Saudi Braces for Change

Euromoney, June 2015

May saw the announcement of the final rules from the Saudi Arabian Capital Markets Authority, heralding the opening of the country’s stock market to foreign institutional capital – starting this month. How will the market change as foreigners come in, and who benefits? And how long will it take before foreign institutions are comfortable enough with the technical side of Saudi trading to move in? By Chris Wright

Credit where it’s due: Saudi Arabia’s Capital Markets Authority said it would spend several months listening to the market before announcing the final rules for the opening of the country’s stock markets, and listen it did. Granted, having listened, it then went ahead with more or less exactly the same rules it had started out with. But, after years as the world’s most inaccessible major emerging market, just listening is a sign of progressive openness.

Besides, ever since the draft rules were published to widespread surprise last August, there has been a welcome sense that the CMA knows exactly what it is doing. If foreign investors had been asked to provide a roadmap for their direct involvement in the Saudi market, the CMA’s proposals are pretty similar to what they would probably have come up with themselves: start with the big guys who are strong and long-term enough to want to invest properly in the market, rather than to short or churn it; make sure the names that matter  – the big pension funds, the insurers, the sovereign wealth funds – can come in; set caps on foreign ownership that are probably important in domestic politics, but which won’t realistically be hit for years anyway;  and then turn to the important minutiae of custody and settlement issues.

Saudi calls these qualified investors QFIs, for qualified foreign institutional investors, and has high hopes for the impact they will have on the local market. “The objective of the QFI programme is to import a specific level of sophistication and expertise,” says Abdullah Al-Kahtani, head of media and investor awareness at the CMA, “that will further support and facilitate the development and stability of the Saudi capital markets and its participants.”

Although it probably won’t be a case of the floodgates opening on June 15, international advisers say they are aware of considerable enthusiasm from qualified investors. “We are seeing a significant amount of interest from international investors looking to participate in the largest market in the Middle East, a market which is known to have strong reputable companies with solid growth prospects,” says Tamim Jabr, head of corporate and investment banking coverage at Deutsche Securities Saudi Arabia.

Financial institutions both within and outside Saudi Arabia have been pleased both by the pace of progress and the fact that it is happening at all: measures like this have been talked about for years, with steadily fading expectations that they would ever see the light of day. Now, domestic and foreign banks, custodians, fund managers and the ancillary businesses that support them are all positioning themselves for what is one of the world’s last capital markets revolutions.

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So, why is this happening?

One can see two layers in the CMA’s thinking. The obvious one is about bringing a level of international rigour to the behaviour of a somewhat frontier-spirited stock market. The other is that Saudi is changing, with a growing young population that will one day need pensions, and with an economy utterly reliant on oil supplies that won’t last forever. In this second context, the opening of the markets is about diversifying the nation’s revenue sources and building investment institutions domestically that will one day fund a country with a lot of retirees.

“The registration parameters were designed to target large well-established foreign institutions with long term investment strategies,” says Al-Kahtani at the CMA. And the hope is that this suits everybody: the local market benefits from the capital and the shifts in market behavior, and the internationals get exposure to a buoyant market.

“Saudi Arabia opening its stock market to international investors is an important development and one we strongly support,” says Ghadir Abu Leil-Cooper, head of the EMEA and global frontier markets equity team at Baring Asset Management, and manager of the Baring MENA fund. “It will allow companies to have wider access to markets and investment opportunities. As the population keeps growing and demand for jobs increases, 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.”

The point everyone makes about market behavior is about retail. “The Saudi stock exchange’s trading activity is dominated by local retail investors who tend to have larger risk appetites and shorter investment horizons, as compared to their institutional counterparts,” says Al-Kahtani. “We believe that the participation of experienced international institutions will provide more stability and further reduce volatility in the Saudi market. Furthermore, international investors will enhance our market’s infrastructure through better quality analysis and research coverage.”

There is room to quibble with that – in an interview with Euromoney in December, Adel Saleh Al-Ghamdi, chief executive of the Saudi Stock Exchange (Tadawul), called the dominance of retail investors in Saudi “a misconception”, pointing out that the ‘individual’ category of investors in Saudi Arabia includes sophisticated and institutional-like HNW and UHNW individuals, not just retail. But still, there’s no denying that it’s a volatile market, and local institutions seem to think foreign involvement will be to the greater good.

“We expect the opening of the Saudi market to international investors to have several positive implications for the Saudi capital market,” says Tariq Al Sudairi, managing director and CEO of Jadwa Investment. “First, the entry of international investors will increase the ratio of institutional investors relative to retail. This will naturally enhance the depth of the market and moderate volatility as institutional investors tend to invest with a long-term horizon and on the basis of fundamentals as opposed to speculative trading.”

