Euromoney: Saudi Companies Dominate Management Poll

Euromoney, December 2014 

Saudi Arabian institutions dominate this year’s Middle East best-managed companies survey. Jeddah’s NCB Capital is the best research house, and monopolizes individual categories; Tadawul, the Saudi Stock Exchange, is the best exchange; Al Marai has the best treasury; and seven of our sector winners are listed in the country, if one considers the Saudi Mobily unit as a part of Etihad Etisalat. Perhaps this should not be a surprise, because Saudi Arabian investment – today and, in particular, for the future – is the subject on everyone’s lips in the region.

Early next year, selected foreign investors will be able to invest directly for the first time into a newly opened Saudi Arabian stock market. It’s a big moment. At the time of writing, the market capitalization of Tadawul, the Saudi Stock Exchange (tellingly, its executives now prefer the latter, more international-sounding description), stood at US$590 billion, bigger than Malaysia, Mexico or Moscow. It constitutes half the Gulf’s total capitalization, dwarfs any neighbour, and according to Deutsche Bank accounts for 45% of the entire MENA region. After several years of a cumbersome middle ground, through which foreigners have had to use a form of total return swap to gain their exposure or go through a local ETF or mutual fund, foreigners will finally be able to buy directly into the one market that truly matters in the Middle East: the biggest, the most liquid, the most diversified.

Our September edition looked in detail at the logistics of this process, explaining the Saudi Capital Markets Authority (CMA)’s proposals and the ideas and restrictions put forward in its consultation paper, whose review period will end around the time this article is published. Readers are encouraged to read that article to understand the parameters involved, but in essence, we should expect a gradual form of opening reminiscent of the one that has taken place in Chinese A-shares, in which initially access is restricted to a group called Qualified Foreign Financial Institutions (QFIs, in Saudi’s abbreviation, like China’s QFIIs). These QFIs, who will need to be licensed, can be banks, brokerages, securities houses, fund managers or insurers, but they must have at least US$5 billion under management and a five year track record. Some restrictions will apply – the headline one is an overall QFI ownership cap of 10% of the overall market – but since that represents about $59 of capital, there is considerable scope for increased foreign involvement.

That’s the how. But what about the why? What will foreign investors find when they have unfettered access to the Saudi markets? Why should they consider investing there? And how will their own presence affect the behaviour of the market itself?

There’s no question that the Saudi Arabian market represents a great deal of potential for foreign investors. It’s not just a question of the market’s scale. It is considerably more diversified and liquid than anything else on offer in the Middle East. The $6 billion IPO of National Commercial Bank which concluded in November (see op-ed) – the second biggest IPO in the world this year, despite being open only to local, or at least GCC, money – brought the total number of listed companies in Saudi to 168, in comparison to about 70 apiece in Abu Dhabi and Dubai and just 43 in Qatar. And the contrast is still more stark than that: while Dubai’s markets are dominated by Emaar companies, and Qatar’s by a handful of state-backed behemoths, there are 40 companies in Saudi Arabia with a market capitalization of more than SR1 billion – sufficient liquidity to be interesting to foreign institutional investors.  Better still, these stocks trade with far greater liquidity than is commonplace in smaller neighbouring markets. Al Rajhi says there has been an average of more than US$1.5 billion of trading volumes per day since 2008, more than all other GCC markets combined, while Deutsche puts average daily turnover volume today at US$2.5 billion, which represents 65% of all regional liquidity. “There’s no denying,” says Aleksandar Stojanovksi, analyst at Deutsche Bank, “that within the regional context, Saudi Arabia is the elephant in the room.”

Additionally, investors will find a diversity of sectors that might at first glance appear surprising. Materials (35%) and financials (34%) dominate the market – petrochemicals fitting within the materials definition – with telecoms accounting for 11% of market cap and smaller sectors such as consumer staples, consumer discretionary, industrials, utilities, energy and healthcare also represented. Compare this to the UAE, where 68% of the market is financials, and 53% in Qatar.

