The Seismic Change in Saudi’s Equity Markets

Euromoney, September 2014

For years Saudi Arabia has been the ultimate stock market loner, combining size and depth with stubborn inaccessibility. A market as big as Russia’s, the Saudi equity market has been closed to all foreign investors bar those who are prepared to tolerate an inefficient and sometimes murky system of swaps and P-notes; those who want direct exposure to the hydrocarbon-rich Gulf have instead had to go for the more open, but significantly less mature, markets of Qatar and the UAE.

But apparently, that’s all about to change. In July, Saudi Arabia’s Capital Markets Authority made a momentous announcement: that foreigners would be allowed to invest in listed shares, starting at some point in the first half of 2015.

This is a very big step, on three metrics: the evolution of Saudi’s capital markets and, consequently, economy; the boost it will give to foreign investor interest in Saudi and the broader region; and an important broader political and social dimension about the opening of a secretive and cautious state. “Saudi Arabia is the last major equity market where foreign investors have had only restricted access,” says Gaurav Shah, CEO of Al Rajhi Capital.

Saudi Arabia’s stock market has a market capitalization of US$590 billion, one of the largest in emerging markets. It is, by a distance, the biggest in the GCC; it accounts for about half of the region’s total capitalization. But it is, today, very difficult to access. Foreign investors access the markets either via swaps – “which give them only restricted ownership rights at higher trading costs”, says Shah – or through a vehicle known as P-Notes or participation securities (which are themselves a form of total return swap).

In August, the CMA put out some draft rules shedding light on how exactly greater openness will be achieved, and there appear to be clear parallels with China, which began opening its own domestic markets by allowing only qualified institutional investors into the market.

These are just proposals, under a 90-day consultation period, but in a market that’s not exactly known for democratic consensus-building it would be a surprise if much changes in the meantime. The proposals refer to Qualified Foreign Financial Institutions (QFIs), very similar to China’s Qualified Foreign Institutional Investors (QFIIs), which will at first be the only foreign entities outside the Gulf to be permitted to invest directly. QFIs can be banks, brokerages, securities firms, fund managers or insurance companies, but must have at least SAR18.75 billion under management  (US$5 billion) and a five-year track record in securities and investment.

There are also foreign ownership limits, as there were when India and China opened up, and as still apply in most of the Gulf. Each QFI and its affiliates can own a maximum of 5% of a company’s shares; all foreign investors together (including other Gulf states) are capped at 49% of any issuer, and all QFIs together, 20%; and in aggregate, QFIs can only own a total of 10% of the whole market.

Despite the restrictions, it’s very likely that foreign fund managers will jump at the chance. “There’s still uncertainty about exactly how and when it will occur,” says Asha Mehta, lead portfolio manager for fund manager Acadian’s frontier market strategies. “But given the breadth of the market, it’s likely to be a very significant event for emerging market and frontier investors.” According to data from Al Rajhi, foreign investors were net buyers in 11 of the 12 months of 2013 despite the irksome swap arrangements imposed upon them, investing a net SAR5.4 billion in the course of the year. It’s true that they took profits in early 2014 but in July, the month of the announcement, they put in a net SAR1.9 billion.

Saudi simply offers a great deal that other regional markets do not. It is not just big, but economically diversified in a way that markets like Qatar and Abu Dhabi are not; alongside petrochemicals one finds banking, food, construction, real estate and retail stocks (indeed, one of the hardest things to find is, surprisingly, pure oil exposure. “It often surprises investors that they have a limited ability to invest in hydrocarbons in the Gulf,” says Mehta. “Very few oil and gas companies are listed.”) There are more than 160 companies listed on the Saudi market, compared to about 70 apiece in Abu Dhabi and Dubai and just 43 in Qatar.

We don’t yet know if some industries will be off limits to investors. “One thing we can probably count on is that the industries of national security, or of national interest, are unlikely to be liberalized in a substantial way,” says Mehta. But Al Rajhi points out that there are 40 companies in Saudi with a market cap of more than SAR1 billion, and that Tadawul – the Saudi exchange – has averaged US$1.5 billion in trading volumes per day since 2008, more than the rest of the Middle East’s markets combined. So even if some companies are off-limits, there’s still room for stock selection. “Saudi Arabia provides investors with more diversification and breadth than other GCC markets,” Shah says.