Westerners would argue that this positive view rather depends on the type of institutional investor, but this is exactly why the CMA has set clear parameters about what sort of instos it wants, with restrictions on track record, investment approach and scale, none of which were changed in the review period (except to allow sovereign wealth funds in). “The whole drive about not going for hot money funds is very clear,” says Madhur Bhandari, head of HSBC Securities Services for HSBC Saudi Arabia. “The criteria they have set up are very stringent: they are trying to get the right kind of money to come in.” Under this analysis, the CMA doesn’t just think foreign institutions will lead to less volatility, but will “provide good direction to retail, and even help to protect retail investors,” Bhandari says.

The second hope, beyond dampening volatility, is that corporate governance will be lifted too. “International institutional investors tend to reward companies that apply best practices in corporate governance and build strong, professional management teams,” Al Sudairi says. Logically, the argument goes, this means listed companies will raise their game in everything from transparency to capital efficiency.

Foreigners think this theory stacks up, though they also counsel patience. “I think it will have a positive impact on the corporate governance side, although I don’t think it will happen quickly,” says Mark Diab, head of MENA equities for Man Investments Middle East in Dubai.

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For fund managers and other big institutions, there are two ways to look at the opportunity: the macro view, which tends to be very positive, and then some irksome practical matters around settlement which might slow things down a touch.

“We believe the opening of Saudi Arabia’s stock market will generate a lot of interest from global equity investors and that investments will increase significantly,” says Peter Elam Hakansson, founding partner, chairman and CIO at East Capital. His Frontier Markets Fund already has a 17% allocation in the fund, a significant overweight, through the synthetic P-note model that (until June 15) is the only way foreigners can gain exposure. “We like the fact that the Saudi stock market overall is large and liquid enough to potentially develop further into an important component in global investors’ portfolios,” he says. “With our already large exposure, we are well positioned on the Saudi market for when international investments increase.”

Many investors have stayed out until now not just because they might not like the synthetic approach but because their investment mandate might prohibit it; those investors will be able to look afresh. “A lot of institutional investors globally can’t go in through synthetic structures, and will be looking at this market, given the very strong macro fundamentals and the fact that it’s a large, liquid and broad market in the emerging world,” says Diab at Man, which is also an investor through P-notes.

When they do come in, they won’t be novices. “It’s not as if foreign investors do not know Saudi Arabia,” says Rajiv Shukla, head of global banking and markets at HSBC Saudi Arabia in Riyadh. “They have already got exposure through swap product and a large number of funds have some degree of experience with the market. Even if they haven’t already invested, you can be sure they have analyzed the market.”

Still, while the macro picture – huge and sustained government spending, demographic sweet spot, an untapped market opening up, reasonable valuations – is clearly alluring, and while institutional investors surveyed by Euromoney do not appear to be concerned about ethical matters such as the role of women or the flogging of critical bloggers, there are technical concerns about the process of trading.

“A lot of big institutions are assessing the operational side of things in terms of how it’s going to work when it does open up, particularly around settlement and T plus zero,” says Diab. “We are definitely one of those institutions who are assessing things to see if we will invest directly or continue through synthetic structures.”

This, rather than any uncertainty about the bigger picture themes of investment, is likely to be crucial in the behavior of institutional capital from day one. “There wasn’t any surprise in the final CMA rules compared to what they had previously issued,” says Diab. “The key thing is still making sure how the operational side of things will work so that people are able to go in and out and benefit from these foreign ownership rules. That is one of the reasons it’s going to take time for foreign institutions to go in: it is likely to be gradual rather than everyone jumping in on the 15^th of June.”

So what’s the big deal about T plus zero? Most developed markets operate on T plus two or three, meaning that after a trade date, there are two or three business days to settle that trade. Under T plus zero, settlement must take place the same day. On one hand, that’s a peerless level of efficiency; on the other, it can only really work in a purely local market, because as soon as you start bringing international transfers and time zones into it, you end up with odd situations. Strictly speaking, buying in Saudi from the west coast of America, you’d effectively need to settle the trade before you’d even bought it.

“The implications for foreign investors are around broker orders coming though, the ability to safeguard assets and move them around,” says Bandhari at HSBC. “Those delays will lead to a requirement to have advance facilities in place to bridge the time differences.

“You could have done a trade, let go of the asset, and what happens if it’s the wrong trade?”