“We believe investor interest initially is likely to be more on the established sectors such as petrochemicals, banking and telecoms,” says Jitesh Gopi, head of research at Al Rajhi. Passive funds, he says, will track free float market capitalization, and so will favour those stocks with a higher weighting in indices; logically that makes Sabic, Al Rajhi and Etihad Etisalat the most likely beneficiaries. “Active investors are more likely to prefer strong domestic-driven sectors such as retail, food and construction, due to their strong growth potential supported by favourable government policies and demographics,” Gopi says, provided valuations remain reasonable. “High dividend-paying sectors such as cement might attract investors looking for regular income.”

Deutsche’s top picks are Sabic, Safco, Samba, STC and Spimaco – one can build a reasonably diversified portfolio in Saudi without ever venturing far from the letter S – and they are likely to be common picks among early investors looking for reliable stocks. Al Rajhi has overweight recommendations on Sabic, Sipichem, Safco, NIC, SPC, STC, Ma’aden and Shaker. We also get a clue of investor interest in the selections of foreign investors through swap structures to date. “The investors who are in the market today will be a proxy for what investors will buy when the market is open,” says Stojanovksi. “The investor base has been very keen to play domestic themes. So anything that has exposure towards the consumer space and the demographics of the region has been attractive, and that will probably be a central theme as the markets open.”

Sabic will be a natural first port of call for investors, through its sheer size. The petrochemical company accounts for more than 13% of the market and has a market cap almost three times the size of Saudi Telecom, which follows it, although in terms of free float market cap it is less dominant (Al Rajhi, with 9.88% of the market, follows on that metric, and then Etihad Etisalat). “The investor base will probably divide into two tiers,” says Stojanovksi. “Those who are already knowledgeable in the market will be looking for second and third tier stocks. Newcomers who now have access to the market will initially spend more of their investor dollars in large caps: Sabic will feature prominently, and some of the financial institutions.”

Others see opportunity in less well-trodden sectors. The Kuwaiti group Markaz, for example, recently put out a report on the Saudi insurance industry. Raghu Mandagolathur, the report author, notes that the industry generated a CAGR of 18.2% between 2008 and 2013, compared to a global figure of 4%; and notes that while US$6.7 billion in insurance premium volumes is tiny on a world scale, the potential is enormous. Saudi already constitutes 51% of the global takaful market, the Islamic equivalent of insurance, and is steadily growing since the government made health insurance mandatory for all nationals. “The opportunities for both local and international insurers are enormous,” says Raghu.

Indeed, the one area that’s hard to find exposure to is oil. “Investors have a limited ability to invest in hydrocarbons in the Gulf,” says Asha Mehta, lead portfolio manager for fund manager Acadian’s frontier market strategies.

Buyers shouldn’t necessarily expect low prices. “Despite the absence of foreign investments, the Saudi market does not offer any obvious bargains in terms of valuations,” says Stojanovksi. At the time of the CMA’s announcement, the Saudi market was trading at a 2015 price-earnings ratio of 13.2 times, just above MENA’s 13.1 times. Price/book (2.5 times) and return on equity (19%) were both modestly above the MENA region, and dividend yield, at 4.1%, slightly below. “While the opening of Saudi Arabia should be positive on many fronts, we expect MENA investment to remain a stock picking game,” says Stojanovski.

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Then there’s the question of how the arrival of foreigners will impact the market itself. Deutsche estimates that foreigners own less than 1% of the market, compared to 7.5% on average in Abu Dhabi, Dubai and Qatar (although see the accompanying article for the Saudi Stock Exchange’s own perspective on foreign ownership – much depends on how one defines the role of other investors in the GCC). If foreign buyers follow that pattern, Deutsche says, we could see US$35 billion of incremental foreign inflow, in comparison to the US$4 billion that has accumulated since indirect ownership was first permitted in 2009. HSBC, for one, has been conducting roadshows in Europe and the US to showcase the idea of international investment into Saudi.

The hope is that foreigners in some sense improve market behaviour – in the sense that they are likely to bring down volatility and increase governance – and so create a virtuous circle through which the market becomes more attractive for foreign and local capital alike. “We see the opening up… as a significant step in the evolution of the Kingdom’s capital market,” says Gopi at Al Rajhi. “The move will lead to more institutional participation, an improvement in transparency and disclosure practices, an increased focus on fundamental themes and drivers, and better access to long-term capital, while reducing the overall volatility in the market over the long-term.” That, in turn, should encourage more private companies to list, says Gopi, increasing still further the depth of the market.

