Asia Frontier Capital Newsletter – Country Report: Saudi Arabia

This month’s country report profiles the Kingdom of Saudi Arabia (KSA). While Asia Frontier Capital does not currently invest in Saudi Arabia, we are always evaluating frontier markets that may possibly hold investment potential. For example, Nepal and Bhutan are both in our fund’s investment universe, although we cannot currently invest in either country. Iran is another intriguing potential market, with a relatively developed stock exchange, though any decision to invest in the country would depend on the repeal of US/EU sanctions.

AFC’s Fund Manager, Thomas Hugger, travelled to Riyadh in early May to attend the Euromoney Conference on the news that Saudi Arabia is planning to open its stock market to foreign investors on 15 June 2015.

The Kingdom of Saudi Arabia (KSA) is known for its incredible oil wealth and is home to the world’s second largest proven oil reserves, standing at almost 16% of the world’s total. KSA is also the world’s second largest oil producer and the world’s largest oil exporter. However, what remains relatively unknown is that it is the 15th largest economy in GDP PPP terms and the world’s 47th most populous country. KSA is home to Muslims’ most holy site of “Kaaba” in Mecca to which almost 2 million Muslims per year travel in pilgrimage (Hajj in Arabic) during the Hajj season. KSA is traditionalist and its conservatism is evident to foreigners from around the world who visit for travel or work, with both of these activities needing sponsorship.

Saudi Arabia’s stock market, Tadawul, is the largest (USD 590 billion) and most diverse stock exchange in the Arab world. Given the stock exchange’s size and the fact that it has always been off-limits for direct investment from non-Saudi or non-GCC investors, it was big news among the emerging and frontier market investment community when the KSA’s Stock Market Regulator announced on 16th April that the Tadawul would officially allow foreign investors to begin trading the markets as of 15th June 2015. Currently, foreign investors can only gain exposure to Saudi Arabia though P-Notes, equity swaps, and a few ETFs. Access by institutional investors has been mostly through P-Notes, which received a boost when the KSA’s Capital Markets Authority (CMA) approved and regulated them, but as a group they never accounted for more than a tiny fraction of the market – probably 5% of total.

The intention behind the decision to open the market is to attract an inflow of foreign capital to help diversify Saudi Arabia’s economy away from oil, boost job creation for the country’s relatively young and consumer-focused population, and hopefully usher in better corporate governance and financial reporting standards to help Saudi companies broaden their reach and further expand into new markets. Despite Saudi Arabia’s reputation of being an oil powerhouse, the Tadawul is very diverse in its composition, featuring large-cap companies in the petrochemicals, banking & financial services, and retail sectors, as well as many stocks listed in the insurance, telecoms, construction & building materials, and real estate sectors. Access to fresh capital via new foreign investment could help many Saudi companies become stronger regional players and penetrate nearby markets in the Gulf and the Middle East, and several fund managers have estimated that the opening could attract USD 50+ billion to the market in the next several years.

Another topic of interest regarding the opening of KSA’s stock market is how it will impact any decision by MSCI to include the Tadawul in its Frontier or Emerging Market index. While MSCI has announced that it will launch a standalone index for Saudi Arabian stocks starting on 1st June, the decision of how Saudi Arabia will be classified will likely not be announced until 30th June 2016, instead of this year, as mentioned in Thomas’ travel report. Regional bourses Qatar and UAE were both promoted by MSCI in May 2014 from frontier to emerging market status.

For AFC, the disappointing news regarding Saudi Arabia’s liberalization plan is that the country chose to adopt a Qualified Foreign Investor (QFI) scheme, similar to China, in which investor participation is limited to funds of a certain size (minimum AUM of USD 5 billion) and track record (minimum 5 years). While this specification likely will not impact large institutional managers, smaller, boutique investors like AFC are forced to remain on the sidelines until we meet the required size and track record requirements. Additionally, foreign ownership limits will mandate that foreign investors’ holdings cannot exceed 10% of the market’s value; with a limit of 5% for a single QFI’s holding in a particular stock and 20% for cumulative QFI holding of a stock.

