Summer 2015

SAUDI ARABIA: A new pipeline opens

Oil pipesSaudi Arabia is letting foreigners into its stock market, but don’t expect an explosion of new capital. The inflows will build slowly, writes George Mitton. Pipelines in saudi Arabia generally transport the kingdom’s oil on its journey to eager buyers outside the country. But a new conduit is opening, and this access route will convey not hydrocarbons but dollars. Under long-awaited rules issued by the Saudi authorities, qualified foreign institutions can directly own securities on the Saudi stock exchange, which is worth roughly $600 billion, for the first time. The Saudi authorities have been disciplined with their timetable, which sought to open registration for qualified foreign investors on June 1 and allow them to begin trading on June 15.  US and Europe-based asset managers and institutional investors have responded with excitement at the idea of owning shares directly in the likes of SABIC, one of the world’s largest chemical firms, and Maaden, a fast-growing mining company. The buzz around this maket is such that some analysts are anticipating as much as $40 billion of foreign capital to flow into the Tadawul in coming years. But will the market attract as much money as people say? Those close to the process say that watchers ought to lower their expectations. This is a gradual process that will develop over time. “I don’t think the volumes on day, week or month one will represent the full potential,” says Arindam Das, head of securities services in the Middle East and North Africa for HSBC, the largest foreign custodian in Saudi Arabia. One reason for scepticism is the time it will take for foreign investors to get their licences. First, applicants must apply for a qualified foreign investor (QFI) licence from the Capital Market Authority (CMA). Then, they must open a securities account with the Tadawul, the stock exchange. They also need a cash account with their custodian, which comes under the remit of the Saudi Arabian Monetary Agency (SAMA).  Applicants were given only two weeks from the date at which registration began, June 1, to get their licences approved before the start of trading. For some foreign institutions, this was not enough time. The Saudi market, although exciting, is not a top priority for every global firm. It may in fact be the smaller, more niche, frontier market asset managers that make the effort to obtain their licences in time to participate in the early days of trading. “I see parallels with the Shanghai-Hong Kong Stock Connect,” says Das, referring to the Chinese initiative launched last November that links the exchanges of Hong Kong and Shanghai. “On day one there was activity, then it slowed down. People said the scheme had been overhyped. But, over time, those problems have been resolved and things have picked up. “This is not like an MSCI index change when, on the day the upgrade becomes effective, all passive funds have to get into the market,” he adds.  He expects only “adventurous early birds” to participate at the start of the scheme, while other investors will come in one or two months later, after they have completed their due diligence. INDICES
The index compiler MSCI has responded to the Saudi timetable. On June 1, the day investors could begin applying for qualified status, MSCI launched two standalone indices, the MSCI Saudi Arabia index, with 19 constituents, and a small-cap version that includes 39. However, as Das explains, MSCI will not be making any changes to its existing indices, such as the widely followed MSCI Emerging Markets index, just yet. Instead, assuming the opening goes ahead as planned, the firm will launch a consultation on this topic with a decision possible in 2016. Judging on previous experience, it generally takes a year from the decision for MSCI to make any index changes, meaning the earliest Saudi Arabia could enter the index is 2017. As Das notes, this change would trigger immediate inflows from funds that track the emerging market index. Some brokers have suggested Saudi Arabia could account for as much as 4% of MSCI’s emerging market universe, though this will depend on how much of the Tadawul is accessible to foreigners. (The CMA will impose foreign ownership limits which will prevent foreigners owning more than 10% of the broad market, to give one example of the limits.) However, the decision is not imminent and the result not guaranteed. In the meantime, Saudi Arabia is likely to remain the province of frontier market fund managers. If the Saudi index fails to qualify for emerging market status, it may enter MSCI’s Frontier Markets index instead, though there is also some uncertainty about this. The Tadawul is so large it would probably account for more than half of the frontier market universe. MSCI says it would exercise caution so as not to “destabilise” the popular index. OPTIMISM
