Saudi Arabia hopes that there will be a lot of interest in its stock market when it finally opens up to international investors next year. But it might only succeed in attracting technical, rather than value, investors.
By Sameer Massis
As the Middle East grappled with political turmoil over the summer, big news came out of Riyadh on July 22. The Saudi Arabian Capital Market Authority formally announced it would open its stock market to foreigners in the first half of 2015. The regulator has worked on rules that will govern foreign investment in the country’s listed companies, for which they will seek feedback from both investors and the public for 90 days. They will then review the responses by the end of the year to assess the market’s readiness for foreign direct investments in its stock market.
This would be another monumental step following the 2008 decision to allow foreign indirect access to the market through swaps and exchange traded funds. It would also make it cheaper to access a wider range of stocks, since not all stocks have participatory notes attached to them. This is big news. Saudi Arabia’s stock market boasts a market capitalization of $530 billion—larger than that of Egypt, Qatar, and UAE combined—and has a daily turnover of over $1 billion, the highest for an emerging market.
Currently, foreigners—other than Gulf State citizens—hold less than 5 percent of the Saudi stock market, and account for a smaller fraction of the daily turnover. The hope is that institutional investors would reduce stock market volatility, triggered by easily panicked domestic retail investors focused on the short-term. In the long-term, it should also feed into investor advocacy towards more transparent and efficient operations for the companies themselves.
Liberalizing the stock market would also make it easier for non-energy sector companies to raise capital. In turn, this would drive the authorities’ broader agenda to diversify the economy away from oil and gas dependency, and create jobs for its growing population. This is important because even as the economy boomed over the last four decades, the world’s top oil exporter and de facto leader of OPEC remained inefficient and backward in many areas. This inefficiency was evident in BP’s World Energy Review, which found that Saudi Arabia consumed more than a quarter of its oil production in 2013, which ranked it the sixth-biggest global oil consumer despite being only the nineteenth largest economy.
Poorer Saudis struggled with unemployment, lack of proper housing, and medical care, whilst Saudi authorities resisted initiating labor reforms until a few years ago. Prompted by the Arab Spring uprisings of 2011, the government showed its willingness to accept short-term commotions as it pursued long-term reforms. Labor market quotas and fees made it harder for firms to hire cheap foreign workers, and favored more Saudis in the workforce. This hit hard the sectors that rely heavily on foreign labor, such as construction, retail, and transport. Similarly, to address the housing problem, the government introduced a mortgage lending law in 2013 despite the local controversy over dispossessing a defaulted homebuyer. Moreover, recent reforms liberalized the civil aviation industry, despite pressuring its flag carrier Saudi Arabia Airlines.
Long-term benefits to these reforms became evident in the 2013 economic numbers as the non-oil sectors’ contribution to real GDP rose to 78.7 percent, the highest since 1970. It remains a long road before the biggest test for the reforms: to reduce the huge energy subsidies that provide Saudi consumers and industries access to the cheapest oil on the planet. Nevertheless, the current planned opening of the stock market is a step in the right direction.
Vanishing Value
Long-term investors look for long-term value in stocks, but the GCC markets already had a run-up this year. For instance, by mid-August the MSCI World Index rose by less than 6 percent, whereas the GCC markets rallied over 18.5 percent. This isn’t justified on a valuation basis, as the UK-based Nomura Asset Management values the GCC P/E at 18. This is expensive compared to the other emerging markets of Asia and BRICs, which stand at 13 and 10, respectively. Even though there’s some fundamental reason for this rally as the pro-growth government policies fueled some local economic recoveries, the main reason is technical. This year’s MSCI promotion of UAE and Qatar by including them in the Emerging Market Index had certainly stimulated the otherwise locally predominated markets. Even JP Morgan blew the whistle on the MENA markets during the summer with an underweighting of both UAE and Qatar. They view these momentum-driven markets to be near the end of their course, with evidence of stretched valuations.
The Saudi Stock Market valuation also looks stretched in more than one metric: P/E of 19.7, P/B of 2.4, with a dividend yield of a mere 2.9 percent. Even the return on equity stands somewhat low at 13 percent, which is lower than that of the S&P 500 of 15 percent. This is surprising, given that the Saudi Index average profit margin stands at 18 percent, which is nearly twice that of the S&P 500 at 10 percent. These higher profit margins are mainly due to near-monopolistic environments created by government legislation or activity. Nevertheless, the loss of this advantage through lower profitability reflects the current inefficiencies in Saudi market companies.
Based on a simple DuPont analysis equation, the return on equity is equal to three terms multiplied together: profit margin, asset turnover, and equity multiplier. This, therefore, suggests that most Saudi companies suffer from a lower asset turnover—i.e. lower sales relative to asset size—and/or that their capital structures are suboptimal. So with the liberalization of the Saudi stock market, it will undoubtedly lower companies’ profit margins. This lends itself to the key question: Can Saudi companies increase their asset and capital efficiencies to overcompensate the profit margin loss?
Riding Liquidity
In practical terms, Saudi Arabia doesn’t need the money, but rather benefits in the long-term through the efficiency effects on company and stock market operations, as well as country reforms. An immediate benefit also is gaining a worldwide status for its market. Currently, MSCI does not even consider the Saudi Arabian market a frontier market. However, MSCI announced that should the Saudi market open to foreign investors, it might make a decision as early as June 2015 on whether to add Saudi Arabia to its Emerging Market Stock Index. Should it be included, this would weigh the Saudi market at around 4 percent of the MSCI Emerging Market Index. The actual inclusion might not take place until 2016 or 2017, but the effect of the announcement would be felt well before then. For instance, even though this year’s MSCI inclusion of both Qatar and Dubai was not effective until June 2014, the effect was already there. Since the announcement, the Qatar Index rose 42 percent, while the Dubai Index hovered over 50 percent. At the end of the day, the Saudi market may make it to the smaller sized $300 billion Frontier Index, but may also take a straight entry ticket to the larger $1.5 trillion Emerging Market funds space. Indeed, the Saudi market’s broad sector and market depth may qualify it to the expedited entry.
In general, due to their smaller size, MENA markets are driven more by technical, rather than fundamental, factors. Moreover, regional instability can easily set panic in the largely retail-denominated stock markets. For instance, the deteriorating situation in neighboring Iraq, as well as local worries in Qatar about hosting the World Cup, and toppy real estate prices in the UAE quickly echoed a market correction that rippled regionally.
Since the MENA markets can change directions quickly, it’s important for savvy investors to exit swiftly as well. This leads to the usefulness of exchange-traded funds (ETFs), which are accessible through any international/US brokerage. One such fund, GULF, seeks investments that correspond to the price and yield performance of the Wisdom Tree Middle East Dividend Fund. A second one is MES, which is the Market Vectors Gulf States Index ETF that seeks to replicate the price and yield performance of the Market Vectors GDP GCC Index. Importantly, both these ETFs are more than 95 percent correlated with the Saudi Tadawul Index over a three-year period. Indeed, either of these ETFs allow foreign investors to obtain the return on the Saudi Index today and gain from any positive news on the stock market.