This raises a question: will market openness, in itself, lead to a bigger pipeline of new IPOs? This splits opinion. Some say there’s plenty coming to the markets anyway, even after NCB’s jumbo arrival. “I don’t necessarily think that just because you open the market you would see a lot of companies wanting to issue,” says Stojanovski. “It has not been a challenge for companies to raise money domestically even without foreign investors.” But he adds: “relative to the region, Saudi historically and going forward would always feature much more than other markets in new issuance.” And whatever the cause, some in the market expert 20 to 30 new or follow-on capital raisings in the first year or two after the markets open.

Much is written about the dominance of retail investors in Saudi Arabia – though, again, Saudi Stock Exchange CEO Adel Saleh Al-Ghamdi offers a different perspective on this in the accompanying interview. Nevertheless, the way that foreign institutions and local retail investors mix in the market will be crucial to its behaviour and development.

Locally, brokers are keen to stress the positives of the way the market works. “Higher retail participation provides much needed liquidity for the market, which is a major criteria for institutional investors,” says Gopi at Al Rajhi. He, like others, cites CMA data showing the curiosity of the Saudi market: retail constitutes 85% of the trading turnover yet only one third of market ownership. “We believe that with higher foreign institutional participation in the future, we might see increased focus on market fundamentals rather than on short to medium term factors, resulting in lower volatility in the long run.”

“Retail investors will continue to have a major role in the market,” says Gopi, “which is needed from a liquidity perspective. In our view, a qualitative shift towards more fundamental-based trading is preferable compared to a quantitative drop in retail participation.”

Foreign involvement will be particularly significant if it leads to inclusion in the MSCI Emerging Markets index. Nobody expects this to take place before 2017, since the approach of MSCI is normally to watch the country for three years prior to including it in an index; the May 2017 review would therefore be the first possibility for an upgrade, and even then, that may be a year or two early. Still, it is now being widely talked about as a possibility for the first time. Deutsche estimates the weight of Saudi in the EM index would be 1.86%, bringing the combined weight of the MENA region to 3% from 1.05% today. “We estimate the incremental fund inflows due to eventual MSCI EM promotion could reach up to US$10 billion, including US$1.5 billion from passive EM funds and US$8.5 billion from active EM funds,” says Stojanovski. Al Rajhi believes that Saudi would represent more like 4% in the EM index. “We believe the Kingdom could enter international indices sooner than later,” says Gopi.

Then there’s an important structural issue to consider.

Because of the dominance of local retail in domestic turnover, the market structure has been geared towards them, most obviously with a T+0 settlement structure. “For them, the current settlement structure works wonderfully,” says Arindam Das, head of HSBC Security Services for MENA. “It’s very efficient, and everything gets settled immediately, within the day. But when the same cycle is extended to foreign investors it doesn’t quite work.”

That’s for a number of reasons. One, foreign investors typically appoint a broker to execute the trade and a custodian to settle it. These are two different entities undertaking two different processes. Ordinarily, it takes time – typically two days, sometimes three – to put the necessary funds in place and match the custodian instruction with the execution of the local broker, and this is why in most markets the model is T+2 or 3. “Saudi, with T+0, makes this extremely challenging,” says Das. “A trade, once done, will immediately settle and the sub-custodian may not be able get the instruction from the global custodian to match with the allegement from the local broker the same day.”

Two, this raises a question about pre-funding. Trades normally go through only if there is an adequate cash balance in the account, meaning investors will need to keep Saudi riyal balances in their accounts in expectation of trading, whether they end up buying or not.

Three, under the T+0 model, once shares are sold, it will be impossible to reverse a trade even if the investor believes that this was an unauthorized or erroneous trade. “Those shares will go out irrespective of whether the custodian approves the trade or not.”

What can be done? There is a proposed new independent custody model, in which the subcustodian becomes the clearing member and hence receives the sale proceeds, reducing counterparty risk considerably, which may help. “However, I’m not sure that all the other changes, like extending the settlement cycle, can be made before the market opens to foreign capital in early 2015,” says Das. “Not necessarily because it’s technically difficult to change, but because it is subject to acceptance by the market and local authorities.”