Regardless of the stipulations to be enforced regarding the opening of the Tadawul, Saudi Arabia appeals to many international investors because of the size and diversity of the stock market, strong demographics (young, consumer class with high income levels), and the potential for large Saudi companies to expand regionally. Saudi Arabia has been in the economic headlines a lot recently due to its decision to boost high levels of oil production over the past year to maintain global market share and to keep pace with rapidly rising US shale oil production, where these combined actions contributed to maintaining a global supply glut and accelerated the rapid fall in oil prices around the globe in the second half of 2014. Slumping oil prices have dramatically changed the economic outlook for many, leading to international oil majors scaling down capital projects, especially those that need high oil prices to be justified, and in the process laying off workers. Many oil producing countries like Russia, Nigeria, and Venezuela, to name a few, that depend heavily on oil export revenues have been harmed by the slump and are being forced to adjust their budgets. But Saudi’s national oil company Aramco has taken the long-term view and is investing heavily despite the low prices, boosting its production and number of drilling rigs and spending on new refining capacity in an attempt to potentially capture larger market share at a time when competitors’ financial woes are deepening. Saudi Arabia is now producing oil at the highest rate in 30 years, at 10.3 million barrels per day, and negotiated at least 20 drilling contracts for offshore rigs in the April alone.

But despite steadily increasing oil production and a commitment to investing heavily to expand the sector, it has not all been smooth sailing for Saudi Arabia. The Kingdom, which has historically been a staunch ally of the United States, has nervously watched the unfolding of nuclear talks between America and Iran, which is seen as Saudi Arabia’s rival for power and influence in the Middle East. Both Sunni Saudi and Shia Iran are major economic powerhouses in the region, and are strong rivals and fierce competitors for leadership in the region and in the Islamic world at large.

King Salman of Saudi Arabia, who was crowned as the King on 23rd January of this year, following the death of his half-brother King Abdullah, has made swift political changes both locally and regionally asserting a very strong regional role. His most recent major cabinet reshuffle shocked and rejuvenated the country’s leadership culture, naming his nephew, Interior Minister Prince Mohammed bin Nayef, as Crown Prince, and his son, Prince Mohammed bin Salman, as Deputy Crown Prince. To celebrate his coronation, King Salman announced a handout to Saudi citizens estimated at USD 32 billion, covering stipends for state employees, soldiers, students, and retirees, as well as numerous other grants. By far King Salman’s boldest decision has been to launch air strikes against the Houthi rebels in Yemen to counter Iran’s growing regional influence, a decision that has been relatively popular amongst Saudis who are wary of Tehran’s power ambitions.

King Salman’s action-packed initial months as Saudi Arabia’s new King may have raised questions among foreign investors, though the underlying investment thesis for Saudi Arabia remains intact and the country has proven itself to be a mover and shaker on the global stage, with the power to steer global oil prices due to its mammoth share of the world’s oil reserves. Although it is disappointing for Asia Frontier Capital to not be able to participate in the opening of Saudi Arabia’s stock market, the country will surely be an intriguing investment destination for years to come and will be a good litmus test of how investor sentiment responds to the liberalization of a large and diversified stock market when it comes with so many rules and regulations. Other frontier markets, including some of the countries that AFC invests in, are also surely watching Saudi Arabia to see how MSCI will decide to classify it as these other countries hope to ascend to emerging market status.

AFC Travel Report: Saudi Arabia

In line with our process of being on the ground in the countries we invest in, AFC’s CEO, Thomas Hugger, travelled to Saudi Arabia to explore the local market and keep his finger on the pulse of the region ahead of the launch of the AFC Iraq Fund.

Organizing a visa to visit Saudi Arabia is not simple. Foreigners travelling to Saudi Arabia need either a visit visa with an invitation from a sponsor or, for a work visa, visitors need a valid work contract from an employer or sponsor. As I was travelling to Riyadh to attend the 10th Euromoney Saudi Arabia Conference, I received the visa sponsorship from Saudi Arabia’s Ministry of Finance.  Despite having a sponsor’s invitation, the visa application procedure still involved lengthy waits at the Saudi Consulate in Hong Kong before being successfully approved, and the waiting continued upon arrival in Riyadh, as I stood for about two hours in the passport control queue at Riyadh International Airport. In the end, I reached my hotel around midnight local time (5am HK time), having had almost a 24 hour day immediately before the start of the conference. Not an ideal start for a business trip.