That creates an opportunity for thoughtful fund management that hasn’t really existed in Gulf states previously. “It presents a ripe environment for active stock picking,” says Mehta. “There are very few markets across the globe today that have this kind of opportunity and that are not represented in portfolios already. We see lots of interesting, compelling stocks.”

On top of that, it has a very positive economic and demographic story to tell. GDP is expected to grow 4.4% in 2014, supported most obviously by oil but also an expansionary fiscal policy from the state, and a young population (half the country is under 26) with increasing disposable income. It has a stable political climate – for the foreseeable future anyway – and has, frankly, managed to buy its way out of the Arab Spring revolutions that swept through other Middle Eastern nations. On top of that, the riyal is pegged to the dollar, so for dollar-based investors there is no currency risk either. There is even a case to be made that it represents a hedge against rising crude prices, in a way that India and China – as net importers of oil – can never be.

Barings Asset Management assesses companies and countries on growth, liquidity, currency, management and valuation. “Let’s go through Saudi,” says Ghadir Abu Leil Cooper, head of the EMEA and Frontiers Equity team at Barings Asset Management. “In terms of growth they have domestic demand, an export market for oil products, and fixed capital formation, so GDP growth is very well supported in the next few years.” Liquidity and the currency are not an issue; management? “For us, since we started covering that market, the level of access has improved.” The huge presence of retail investors in the Saudi market “puts a lot of pressure on companies to pay back money through dividends: you have a lot of discipline of companies returning to shareholders.” And on valuations, although the whole of the Middle East is at a premium to emerging markets, she argues it is justified by higher return on equity. Put it all together and, even with the restrictions and headaches around exposure, Saudi accounts for 11.7% of Barings’ Frontier Fund and 17.5% of its MENA fund.

Logically, openness ought to improve the condition of Saudi issuers, thus increasing the appeal still further. “We believe the opening up of the Saudi capital market would be a significant step in the evolution of the Kingdom’s capital market,” says Shah. “The move will lead to improved institutional participation, 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.”

“The better market access will lower the implied risk premium for the market leading to a lower cost of equity,” Shah adds. More privately-held companies should be attracted to list on the market, making it deeper and broader, once again making it more attractive for foreign institutional investors. The idea is a virtuous circle.

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So why open?

Ghadir at Barings believes it represents part of a broader understanding in Saudi Arabia that some changes are needed. “I think this is a necessary step from the Saudi side,” she says. “They realise there are benefits to opening their market for a few reasons. The first is very clear: they will not be able to look after their population forever from the endowment they have from oil and gas. They have a very young population that is growing and needs jobs, so they need a dynamic and open economy in order to do that.” An open capital market, allowing wider access to funds, helps create that environment, she says.

“The second side of it,” she says, “is the amount of infrastructure projects that are going to have to be funded.” Then there’s the long-term. “What we have at the moment is a job creation/employment/young population issue. But that becomes a pension issue going forward,” she says. “You need fully working markets by then to allow a full range of savings products to pay for those pensions.”

For those who have dealt with Saudi for many years, this decision to open is something of a surprise. “I used to say: not in my lifetime,” Ghadir says.

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Investors are already thinking further afield to potential MSCI index inclusion for Saudi Arabia. Its absence from any major index, caused by its inaccessibility, means that a considerable bloc of capital just doesn’t feature in investor portfolios at all; index accession would make it not only attractive but a necessity for passive funds to gain Saudi exposure. It is understood that if Saudi were to be added to the MSCI Frontier Market Index, it would represent more than 60% of it. That’s clearly ridiculous and inappropriate, so it would more likely go straight to the emerging markets index, where it would account for a 4% weighting.

There is a precedent for this. Qatar and the UAE, after several years on MSCI’s watch list, both graduated to the emerging markets index this year, and the experience has no doubt been closely watched by Saudi’s CMA.