Much as the CMA and Saudi exchange want to accommodate foreign investors, it would be unreasonable to expect them to change everything about market practice in order to do so. “They would have to be very clear that this change is beneficial for everyone in the market rather than just one investor segment,” says Das. “They would need to be sure what would happen to the local investors who account for 90% of trading, and it’s a valid point: you can’t change the whole system for the benefit of 10% of the investor base. They will want to take a decision after careful consideration of the pros and cons, and that’s not going to happen in the space of the next few months.”

In the meantime, brokers and custodians will need to persuade foreign investors to pre-fund, or to make credit facilities available to them in order to allow a swift purchase and settlement of trades. “We will need them to have standing instructions for settlement from global custodians, and if there is then a dispute, to take it to a dispute redressal mechanism.”

Be that as it may, custodians like HSBC – a powerful presence locally in Saudi Arabia as well as internationally – perceive a clear chance in Saudi’s opening. “It’s a huge opportunity,” says Das. “In Saudi we have most international global custodians and broker-dealers signed up with us, but because foreign investors can’t yet invest in the stock market, assets so far through that route have been negligible compared to the size of the market. Now, the market opportunity pretty much doubles. We have effectively been playing in a field where half that field was closed for everybody.”

It’s interesting that HSBC, and other global custodians, will not only gain an opportunity with Saudi but will be expected to help it take shape. Under draft regulations, the CMA has created a category of intermediaries called AAPs (Assessing Authorised Persons), through which authority is delegated to assess applications of foreign investors who want to come in. There is already a list of APs, or authorised persons, including both custodians and brokers; any of these will be able to apply to become an AAP, and HSBC is one that will definitely do so.

This delegation “is an extremely progressive step,” says Das. “It took 20 years before India came up with its FPI [Foreign Portfolio Investor] system, where custodians have the authority to decide the eligibility of applicants wanting to become FPIs. Going to that stage straightaway in a market that is opening up for the first time is very significant.” Moreover, the CMA has then imposed upon itself a very short timeframe to decide whether investor documentation is in order, and gives itself just three days to overrule any custodian’s decision on an appropriate investor. The effect is that custodians are not just a first line of defence putting recommendations in, but a real authority. “Our determination should be final unless the CMA chooses to overrule it.”

Combined with the fact that the CMA announced a three month review and consultation period – which many market participants have taken part in, saying that they feel they have been listened to, even if their advice is not ultimately taken – there is a clear sense that Saudi’s regulators are trying something quite new here, with a consultative approach quite unusual in this often insular country. But is it ready for the onslaught? Locals are confident, noting that several steps in recent years – such as aligning working days with other GCC markets and gradually improving corporate governance – have led towards this. “We believe the Kingdom’s regulatory environment is ready for foreign investors, and the regulators are well prepared to address any specific needs as we move forward,” says Gopi.

There is, perhaps, a ceiling to what we should expect from Saudi openness, and not everyone is wholly optimistic. “To be a financial centre, you need to create an environment where market participants are happy to live and work: bankers, sponsors, investors, the whole range of participants that make a financial centre tick,” says Paul Harter, Dubai head of law firm Gibson Dunn & Crutcher, which among other things is a leader in Middle East M&A. “Saudi is never going to be a place that is going to attract that kind of talent in any significant numbers. Dubai is just an hour away and is an extremely open society, even by western standards.

“Saudi Arabian regulation is not at all suited to international commerce,” he continues. “The insolvency law dates from the 1930s. It still provides for mandatory incarceration of categories of bankrupt persons and, by inference, for directors of bankrupt companies. I believe the Saudis are going to be forever unwilling to implement not only the legal structures but the physical environment it would need.”

Still, being a financial centre is not really what Saudi is aspiring for here; more a gradual opening in order to develop its capital markets and create greater efficiency in capital raising for its companies, and a more sophisticated and rigorous market for its own pension institutions to invest in when the moment arrives for them to develop. In that respect, living norms in Riyadh aren’t really the point, so much as a market environment that international capital finds acceptable. It appears that the last remaining closed market of significant size is on its way into the global fold.

BOX:

Adel Saleh Al-Ghamdi is the chief executive officer of Tadawul, or the Saudi Stock Exchange, as he now prefers to call it – a sign in itself of the increasing attention he and his institution are paying to the world outside Saudi Arabia.

