By Neil Halligan
The opening of Saudi Arabia’s stock market was greeted by heavy news coverage from around the world. Experts say it may take years for the impact of the move to be fully felt
The last of the world’s major economies flung open its stock market doors to the world in the last 14 days, and while it didn’t produce a massive influx of money from investors from outside Saudi Arabia, it was nonetheless a momentous occasion for the Tadawul All Share Index.
By the closing bell, foreign investment in the $564bn market took place in seven out of the 170 stocks listed, amounting to less than a tenth of a percentage point of each company.
“It’s what I have been saying for some time,” says John Sfakianakis, Middle East director of Ashmore Group, speaking about the opening five days of trading in Riyadh.
“Initially you will see a lukewarm reaction, and people will just take their time, and foreigners will invest more money gradually, but it’s not going to be in one go at the beginning of the opening up of the market,” he adds.
Much has been made of the inflated valuations of Saudi listed companies, and the market itself is up by 15 percent this year, compared to just 2.4 percent growth for the MSCI Emerging Markets Index. But since 15 June, the market has sunk somewhat, which should be encouraging for foreign investors.
“The valuations were a little bit on the high side and I think that with the correction that we’re seeing today, things will become more attractive for local and foreign investors. I think there’s a lot of re-pricing that takes place when a market like Saudi opens up,” says Sfakianakis.
The timing — just before Ramadan — is also playing into the current activity on the Tadawul, but Sfakianakis says that it was always going to take until after the summer before the real effect of opening to foreign investors is seen.
“I think you will see a pick-up in activity come September, while everyone comes back. Now we’re seeing the seasonal effect of a down market. For the first two weeks during Ramadan, the market goes down, it corrects, volumes are down and then it picks up in the third and fourth week. I think that will be an incentive for foreigners to begin to take notice and to invest more money,” he says.
Previously, foreigners could only buy stocks in the Saudi market through indirect channels such as swaps and participatory notes. Ahead of the planned opening to foreigners, the Saudi Capital Market Authority issued a detailed set of rules last month governing Qualified Foreign Investors (QFI) who are allowed to access the Saudi stock market.
HSBC was the first to receive the licence, and Sfakianakis’ Ashmore Group is one of six applicants that has been due to get a licence in recent days.
“It’s pretty straightforward process where you have [to] submit the appropriate paperwork, but it’s not a back-and-forth, bureaucratic, red tape kind of thing,” he says.
Sfakianakis says Ashmore has had interest from big institutional clients, but also from smaller investors.
“We have also seen more specific enquiries about how to invest and ‘how can you manage money for us’,” he says.
There was great anticipation ahead of the opening of the Saudi stock market to foreigners, with the world’s financial media tuned in. Yong Wei Lee, head of MENA equities at Emirates NBD, says he can see why, describing it as a “game-changer”.
“The Tadawul is a pretty big and deep market. It trades on average — not during Ramadan — in the region of $2bn to $2.5bn per day. That’s pretty liquid. It’s got a fairly decent market cap size, about $560bn. If you put that in a global ranking, it’s ranked 18th largest in the world. It compares well to other emerging markets such as Russia, South Africa and Malaysia — it’s larger than these in terms of market cap,” he says.
Lee agrees that the large-scale investment will take time as interested parties become accustomed to the new opportunities.
“I do think the opening of the Saudi market to international investors is truly going to be quite a game-changing event over the medium to long term. It’s just not going to be a big bang on day one. Even if it’s weeks or months later, I don’t think it’s going to be something that bothers them so much, from a QFI perspective.
“A more important consideration is that people have accounts set up properly and customers are comfortable with the set-up. They also need to do their own analysis on what stocks to buy, which will probably take some time. I think you will see more and more QFI investors coming through, but eventually when these foreign investors consider the merit of Saudi versus other emerging markets, they will probably start to come in. It’s a big deal, but you also need to have the MSCI upgrade to really complete the picture for them,” he says.
QFIs and their clients will not be allowed to hold more than 10 percent of all available listed shares, which amounts to $56bn under current valuations. Sfakianakis says the next two years could see foreign investment reach about one third of that.
“There are two tranches. There will be one tranche that comes prior to MSCI inclusion and that should be in the neighbourhood of up to $20bn, but it could be $15bn, it could be $10bn. There’s a second tranche where we will see money coming in as the MSCI emerging markets index includes Saudi Arabia and that should take place around 2017, give or take six or 12 months. That will be serious amounts of money that will be injected into Saudi. I think these are the two landmarks or milestones that we’re watching,” he says.
While access to the market is one of the crucial factors, another important facet in opening to foreign investment is the upgrade of Saudi Arabia to the MSCI Emerging Markets Index.
“In my opinion, that’s a lot more significant than the market opening up. Having said that, the market opening up is a precursor to MSCI upgrading the market — one leads to the other,” Lee says.
The process is already under way, with the MSCI recently saying that it is now consulting foreign investors gauge their thoughts on a number of issues, according to Lee.
“The first one is regarding the QFI rules and were they comfortable with that. The second one is the potential constraints due to the 20 percent foreign ownership limit for each security. The third one was regarding settlement — Saudi operates a ‘T+0’ settlement cycle, and are investors comfortable with that — it means you have to pre-fund your trades. The fourth factor is the comfort level that a foreign investor has with regards to operating both custody and trading accounts,” he says.
Once foreign investors say they are comfortable with these issues, the process will then go through a review stage.
“From then, after about 12 months, if all goes well with their review with foreign investors, MSCI will then likely announce that the Saudi market could be included in the Emerging Markets Index. There’s a 12-month implementation period post the announcement, which means we could see 2018 as a possibility for Saudi Arabia to be officially included in the Emerging Markets Index. The CEO of the Tadawul has come out to say that their target is for 2017, which sounds a bit of a fast-track. If they can get it by 2017, that would be great,” Lee says.