Diab adds: “The extra challenge is that things have to be pre-funded, as opposed to settling two or three days later, which makes things a bit more challenging. It might slow things down in terms of immediately acting on movements in share prices if firms haven’t got funds in Saudi accounts prior to trading.”

Now, it would be a simple enough matter for Saudi to simply switch to T plus two or three, but what message would that send? That foreigners are more important than the locals who have sustained the market all this time? Consequently, neither foreigners nor locals expect that change to be made – and certainly not immediately.

“I don’t believe, in the first instance of opening up, that the Kingdom will change its market, as the majority will still be held by locals,” says Bandhari. “There is an understanding among the authorities that this is a complex issue, but don’t expect change on day one.”

After all, the fact that things aren’t greatly convenient for foreign investors today hasn’t stopped them joining the party. “The regulators will have noticed that, since the swap market came into play in 2008, foreign investors have continued to play in the market,” Bandhari says. “Similarly T plus zero is not ideal from a foreign investor perspective, but those investors are not totally unused to Saudi Arabia.”

From the CMA’s side, it expected some challenges and was ready for them. “As is the case with the introduction of any new body of regulation, certain obstacles have appeared along the way,” says Al-Kahtani. “The establishment of risk control procedures through robust eligibility criteria, ownership restrictions and monitoring and enforcement procedures was a challenging task. That said, we are confident in our readiness for the commencement of the programme.”

And while there is some expectation of teething problems, they should be surmountable. Saudi Fransi Capital, for example, did a trial run of the whole process back in 2011 – accounting opening, due diligence, know your client, transferring money, purchase order, sell order, transfer money out, account closure – and found it worked fine. “I think readiness is not a problem,” Yasir Al Rumayyan, CEO of Saudi Fransi at the time of the interview but now advising the court of King Salman, says. “Most broker-dealers in Saudi have very advanced systems.” Even on the settlement side, he said that the necessary process – providing a facility to foreign financial institutions by broker-dealers – was something they already offered to GCC clients anyway.

The verdict, then, is that foreign money probably won’t flood in as buyers find their feet with unfamiliar systems. But it’s on its way. “Our expectation is that there will be a huge amount of interest which will, over time, certainly generate volume,” says Rajiv Shuklar at HSBC. “But it is not going to be a big bang. All the big players who want exposure to this market will want to have the ability to trade, but it’s unlikely to produce high volumes from the first day. It will be a gradual process, and at the start they will be busy with the administrative work, getting ready and registered.”

Oh, and don’t expect an instant death for the P-note: it’s worked well enough for years, and for those investors who don’t meet the QFI criteria, will remain the only option for the foreseeable future. “The synthetic route has been reasonably efficient,” says Diab. “You only get the economic benefits, without the ability to vote at AGMs and nominate directors to the BOD.” But you do at least get the exposure you wanted. Bhandari adds: “There will be many investors who cannot meet the criteria for direct investment who will continue to use swaps.”

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Plenty of people stand to benefit from all this: local and international, fund manager and intermediary. “The opening of the market should have a significant and positive impact on all market participants, including the international banks active in Saudi Arabia,” says Jabr at Deutsche.

Gaurav Shah, CEO of Al Rajhi Capital, says he expects his bank to benefit “in all areas of financial services, as these are not stand-alone areas and go hand in hand.”

Brokerage is the obvious one. “We are gearing up our service position to the demands of institutional investors,” he says. “We also see increased efforts in the asset management business to cater for clients seeking managed investment solutions.”

Equally, though, Shah and others know that if the foreigners are coming in, then they at home are going to have to raise their game. “Investment firms will have to ensure that they have the latest technology supporting institutional trading platforms, quality research offerings,” and will have to hire “experienced institutional equity sales personnel capable of delivering the highest standards of client service,” Shah says. Indeed, there is already talk in Riyadh of a clamour for experienced people in institutional equity sales, and of rising salaries.

One of the best-placed institutions is going to be HSBC, in its various forms: as an international investment bank looking in, as a Saudi-based investment bank already locally entrenched, as a major partner in Saudi British Bank, and as a custodian not just outside Saudi Arabia but within it. Custody is going to be absolutely at the heart of the opportunity that comes with this new open market, and HSBC is one of the few institutions that’s going to be able to bring foreign investors in to local stocks in Saudi without having to go through a third party broker or custodian.

