[2007-08-01]  Saudi Equity Market Is Starting to Look Attractive
Saudi Arabia's economy has shown an impressive growth during the last few years and the Kingdom is expected to see a huge surge in foreign direct investment by 2010. This anticipated increase is likely to be driven by the opening up of key sectors to outside investment, such as petrochemicals, telecommunications, power, mining, infrastructure and the development of six economic cities across the country.

The continuous efforts of the government to diversify the national economy and increase the contribution from the non-oil sector are paying off. Despite high oil prices and increased revenue, the share of the oil sector has been averaging around 40 percent of Saudi Arabia's GDP. This diversification has reduced Saudi Arabia's investment risk and has been confirmed by Standard & Poor's recent revision of the country's sovereign rating. On July 16, Standard & Poor's raised its foreign and local currency long-term sovereign credit ratings on the Kingdom to 'AA-' from 'A+. The country's outlook is stable.

With a GDP of SR1.296 trillion ($345 billion), Saudi Arabia is the largest economy in the GCC region and has the largest stock market in terms of market capitalization. As of June 30, 2007 the Kingdom's stock market capitalization stood at SR1.111 trillion, or a shade over 36 percent of the GCC's total market capitalization.

After hitting a record high of 20,634.86 points in February 2006, the Tadawul All-Share Index (TASI) has lost more than SR1.96 trillion in market capitalization over the last 16 months. In 2006, the TASI declined 53.26 percent, making it the worst performer in the region.

There have been several reasons cited for this massive correction including lofty market valuations, deceleration of corporate earnings growth, asset allocation shifts, lack of institutional investors and geopolitical concerns. There has been enough written on the reasons behind the large sell-off and I will not dwell on this further.

For a value investor, the decline in TASI and corresponding market valuations since the first quarter of 2006 indicate that the sell-off was warranted. Market valuations were excessive and the buying euphoria created bubble-like tendencies. The rest is history.

Now, we are in the sixth quarter of the bear market and many investors remain on the sidelines. Trading volumes have declined as has the value traded. However, market valuations are now reasonable. The current earnings yield stands at 7.03 percent. Given the Saudi equity market's risk profile, current market valuations of a price-earnings ratio of 14.90 times and a dividend yield of 3.40 percent (based on 2006 payouts) appear sustainable over the long term. From an investment perspective, the Saudi equity market is starting to look attractive.

An oil-exporting emerging market like Saudi Arabia has historically traded at a premium to the MSCI Emerging Markets Index. From a qualitative point of view, within the context of some larger emerging markets, however, Saudi Arabia's stock market is still in its early stages of development. The number of listed companies is low as is the breadth of sectors available to investors. The participation ratio of domestic institutional investors is below that prevailing in many emerging markets. Yet, these are the traits of most emerging markets at this stage of their evolution.

There is much to look forward to. Initiatives are being undertaken to improve investor confidence and market microstructure. The securities market regulator, the Capital Market Authority, is striving to bring new products to the financial market, improve transparency, enhance disclosure and corporate governance standards. Tadawul, the stock exchange, is working on launching a new trading platform and introducing new trading products to the market.

Foreign investors are currently restricted from investing directly in listed equities. If and when foreign investors are allowed to participate directly in Saudi equities, we expect a strong equity demand materializing and forecast that the market will enter a new phase in its growth.

The boom in stock prices witnessed over the 2003-2006 period was mainly a pure domestic phenomenon. However, the rise in stock market capitalization that materialized earlier has not only been due to soaring domestic liquidity chasing a relatively limited number of stocks. Other factors, such as a conducive regulatory and business environment has contributed to new listings. The number of listed companies has gradually been increasing. Currently, there are 98 stocks that trade on Tadawul. Last year, 10 new stocks were listed on the stock exchange while 18 new companies had IPOs up to the end of the second quarter this year.

Another positive factor is a key trend prevailing in Saudi Arabia, like in much of the GCC. This is the tendency for assets to remain onshore as a consequence of the development and encouragement of the domestic capital market, supported by investment opportunities, economic development and growth. Domestic liquidity is supportive of market gains in the coming few quarters.

New listings broaden the market and attract new investors. Despite their seemingly adverse short-term impact, IPOs are not necessarily liquidity drainers over the longer term.

Based on the strong economic fundamentals, sound government policies, positive macroeconomic factors and current levels of the Saudi stock market, we remain optimistic on the outlook for Saudi equities. In the past few years, the Saudi government has launched an upgrade of its law and regulatory standards including the restructuring of government agencies, promulgation of new laws, establishment of new institutions (for example, CMA) and a further liberalization of trade regimes (for example GCC custom union). These reforms have resulted in strong improvement in the Kingdom's investment climate, liberalization and privatization in the non-oil sector, better enforcement of property rights and a more incisive regulatory framework. In the past three years, Saudi Arabia has reduced public debt from the peak reached in 2002 ($182 billion or 96 percent of GDP) to about $100 billion or 30 percent of GDP in 2006.

Over a complete market cycle of three to five years, the Saudi market offers strong return potential. Investors should seek value in the market and be positioned to take advantage of the growth opportunities expected to unfold across the breadth of the Saudi economy in the coming years. The slowdown in corporate earnings was healthy and current levels of corporate profitability are comforting. It should be recognized that double digit earnings growth witnessed over the past few quarters did not appear sustainable.

Over time, with the improved macroeconomic scenario, investors will eventually appear more willing to pay up for a "stable" to "strong" growth. The reduction in risk will provide a corridor for an equity market re-rating and price-earnings multiples will expand. We remain confident that in the coming quarters, investors will begin looking beyond "near-term" profitability, focusing on the growth opportunities offered by various sectors of the Saudi Arabian economy and will be willing to increase equity market allocations.



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