There are also potential benefits for neighbouring markets in the UAE and Qatar, whic could see greater interest from big foreign investors who may have shunned the region when the Tadawul was closed.
Sebastien Henin, head of asset management at Abu Dhabi-based The National Investor, says the inclusion of the kingdom in the MSCI benchmark could change this.
“So far we have only three countries in the region included in the MSCI benchmark, and they have a combined weight of 1.5 percent. We have Qatar, the UAE and Egypt, but it’s very small. We know at the same time that the region is a bit complicated to understand due to geopolitics and the fact that these economies are all oil-driven, so most of the time investors are not necessarily aware of these economies and at the same time the weight is so small that it’s really easy for them to ignore these countries,” Henin says.
“What might be a game-changer — it will probably happen in a couple of years — is when Saudi Arabia is also included in the benchmark, we will have a combined weight not too far from 4 percent. With this weight, it will be more difficult for foreign investors to ignore the region,” he adds.
With a deep market that’s very liquid, the Tadawul offers investors some attractive investment opportunities, Henin says.
“What is interesting is you have in the petrochemical sector some giants such as SABIC, with $80bn-plus of market cap. What is very interesting for foreigners, what they would love with SABIC, for instance, [is] the fact that it has such a low fixed-stock cost is very appealing for foreign investors because they will be able, even in a difficult environment, to fail with good profit margins. We have seen that recently during the first quarter of the year. Despite the fall in oil prices, it has been able still to secure some good profits, so I think this defensive aspect will be very interesting,” Henin says.
Foreign investors will also have access to an Islamic finance giant in Al Rajhi Bank, the largest listed Islamic lender in the world.
Sfakianakis believes the non-oil sectors will attract investors in the years to come.
“It’s all about the demographics, the retail, healthcare, food, it’s all about the people side of the story of Saudi Arabia. It’s all about the domestic economy, the dynamics of the local consumer more than the petrochemicals, and all these things that are impacted by low oil prices.
“And of course, selectively, the banks. As banks, they will be re-rated given that as interest rates rise in the US, things will look better for them over this side of the story. I think it’s all about the companies that have a very good base on anything related to wholesale retail, consumption, food, healthcare, a bit of real estate,” he says.
Lee says foreign investors will need to understand where the structural growth and demand drivers are in Saudi and compare the valuations of these stocks with alternatives they can find in other emerging markets.
“I think areas that are under-penetrated in Saudi include the banking, insurance, healthcare and consumer sectors. They will have to look at these and the growth they get in earnings from these companies, look at the valuations and compare these to other emerging markets. If the numbers stack up well, I think they will come in.
“The consumer sector does look quite interesting in Saudi. The valuations are not cheap relative to the market itself, but relative to other emerging markets they do stack up pretty well in terms of earnings growth and valuations,” he says.
The timing of the opening of the Tadawul to foreign investors comes after many years of talks. Rumours were more persistent three or four years ago when the market was weak, but now the time has come, the move appears to be have been driven by a number of factors.
“I think the authorities have two views on that,” Henin says.
“The first is to improve the efficiency, in order to avoid having the market driven by retail investors. The second aspect, which is maybe less relevant these days, is to attract money, not necessarily because they need money in terms of the capital market because of some project they want to finance, because there is enough money in Saudi Arabia. But maybe to support the price of listed companies in the stock exchange. This aspect is less relevant these days because the market has performed pretty well. The third one, maybe more political, is to be more open to the world. To open the stock exchange is an important step in any country so we can look also at that as a general opening for the country.”
Sfakianakis says the decision is also based on opening up the economy and transparency among the companies.
“I think the opening up of the market is part and parcel of the opening up of the economy. This was the last and only remaining major reform that was waiting to happen. We have been talking about the opening up of the market for the last four or five years. It had to be done. I think the main reason for doing it was transparency governance — they want to make companies more open and a level playing field, rather than just the interest to have more money to come into the market. I don’t think it’s motivated primarily by money,” he says.
The price of oil will, of course, play a key role in any overseas investments, as well as any possible escalation in the geopolitical issues along the Saudi borders, particularly in Yemen. Sfakianakis says there are a number of factors to watch out for over the next six months.
“The second half of the year will be all about oil prices and spending, and of course towards the end of the year, the budget. I think these are the three key things that we’re going to be watching for.
“And come July, we’re going to have the second quarter results from the companies, which should feed into the recovery that we expect should happen. Over time, for the rest of the year, the market should do quite well,” he says.
Investors around the world will certainly be keeping an eye on the Tadawul, and the many issues that affect the kingdom and its economy.
A stockpicker’s guide to the Tadawul
Hootan Yazhari, head of MENA and global frontier markets research at Bank of America Merrill Lynch, explains which equities are catching his eye.
Given the relatively challenged fundamentals and rich valuation, our preference is to focus on companies which have exposure to our key investment themes in Saudi Arabia, as well as specific catalysts which could underpin outperformance. We see a number of structural trends in the Saudi economy and in particular highlight:
r Low penetration levels, improving education and a rise in disposable income which should benefit the consumer and healthcare sectors. We highlight Jarir, Al Othaim, Al Hammadi and Almarai as our top picks on this theme.
r Significant potential to benefit from the US rate cycle via the Saudi banks where Samba and SABB are our top picks.
r Ambitious growth plans in infrastructure and housing, which could positively impact cement demand. Our preferred name is Yanbu Cement, which also has one of the most attractive yield stories in the market.
r The ability to benefit from a future recovery in oil prices via the low cost Petchems sector as well as attractive capacity additions. We highlight Sipchem as our top pick.