Everyone seems optimistic. The opening of the market “will be a positive development for the investment management industry in Saudi Arabia, and for Jadwa in particular,” says Al Sudairi. Jadwa is, in some ways, emblematic of the possibilities that a transforming Saudi Arabia represents: it dates from an earlier CMA milestone, the issuing of investment banking licences in 2006, and has since built a business with SAR20 billion in assets under management across public equity, fixed income, private equity and real estate. “We expect international institutional investors to have strong interest in the Saudi equity market given its scale, profile and growth prospects,” says Al Sudairi. “We also expect that many of these institutions will look to invest in the Saudi market through specialized local investment managers who have the geographic focus and on-the-ground understanding of the investment landscape.”

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Whatever the markets themselves do, Saudi will also judge success by the knock-on effects to local institutional nouse. “Saudi pension funds stand to gain from the stability and sophistication that large foreign institutions are expected to bring to the Saudi market,” says Al-Kahtani.

The country knows from experience that this is a process that takes time. “They have been working now for a good 10 years to get the debt capital markets to develop, and indeed they have, but we still don’t have the diversity of investors,” says Bhandari. “You don’t have the pension plans you would expect, and employee liabilities are not pre-funded. There is a lot of catch-up to do in terms of institutionalizing on that side. There is some expectation that the catalyzing of institutional activity on the equity side flows through to debt.”

There is a hope that all of the capital markets will be transformed by what happens this month. Jabr hopes to see convertibles, equity derivatives and cross-listings in due course.

But in the end, it’s all about whether the money comes in. On balance, it probably will. “Whether the market opens or not is irrelevant if the fundamental reasons to be invested in Saudi are not compelling which we think they are,” says Diab. “A lot of international investors only see the Yemen conflict and ISIS: they don’t see the massive spending the Saudis are likely to be doing over the next few years, how they are trying to diversify the economy. Those things are an important backdrop.”

BOX: IPOs

Beyond the brokerage, custody and settlement opportunity, there are high hopes that a more open market will lead to more IPOs, and a chance for investment banking fees. This one, however, is not so clear-cut.

Even with a purely domestic market, NCB became the second-largest listing in the world in 2014 last November. Since that $6 billion launch, however, not much has followed. “Although the IPO activity has been light since the NCB IPO, our understanding is that the pipeline is good,” says Shah. He says he expects around five companies to be listed this year, many of them worth over SAR1 billion. “The liquidity is quite good for IPOs in the Saudi Arabian market,” he says, “and can be accommodated without international capital,” so once foreign money does come in, capacity should be greater still. “We expect more companies to be listed in the future, and as the market opens, we expect participation from foreign investors as well, depending on final regulations.”

Jabr at Deutsche believes there is “a strong pipline of IPOs. The market has recovered over the past couple of years and there is a good sense of maturity developing in family-owned businesses who are looking to evolve and grow. We therefore expect many new issuances over the next 18 months.”

But will anyone make money from them? International banks naturally hope that they will gain mandates on local IPOs by pledging to place shares with a new international audience. But it is understood that on the NCB IPO, fees to advisers amounted to 0.1% of the proceeds, compared to 1.2% on the Alibaba sale that was the world’s largest IPO last year.

It is important to understand that an IPO in Saudi Arabia has a different set of priorities than one elsewhere in the world. It is intended as a method to distribute wealth, and so the pricing generally does not reflect demand. In NCB’s case, for example, any objective assessment of the listing would show it as ridiculously underpriced, and indeed, it rose by almost half within four days. But that doesn’t represent bad bookrunners, but national priorities.

Nevertheless, the conduct of IPOs has changed over time. “Back in 2006, there wasn’t a concept of book-building here,” says Jabr. “Now it is common practice in almost every IPO, providing further evidence that the market is developing in the right direction,” he says.

“Historically, most deals have priced at the upped end of the range, which is a sign of strong demand: investors want to get their hands on IPOs. In the future we think investors will become more selective on what to invest in, and at what price. The use of equity research therefore will undoubtedly increase.”

ENDBOX

SECOND ARTICLE: Where fund managers are likely to invest

The first thing that always surprises new potential investors in Saudi is that, not only is it not all about oil, it is actually very hard to get exposure to oil stocks. Petrochemicals are a different matter, but even then, they’re hardly dominant. “Around 170 companies are listed on the Tadawul, of which only 14 belong to the petrochemical sector,” says Gaurav Shah, CEO of Al Rajhi Capital. “The Tadawul has 15 sector indices, which says much about the diversity of the market.”

In terms of regional scale, there is plenty outside of resources and petrochems. Al Rajhi and newly-listed NCB are among the biggest banks in the Middle East, Saudi Telecom one of the biggest telcos, and Almarai one of the largest integrated dairy companies in the world, never mind the region. In materials, even if oil is little represented in listed stocks, Maaden has exposure to gold, phosphate and aluminium.