These caveats are not hampering optimism among the many asset managers planning to invest in Saudi Arabia once it opens. Fund managers are being increasingly vocal about their excitement about the Saudi market, which contains 178 stocks spread across 15 different sectors. These enthusiasts are quick to point out that many of the stocks on the Tadawul are not involved in the oil industry. “In fact, not a single oil company is listed on the Tadawul exchange,” says Jan Dehn, head of research at Ashmore, which recently set up its first Middle Eastern office in the Saudi capital, Riyadh. The oil link is important because the Saudi market fell sharply at the end of last year at the same time as the oil price collapsed. Dehn concedes that the Tadawul includes a number of petrochemicals firms whose feedstock is oil, which have some correlation with the oil price, but he says even in the current environment, these firms remain “exceptionally profitable”. A low oil price does affect Saudi Arabia’s government revenues, of course. At time of writing, a barrel of Brent crude costs less than $70, meaning Saudi’s national income will be far lower in 2015 than in previous years. However, the country has said it will prop up government spending by eating into its reserve funds, a promise that the new monarch, Salman, has already delivered on. “The new Saudi king’s affirmation of the country’s commitment to domestic spending and development and job creation creates favourable tailwinds for consumer-focused sectors, aided by the announcement recently of two extra months of salaries and bonuses,” says Dehn. SECTORS
For some investors, the collapse in the oil price and the resulting fall in the Tadawul was a boon. Emre Akcakmak, portfolio manager of the East Capital Frontier Markets Fund, says the fall created “good entry points” in the market. Buying at the market’s low point helped the performance of the fund – the Saudi market has recovered by about a quarter since December. East Capital, which is based in Sweden, is optimistic about the Saudi market. Peter Elam Hakansson, founding partner, says the Saudi firms it invests in are increasing their earnings at 15% a year on average. The firm has allocated 17% of the Frontier Markets Fund assets to Saudi Arabia. So far it has invested indirectly, using participatory notes (P-notes). The opening up will give the firm more options to access the market. “On our focus list in Saudi Arabia we have companies like food retailer Al Othaim, high quality education company Al Khaleej, dairy company Almarai and airline caterer Saudi Airlines Catering, just to mention a few,” says Hakansson. “We also invest in fashion retailer Al Hokair, which is growing not only in Saudi Arabia, but also in other attractive frontier markets such as Morocco, Kazakhstan, Serbia and Georgia.” DEMOGRAPHICS
Saudi Arabia is particularly attractive because of its demographics. Its population of roughly 27 million is much larger than its neighbours in the other Gulf countries. Significantly, it is a young population that is growing rapidly. There is the potential for a boost to economic growth as these young people enter the workforce and begin contributing to the economy. Not only that, but Saudi Arabia, which has traditionally kept tight control of its borders, is starting to become more open, and this opens up the potential for wholly new industries. “Barings has identified companies where tourism should drive earnings growth in the medium term, as Saudi expands the airport and Mecca infrastructure and the government increases the annual quota of religious visas,” says Ghadir Abu Leil-Cooper, manager of the Baring MENA Fund. “As the population keeps growing and demand for jobs increases,” she adds, “a thriving capital market with good corporate governance should provide the foundation for a more diversified balanced economy, far less dependent on the oil price.” HEADWINDS
Not all the prospects are good. Saudi Arabia is currently bombing Yemen as part of an intervention in that country’s civil war, which threatens to destabilise the entire south-east region of the Arabian Peninsula. Should the conflict escalate, there is likely to be a broader effect on the Saudi economy that could affect the stock market too. Elsewhere, Saudi Arabia faces the prospect of an erosion of its regional influence as Iran renews its ties with the West and becomes a more powerful player. Akcakmak, of East Capital, says, “the outcome of Iran’s nuclear talks may also heat up the regional power struggle, but we do not subscribe to the idea that this power struggle will develop into something worse that could derail the Saudi Arabian economy”. Beyond these concerns, Saudi Arabia continues to generate negative press coverage in the West. Sweden’s foreign minister recently triggered a diplomatic incident when she described Saudi Arabia as a dictatorship that violated women’s rights. Sweden cancelled an arms agreement with Saudi Arabia worth about $1.3 billion to the Swedish economy. Separately, the Saudis were widely criticised for sentencing a blogger, Raif Badawi, to 1,000 lashes and ten years in prison for writing critically about the government. Clearly, not all of Saudi Arabia’s publicity is good. However, for fund managers, there seem to be enough interesting stocks to make the Tadawul an appealing target for investment.  It remains to be seen how many of the potential investors are ready to trade on the Tadawul as soon as they are able and how many will wait on the sidelines. ©2015 funds global mena

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