Asked how the opening of his markets to foreign capital will affect the exchange, his first comment is to point out that Saudi is not totally isolated from the rest of the world. “It is worth noting that the Saudi capital markets, to a large degree, are already open to foreign investment flows,” he says. “Indeed, the ETFs and mutual funds markets have no legal or regulatory restrictions inhibiting direct foreign investor participation.” Through these methods, foreigners – including those in the GCC, foreign strategic shareholders and resident foreign investors – already held 8.2% of Saudi Arabia’s market cap by June 2014.

The new CMA rules, he says, “will simply serve to widen the access channel” so that foreign institutional capital joins those investors who have been using the Saudi Equity Swap Framework, the indirect model that has been available since 2008.

If this sounds like he is making light of the step his exchange is about to take, it is perhaps a preamble in order to demonstrate that the Saudis are not taking a blind step into the unknown, more an extension of something that started some years ago. Nevertheless, it is clear that this next step will be transformational. “We expect the new rules, once approved by the CMA, to reposition the Saudi Stock Exchange as a more inclusive international exchange able to compete, as we go forward, with our more developed international peers,” he says. And this is the point: competition.

“We expect the impact on the capital market as a whole to be more profound,” he says, specifically citing enhanced reporting, investor relations and corporate governance through a higher level of shareholder activism, a more diversified and sophistication institutional investor base with longer term investment horizons, and the promotion of more advanced market infrastructure, including broader and more sophisticated research coverage.

That’s the advantage from the local perspective. Why should foreign investors take part? “Saudi Arabia benefits from strong demographics, a healthy economic development pipeline, and comprises the largest and most liquid stock market in the Middle East and North Africa,” Al-Ghamdi says. “Investors naturally gravitate to such markets, particularly sophisticated foreign institutional investors,” he says, citing the flow of foreign capital into emerging markets over the last decade. “As a market that is relatively new to foreign investors, the diversification benefits of investing in the Saudi market will also be quite compelling.”

He speaks, once more, of competition, on a local level in the Gulf, calling the Riyadh bourse “the exchange of choice in the Middle East and North Africa. We expect regional issuers to be drawn by the comparative advantages our platform provides them versus their local venues,” he says. “Ultimately both issuers and investors are attracted to well-regulated, highly liquid markets.”

When Euromoney asks about the dominance of retail investors in Saudi Arabia, Al-Ghamdi describes this as a “misconception,” pointing out that the ‘individual’ category of investors in Saudi includes sophisticated and institutional-like HWN and UHNW individuals, not just retail.

In any event, foreign investors active in Saudi through the swap framework have historically shown a negative correlation to Saudi individual investors in the way they invest. “If this trend continues, it follows that foreign institutional investment flows, under normal market conditions, will ultimately serve to reduce the level of volatility in the market versus historical measures.”

Al-Ghamdi says the IPO pipeline “seems quite healthy”, even after the SAR90 billion National Commercial Bank listing. “IPO activity is intimately linked to market valuations, in the sense that issuers become more likely to undergo the transformation process and come to market when valuations are rising, as they have been during the course of 2014.” The exchange has an outreach programme targeting family-owned businesses, and the feedback from that programme suggests a positive outlook for IPOs, he says, in addition to a number of listings expected from the finance leasing sector in light of requirements in the Finance Companies Control Law, which was issued in 2012.

Al-Ghamdi has been busy ahead of Euromoney’s interview, working with the Capital Markets Authority on initiatives relating to the changes ahead. The initiatives, he says, will give his exchange more of a leadership role in developing listing rules. “We are hopeful that this will set the stage for significant capital market developments over the next five years.”

While the timeframe for opening the markets has been a CMA decision, there’s no question that both exchange and regulator have watched Qatar and the UAE’s upgrades to the MSCI Emerging Markets index. “The well-deserved upgrades to the UAE and Qatar have improved coverage of the region, enhanced foreign and local investor confidence, and will serve to foster further development of international best practices in surrounding jurisdictions,” says Al-Ghamdi. But he’s keen to point out, too, that the two markets have nothing like the scale of his. “The Saudi stock market, from a GCC context, represents 50% of market capitalization and more than 70% of trading value, where more than 40 of the top 100 listed companies in the region are actively traded, and where the most sophisticated and diverse range of electronic trading and subscription channels are available to access the market. We have our own compelling story to tell.”