Saudi Arabia – A brief introduction
Saudi Arabia does not come to mind when one thinks of frontier markets. By most measures, Saudi Arabia is a developed country or near-developing country. The fact box below demonstrates this:
Saudi Arabia’s GDP per capita puts it a hair below that of Portugal ($22,699) and slightly above that of Taiwan ($21, 592).
However, Saudi Arabia’s economy in many respects is undeveloped and remains restricted to foreign access. Around 90% of Saudi Arabia’s export revenues derive from petroleum or petroleum-based products. The government is taking efforts to change this through their ninth five-year plan, which was revealed in 2010. It is ambitious, with $385bn in spending across a number of sectors. The plan endeavours to reduce reliance on petroleum and to assist in reducing chronic youth unemployment (10.5% in 2011).
The plan includes $73bn in spending for the construction of 117 hospitals, 750 primary health centres and 400 emergency centres. In water resources, the plan looks to double the existing capacity of desalinization plants from 1.05 billion cubic metres to 2.07 billion cubic metres. In transportation the plan will look to complete the country’s network of railways, expansion of airports in Jeddah and Makkah as well as establishing a port in Ras Azzour. The government will build over 100 post secondary institutions and 1 million in affordable housing units. The scope of this plan ensures that Saudi Arabia will have a high level of growth through 2015; inflation will be the primary challenge mitigating growth.
As a result of this spending plan, Saudi Arabia will continue to be reliant on high oil prices. The break-even for the government budget in 2012 is $90 a barrel and this is expected to rise to $100 a barrel in 2013. This creates the risk of heavy borrowing being required to fund spending should oil prices decline. However, Saudi Arabia is rated AA by rating agencies and should have no trouble in issuing debt.
Any concerns regarding whether this money will actually be spent should be allayed. Approximately $85bn has already been disbursed and funding is of no concern when Brent is hovering around $125. Incredibly ambitious projects that have been announced such as the 1KM tall Kingdom Tower are more suspect, but it appears to be coming along well.
Saudi Arabia’s law is based on their interpretation of Islamic Shariah law. While this frightens some investors, in corporate areas this has little impact. In terms of securities law, contract law, and tort law, laws can be considered to be similar to legislation in developed markets.
Law is administered by judges who receive both Islamic training and a traditional legal education. However, there is a marked lack of transparency in the legal process in Saudi Arabia. Organizations such as Amnesty International have highlighted numerous instances in which courts have decided in favour of Saudi citizens despite a foreigner having the stronger case.
Saudi Arabia’s currency is the Saudi Riyal (SAR). It has been pegged to the USD since 1986 at a rate of 1USD = 3.75 SAR. Given that Saudi Arabia receives payments for its oil in USD the peg can be relied on. The only period in which the peg failed was briefly between September 18, 2007 and December 2007 when the US Fed cut interest rates and SAMA (Saudi Arabia Monetary Authority) did not follow suit due to concerns of inflation.
The Equity Market
Saudi Arabia’s only stock exchange is the Al Tadawul Exchange. It is based in Riyadh, the capital and Jeddah, the commercial hub of Saudi Arabia. The Al Tadawul Exchange is the largest exchange in the Middle East and has been successful in continuing to increase the number of companies listed on the index (currently 151).
The Tadawul Index is an all-share value-weighted index of the exchange. It has been calculated since 1994, and in that time an investment in Saudi Arabia would have yielded a 718% return. This compares with a 461% return on the S&P 500 for the same time period.
YTD in 2012, the Saudi market is up +22% as of the end of March, making it one of the best performing markets in the world. Valuations remain reasonable with forward P/E’s trading at 15.2 compared to a 5-year average of 17.8. With expected strength in the economy which is forecasted to grow 5% in 2012 and 6% in 2013 the market remains attractive.
The solid performance in Saudi Arabia does come at a cost and that is substantially higher volatility than a developed market index; over the last 5 years standard deviation has ranged from 21% to 27% (rolling 5-year).
Correlation between Equities and Oil
The correlation between Saudi equities and oil prices is mixed. The two share a quarterly correlation over the last 15 years of 0.4 and a monthly correlation of only 0.3. Even with a time lag of 1 month to assume that equity markets fail to factor in commodity prices immediately, the correlation does not increase markedly.
A scatter plot of the Tadawul Total Return Index and Brent Crude prices shows that the assumed positive linear relationship between the two breaks down quite often. However, a 4-order polynomial equation begins to show some relationship between the variables (see below). The outliers in the chart below are primarily a result of sharp moves in equities in 2009 when the recovery in oil prices lagged.
It can be inferred from above that if we assume Brent Crude to be the independent variable, then there is a statistically significant relationship between Saudi equities and Brent Crude. Because of this, Brent crude could be used to model Saudi equities. However, as the Saudi economy weans itself from a severe oil dependency this relationship will breakdown, resulting in significant risks to investors purchasing Saudi equities as a proxy for bullish views on oil.
The table below shows the 25 largest listed companies in Saudi Arabia. They represent a cross-section of industries with the largest sectors consisting of financial and petrochemical companies. In this list there are several clues as to why Saudi Arabia is not yet a developed market.
First, these 25 companies represent 37% of the average turnover on the Saudi Exchange, a ratio that would be significantly less in a developed market. Another clue is the high growth valuations in traditionally defensive industries. The Saudi electric company is trading at a forward P/E of 29.6 on the basis of expectations for significant growth and capital spend for building Saudi Arabia’s electrical grid beyond the major urban centres. A utility company in Western Europe or North America is highly unlikely to trade at such multiples.
The volatile nature of the exchange can be seen in the betas of the largest companies. Most are inline or even less volatile than the index as a result. Debt-to-equity ratios are similar to what is seen in these sectors across the globe.
By virtue of being the largest economy in the GCC, Saudi Arabia attracts listings from other countries. Companies such as Etihad Etisalat, a large firm from the United Arab Emirates, have been listed for many years. However, countries outside of the GCC were not allowed to invest until earlier this year, and this article covers this development.
Given the high savings rate, the booming economy, and large population relative to the rest of the Middle East, Saudi Arabia should be expected to have a large number companies interested in listing in Saudi Arabia.
Can Foreigners Invest?
The short answer: No. Saudi Arabia’s markets are regulated by the Capital Markets Authority (CMA). The CMA had a long-standing policy in-line with Saudi protectionism in most industries that foreigners may not invest in Saudi shares. This was partially relaxed in 2008, when foreign residents of Saudi Arabia and other GCC (Gulf Cooperation Council) members were able to invest in the Saudi market. Swap agreements were permitted in mid-2008, but this has yet to become a significant driver of liquidity on the Tadawul exchange.
Currently, the CMA is working on a policy to allow foreign investors to begin investing in Saudi Arabia. The draft legislation currently permits those managers with $5bn or more AUM to invest in Saudi Arabia, in an effort to limit hot money flows. Further information can be found in this NYT article.
Over time, we expect Saudi Arabia to continue opening up and it is very likely that by the end of 2012, most investors will be able to invest with a large asset manager. On the other hand, personally investing is likely still some years away.
In the meantime, those interested in the Saudi market should access this market simulation website, here.
This post is meant to be a brief introduction to Saudi Arabia and its equity market. If you have any questions after reading this, please let us know via e-mail or in the comments below.
Mark Mobius on Saudi Arabia http://www.businessweek.com/news/2012-03-27/mobius-leads-saudi-bulls-on-volatility-riskless-return
Rabobank Country Report http://www.rabobank.com/content/images/Saudi%20Arabia-201111_tcm43-105970.pdf
Tadawul Exchange: http://www.tadawul.com.sa