The Euromoney Conference was very well attended, with 1,600 delegates. Most of the participants, however, were locals or from other GCC (Gulf Cooperation Council) countries like Kuwait and the United Arab Emirates (UAE).  “Coincidentally”, the Capital Market Authority (CMA) of Saudi Arabia announced the day before the conference the conditions for the opening of its USD 590 billion equity market to foreign investors as of 15th June 2015. Unfortunately, the CMA did not change its first provisional release and will open its markets only to the “big boys”: fund management companies, insurance companies, and brokerages with at least USD 5 billion of assets under management and a minimum track record of 5 years. This is very disappointing for a small and young fund management company like Asia Frontier Capital Limited since we are at least 2 years away in order to be able to apply as a “qualified investor”. Additionally, foreigners are allowed to own an aggregate maximum 49% of a company and an aggregate total of 20% from “qualified investors” (the balance can only be owned by “strategic investors”). Each qualified investor is also allowed to own maximum 5% of any company. Lastly, foreigners in aggregate can only own at most 10% of the total market.

Of course, the local conference attendees were extremely excited about the fact that foreigners will finally be allowed to officially invest, and were even more upbeat on the hope that Saudi Arabia will be part of the MSCI Emerging Market (EM) Index soon. The opening of the market and the possible inclusion in MSCI’s EM index have led many local investors and market participants to believe that the stock market will skyrocket on and after 15th June 2015 due to hopes for massive foreign money inflows. I personally have my doubts about these “assumptions/hopes”, as markets are discount mechanisms and events may not play out as hoped – as you will read later in this report.

The conference began, after a reading of passages from the Holy Qur’an (Koran) with the opening speech by the Minister of Finance, followed by upbeat presentations from the Chairman of the Capital Market Authority and the CEO of the Saudi Stock Exchange (Tadawul), as well as other presentations from listed companies and fund managers. The most interesting session, however, was the last discussion of the first day in which the MSCI representative for the Middle East was in a panel with three CEOs of local fund management companies. The MSCI representative came under pressure due to his statement that Saudi Arabia will most likely not be included in the MSCI index until June 2017 at the earliest, which somehow surprised and obviously frustrated many local attendees in the audience.

The reason for the extended timeframe is that MSCI announces the reshuffling of countries in its indexes every year by the 30th of June, but the actual implementation of the reshuffling does not occur until one year after the announcement, in order to provide the index followers with enough time to prepare and adjust, which makes absolute sense.  The obvious frustration from the local fund managers stemmed from the fact that most likely this kind of announcement/decision will not be made until 30th June 2016, and not 2015, as had been expected by some in Saudi Arabia. The MSCI representative tried to explain in detail how the process at MSCI works: over the next 12 months, MSCI will contact thousands of investors from all over the world and collect feedback regarding the investors’ experiences, concerns, and accessibility of the country’s stock market before making any index classification decision.

From my experience, the in-depth classification process that MSCI adheres to is very important. Many investors think that the reason why a country is included in an index is solely based on the size and development (GDP per capita) of the country’s economy. However, based on our research at AFC, one of the most important factors for MSCI to consider when deciding on a country’s potential inclusion in a certain index is the accessibility of the country’s stock market to foreign investors. It is for this reason that I think some observers may be disappointed in 2016 when MSCI announces its classification decision, as it is certainly possible that Saudi Arabia will be included in the MSCI Frontier Index and not in the MSCI Emerging Market Index.

AFC’s theory here is that as of today, the two Chinese A-share stock markets (Shanghai and Shenzhen) are not included in the MSCI Emerging Market Index (China is part of the MSCI Emerging Market Index – but only H-shares, red chips, P-shares and B-shares – but not A-shares) since it has a very similar structure with a “qualified foreign institutional investor”  (QFII) regime (however, the direct access has improved a little bit since the “Shanghai-Hong Kong stock connect” which started on 17th November 2014 and allows investors in Hong Kong to invest in Shanghai A-shares without a license). According to the China Securities Regulatory Commission’s website, as of November 2013, China has granted only 251 institutional investors with a QFII license after 10 years of existence. China’s minimum assets under management requirement for a fund manager (USD 500 million AUM) is also much lower than Saudi Arabia’s (USD 5 billion AUM). I cannot see Saudi Arabia having more than a handful of QFI investors by 30th June 2016, when MSCI will be able to make a decision regarding Saudi Arabia’s index inclusion, and this could possibly have the implication that Saudi Arabia will start “only” in the MSCI Frontier Index and will be below its smaller (in terms of market capitalization, population, and land size) neighbors like Qatar and UAE.