A common conclusion is that consumer will be the place to be.

“The consumer-related sectors are being driven by a young growing population with increasing disposable income,” says Diab. “The salary increases and stimulus from the government, whether to military or government employees, has given a boost to consumer driven companies.” He also likes some high-dividend petrochemical stocks, some bank stocks where he sees value, and healthcare.

East Capital Frontiers Market Fund has a 17% allocation to Saudi Arabia through the P-note method – the largest overweight allocation in the fund. “Tadawul lists several high-quality companies in some of the sectors we favour the most in frontier markets: consumer goods, retail, education and healthcare,” says founding partner, chairman and CIO Peter Elam Hakansson.

Hakansson says his fund is closely monitoring companies that give exposure to the rising middle class in those areas, plus mobile telephony and banking. “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.” It also invests in the fashion retailer Al Hokair.

“Supported by the strong demand for consumption originating from a young and growing population, the Saudi companies that we are investing in are increasing their earnings by some 15% a year, on average,” he says. “Besides this natural push that comes from the young population, low levels of per capita penetration act as another structural growth opportunity for a good number of companies in the country.” He also likes levels of liquidity in Saudi.

Other sectors are well placed too. Emre Akcakmak, portfolio manager at East Capital, notes the impact of the mortgage law that was passed in 2013 which, combined with a rising population and housing shortages, pushed residential unit prices in Riyadh up by 5 to 8% in 2014. Any visitor to Riyadh now is struck by the scale of construction underway, both residential and in the planned new financial district. Under the ground, the 178 kilometre metro should be completed by 2018 after US$23 billion of investment.

Shah adds: “The government’s recent move to tax undeveloped land is poised to accelerate real estate development and support allied sectors such as banking, cement, building and construction.”

Some opportunities are more specific. Ghadir Abu Leil-Cooper at Baring Asset Management highlights religious tourism, and has been identifying companies where tourism should drive earnings growth in the medium term, such as through the expansion of Mecca’s airport and other infrastructure, and the government increasing the annual quota of religious visas.

Some are already surprised by the level of corporate openness. “Meeting companies in Riyadh is very rewarding,” says Akcakmak. “There are many entrepreneur-led companies with professional management teams that are accessible and open for discussion on their operations and future strategies. We expect levels of investor relations activity to improve even further as the market opens up to foreign investors.”

While the oil price clearly has investors wondering about the region’s fortunes, two points are relevant: one, since foreign currency reserves are at about $750 billion and there is almost no state-level debt, there has been no impact on budget expenditures; and two, some fund managers welcomed the drop in share prices in December as an entry opportunity and have since been rewarded with a 25% bounce. “Despite the decline in oil prices, liquidity and turnover in the market continues to remain high, while the decline in stock prices has provided better opportunities for long-term investors,” says Shah. Even now, the Tadawul index is only at 14 times earnings, lower than a year ago.

Beyond that, there’s geopolitics, from intervention in Yemen to the knock-on effects of a possible end to sanctions on Iran. “But we do not subscribe to the idea that this power struggle will develop into something worse that could derail the Saudi Arabian economy,” Akcakmak says.

Investors are expected to start with large-caps like Sabic and then move down to smaller caps, particularly in consumer, and in time there will be a passive angle too. “Whether [opening] will affect valuations is another question because at least part of the opening up is already priced in,” says Diab. “But I think the market will see flows, especially if Saudi – and this should happen eventually – gets into international indices. The market is likely to see several billions of dollars of passive inflows because of that.”

This question of MSCI inclusion – when and how it happens, and what the impact will be – has been perhaps the most widely discussed subject around the Saudi markets ever since the draft rules were issued. Ordinarily, given MSCI’s rules on assessing new markets for inclusion in an index, one would expect a minimum of three years; some think two, or even less, though there is perhaps a sense of hope triumphing over experience in some of the shorter predictions. Then there’s the question of what index Saudi goes into: one assumes that common sense prevails and it leapfrogs the MSCI Frontier Index (otherwise it would make up 40% of that index) to become part of the Emerging Markets Index, by which time one would expect it to account for 4% of it. Al Sudairi at Jadwa estimates “two to three years” for all this to happen, and says: “we estimate that the Saudi market may attract up to US$40-50 billion from international investors over this time horizon.” But, despite the fanfare over MSCI inclusion, he expects only 20% of that flow to be passive, and 80% active.