To take Qatar as an example, the decision to open the capital markets to foreign investors in 2005 was the first step in a long process that eventually took it to being accepted into the MSCI Emerging markets index in 2013, an acceptance that finally took effect this year. Several points about the Qatar experience are relevant for Saudi: one, the length of time involved, and Saudi should be realistic about how long it will take from this step to lead to MSCI inclusion; two, the behaviour of the market, which trebled in a year and a half following the first liberalisation steps before falling most of the way back to where it started within a year later; and the practical impact of an increase in liquidity and depth to the market. Also, it’s worth noting that when Qatar increased its foreign ownership limits on listed companies from 25% to 49%, it was in the bigger stocks, particularly the major banks, that the foreign ownership levels increased in practice. Perhaps this is to be expected in Saudi too: one might expect investor interest to focus in the early days on the household names like Sabic (at 13.22% of the domestic index, the biggest stock in Saudi Arabia), Al Rajhi, Etihad Etisalat, Saudi Telecom and Samba Financial Group.

Qatar is not, by any means, fully open. “To me, running a MENA fund, I still have to do things like moving money to a trading account, and it still looks, sounds and feels more frontier than emerging to me,” says Ghadir at Barings. “But they’ve done enough to make MSCI happy to include them in the MSCI indices.” So full openness is not required for index inclusion, a point Saudi will have noticed with interest.

Qatar is also interesting in that it has been allowed MSCI ascension without fully removing foreign ownership limits. Also, foreigners don’t own much of it anyway: 9.6%, compared to 5.9% in Abu Dhabi and 13.6% in Dubai.

For this reason, those in Saudi don’t find the initial 10% limit particularly restrictive. Shah points out that the combined foreign holdings in Qatar and the two UAE bourses – US$33 billion – Is lower than the implied $50-60 billion potential suggested by the 10% cap that will apply in Saudi. “We believe that the cap is not an immediate concern and with the slew of IPOs lined up, the total market value and the investment potential will likely increase going forward,” Shah says.

Nevertheless, a 10% ceiling on foreign ownership of the market is unlikely to cut it with MSCI. “Getting inclusion in the index will be driven to some extent by foreign ownership limits and access to the market,” Mehta says. “Look at China A-shares not being allowed in to the emerging markets index.” This is a reference to MSCI’s decision, announced in June, not to include A-shares in its emerging markets benchmark, largely because the QFII programme there is not sufficiently open. China’s QFII quota at the time was $86 billion, considerably more than is envisaged in Saudi.

Even when Saudi is considered a candidate for MSCI inclusion, the approach is for MSCI “to watch the country for three years prior to including it in an index,” Mehta says, so in any circumstances index inclusion is still several years away. Mehta says May 2017 would be the soonest it could possibly happen, and there’s no certainty of that.

Indeed, after all this time, why rush? “You wouldn’t think they would open completely: it wouldn’t be in keeping with their conservative habit of doing things gradually,” says Ghadir. “Their peers around them are not fully open, and there’s no advantage to be gained from leadership.”

One impact of foreign entry could be a shift in the behaviour and dominance of retail investors in day-to-day trading. According to the CMA, retail investors accounted for 87% of the trading turnover in the Saudi market in the first half of 2013, despite holding only about one third of the market by value. Institutions hold most of the stocks, but don’t trade; they’re barely 10% of trading turnover.

Finally, there’s the bigger picture. “The opening of the Saudi stock market may be part of a gradual openness in the whole Saudi economy – even its society. Nobody is suggesting that Saudi is about to become a democracy overnight. But the Arab Spring did not go unnoticed by Saudi’s ruling elite, and in the various packages that followed we saw the first hints of greater concessions to the masses.

BOX: The law

While foreign investors are likely to find Saudi investment very attractive, lawyers say they should consider the legal environment too. “One of the difficulties with Saudi is enforcement and recognition of court processes, in terms of transparency and consistency,” says Mayank Gupta, a partner in the finance group at Mayer Brown. “Yes, the Saudi courts have a very specific set of laws, but it has been very difficult historically to enforce against specific classes of assets.”

“If you’re a foreign institution lending into a Saudi borrower and your collateral is based on taking Saudi security, the number one question is, if there’s a default, how do you enforce against that Saudi security? It’s incredibly difficult and I don’t think opening up the stock exchange is going to change that.”

Nevertheless, Gupta believes the intention is for a legal environment that fits international participation. “The opening up of the stock exchange is a welcome development and demonstrates that the Saudis are serious about becoming a hub for foreign investment,” he says, noting that recent changes to arbitration legislation represent another move in the right direction.