liquidity of the Abu Dhabi Securities Exchange (ADX) and the Dubai Financial Market.
Nick Wilson, chairman of the Gulf Investment Fund, says: “This type of reform and market engagement will drive additional improvements to the UAE business environment, including to the areas of corporate governance, reporting and market liquidity.”
For investors, the move is important because it will increase the diversity of stocks on local exchanges.
“ADX is dominated by banks and real estate, and investors don’t get much exposure to other sectors,” says a Dubai-based investment banker.
However, while a listing may offer family-run companies access to liquidity, it may also require a cultural shift in thinking, with many families unsure about giving up control of their businesses, according to Christophe Lalandre, managing director of Lombard Odier in the Middle East.
“Equity brokers in the country are very positive on this idea,” he says. “There will be more liquidity and more listings on the market.
“One message each group has to assess is that liquidity will be positive, but their independence will be different. It is a fundamental shift for the market, but it may take some time.”
The Dubai-based investment banker agrees that the proposal is positive for the market and offers families a way to access liquidity without relinquishing control of the whole business.
“Families weren’t happy to list majority stakes, so this is a way for them to list,” he says.
The move should also boost access to funding for small and medium-sized enterprises, which remain the most underserved part of the UAE’s economy.
Another key issue for investors is the limited liquidity seen in UAE and Saudi markets. Many argue that the UAE spreads itself too thin by having three different stock exchanges – Nasdaq Dubai, Dubai Financial Markets and the Abu Dhabi Exchange.
Developing a more diverse investor base would help address the liquidity issue, while driving a greater variety of listings would also bring in a more liquid retail investor base.
“More diverse listings will attract a new type of investor – and a retail investor base, which is more short term, does quite a lot to improve liquidity,” says Pigott.
Progress is being made on the investor side, with the Dubai International Financial Centre’s (DIFC) new pension scheme adding variety to the UAE’s investor base, which is largely dominated by banks.
The DIFC’s first defined-contribution pension fund launched on February 1 and is expected to create a substantial pool of assets.
Kronfol says that the scheme will be rolled out in the DIFC initially, with expectations of a successful role out of similar funds across the UAE.
“GCC pension funds may reach $40 billion over the next five years, which is a significant pool of assets,” he says. “They will look to invest inside and outside of the region, too.”
The scheme will be managed by Mercer and Zurich, with Franklin Templeton’s sukuk fund one of 12 investment options.
“It’s very positive for the region, which needs to develop its long-term investor base,” says Amir Riad, head of corporate finance and investment banking at ADIB.