For further reading, here are some articles regarding KSA’s stock market opening to foreign investors:

http://www.economist.com/news/finance-and-economics/21650587-foreigners-will-be-allowed-buy-shares-next-monthwithin-limits-cautious-opening

http://blogs.wsj.com/frontiers/2015/05/06/doors-to-saudi-arabias-market-remain-shut-for-many-investors/

http://blogs.wsj.com/frontiers/2015/05/04/saudi-market-will-open-to-only-the-biggest-foreign-investors/
Another big discussion topic at and outside the conference was the latest announcement by King Salman regarding the reshuffling of the cabinet. The King elevated his 55 year old nephew, Muhammed bin Nayef, as Crown Prince and more importantly his 30 year old son, Muhammed bin Salman, who was previously the Defense Minister, as Deputy Crown Prince.

I also had the opportunity to travel around Riyadh (mainly in taxis due to the near non-existence of public transport), which is the capital of Saudi Arabia and with 7.3 million people the largest city in the country. Riyadh is situated on a large plateau in the middle of the country, as seen in the following picture which I took from the “Kingdom Center” located in Al-Olayya (Olaya), the commercial center of the city. Except for a few high-rise buildings in Olaya, almost all of the houses outside the commercial district seemed to be smaller 3 to 5 storey buildings.

However, a new financial center (left photo) is being built (in the far end of the right photo):

To me, Riyadh resembled an American city in many ways: grid-like, square-built new towns on either side of the main King Fahd Road highway which runs through the middle of Riyadh. The highway is chock-full of cars all day, primarily Japanese, Korean, and American cars. To my surprise, there were hardly any European cars on the road – according to locals I asked, European cars break down more often in the Saudi heat and car exporters to the GCC export cars with GCC specifications to deal with the demanding weather conditions. Most of the Mercedes that I did see were very old, though Bentley seems to be the preferred car of the KSA elite. At nearly every corner, one found US fast food chains like McDonalds, KFC, and Dunkin Donuts. Another similarity to the US is that when travelling into more remote areas, where huge enclosed compounds for the expatriates (including golf courses) are located, one can find lots of small shopping malls, reminiscent of American suburbia.

Public transport in Riyadh is still relatively undeveloped. Only a few run-down mini buses driven by aggressive Pakistani or Bangladeshi drivers cruise through the city’s traffic jams. But there is good news for the myriad of foreign workers (primarily from Pakistan, India, Bangladesh, or the Philippines) who rely on public transit: a six-line metro system is in the process of being built and should open in 2019 (the picture below shows the Kingdom Centre with the construction site of the Riyadh Metro in front):

From a foreigner’s perspective, KSA is a conservative country when it comes to the participation and interaction of both sexes, especially outside family life. The streets are dominated by men, while malls and restaurants have female-only areas or family areas separate from those used by men. At the Euromoney conference, however, there were many female participants.

AFC Bournemouth

On a slightly different note, ever since I spent 20 fantastic weeks in the beautiful city of Bournemouth in the South of England back in summer 1983 to improve my English,  I have been a supporter of its local football (for US readers: ‘soccer’) team, AFC Bournemouth (www.afcb.co.uk) or “The Cherries”. The team was founded in 1899 and never played in the first division and nearly went out of business due to financial problems twice during the past 20 years. But in the current 2014/2015 season, this tiny team achieved a miracle and managed to get promoted to the prestigious “English Premier League” (EPL) for the first time where it will play next season against the big teams like Chelsea, Liverpool and Manchester United.

Asia Frontier Capital and The Cherries have some similarities: Obviously both use “AFC” in their name, and both are still small players in an extremely competitive environment – The Cherries in football and AFC in fund management – dominated by large and powerful global players. But like The Cherries proved, with passion, determination, dedication, good leadership, and hard work, it is still possible for small companies or clubs to play in the premier league of their fields and achieve outstanding performance.

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