Tadawul opening to foreign investors ‘a key milestone’
, August 29, 2014
The Saudi Arabian index is the region’s most diverse capital market due to its size and maturity, and has been gearing up to welcome foreign investors for sometime now, said a report.
Although foreign investors have been able to access the Saudi Stock Exchange (Tadawul) through indirect routes, via swaps and exchange-traded funds, allowing direct foreign ownership will be a key milestone for the development of Saudi Arabia capital markets and the wider economy, said the report by Jadwa Investment.
The company said the opening up of the Tadawul is an overall positive but a cautious and considered path to reform is the best way forward.
According to the draft proposals released by the Capital Markets Authority (CMA) any Qualified Foreign Investor (QFI) wanting to take part in the Saudi stock exchange will have to have at least $5 billion assets under management (AUM), possibly reduced to $3 billion, and have been operational for a minimum of five years.
The other limitations that will apply will include each QFI (including affiliates) can only hold a maximum of five per cent of issued shares of any one listed company; all foreign investors (including resident and non-resident, swaps and QFI’s) have a combined ceiling of 49 per cent ownership of issued shares, in any one listed company; QFI’s together can only own a maximum of 20 per cent of issued shares of any one listed company; and swaps and QFI’s can only own up to a maximum of 10 per cent of aggregate stock market value of all listed companies.
Short to medium-term outlook
The opening and eventual inclusion of the Tadawul into MSCI will raise the risks of over pricing of stocks in the short to medium term.
With the greater dominance of retail investors and their higher risk appetite, there is a strong possibility that the Tadawul could move beyond fair value levels.
With the Saudi stock exchange expected to be included into the MSCI Emerging Markets Index by 2017, a similar pattern of events could occur to what was seen in Qatar and the UAE. Both countries stock markets rose before the inclusion of the respective indices, in early June, into the MSCI Emerging Markets Index, and then dipped immediately after.
Qatar’s benchmark QE Index advanced to five year highs in early June and then dropped, while shares on the Dubai Financial Market General Index dropped by 22 per cent by the end of June.
There are already signs that the Tadawul All Share Index (TASI) is moving towards being over heated, having risen over 10 percent since the announcement on July 21. Furthermore, current price/earnings (PE) valuations are trending above the long term average, with PE at 20.4 in early August, although it still below previous peaks of 27.4, in mid 2006 (Figure 2).
The governmental spending and international oil prices are maintaining elevated levels of business and investor confidence, as sectors with strong linkages to the domestic economy, such as construction, transportation, retail and manufacturing, continue to perform well, but so will the two largest sectors, banking and petrochemicals.
The banking sector is riding high from soaring consumer lending and a widely anticipated rise in US interest rates will add to future profitability. The petrochemicals sector continues to benefit from low feedstock prices, which means it is well placed to benefit from an upturn in demand as the global economy picks up.
Strong foreign participation expected
The stock market has a number of exceptional companies. Currently, foreign ownership of Saudi stocks amounts to around $8 billion, or 1.4 per cent of market capitalisation of $580 billion.
With the Tadawul viewed as one of the final major global equity markets to open up, foreign inflows are anticipated to be strong immediately after it opens to QFI’s in H1 next year for reasons including swap purchases and lower transaction costs.
A key indicator of the interest generated by the Tadawul’s opening is highlighted by the surge in the value of shares bought by foreign investors, via swap agreements, immediately following the announcement to open up. Swap agreements reached record levels in July. The large positive swing in purchases of swaps demonstrates that investors are positioning themselves before direct foreign ownership takes place, as they realise prices may be less attractive once the Tawadul opens up.
The foreign institutional investors are likely to have lower trading fees once they are able to buy directly into Saudi Arabia’s stock exchange. Swap agreements are more expensive for foreign investors when compared to direct cash transactions since local brokers buy the stock on behalf of the foreign investor and charge for custody and brokerage. International banks holding a licenses to offer swaps charge around 25 basis points (0.25 per cent).
As the market opens up, foreign investors will benefit from lower transactions cost through direct access to stocks, resulting in transaction fees dropping to 12 basis points (0.12 percent). In addition to this, foreigners investing in the Saudi stock market will reap the benefits of a zero tax liability on capital gains and a withholding tax rate of 5 percent on dividend payments, which is amongst the lowest, globally.
Beyond the short term we believe that total foreign inflows could total between $40-50 billion, but this will only be the case if active investors feel there is value to be had in Saudi stocks.
Increasing role of institutional investors
The Saudi stock exchange’s trading activity is dominated by local retail investors. According to the CMA, at the end of last year around 4.3 million retail investors had invested in listed companies, holding around a third of total listed Tadawul shares by value.
Currently, retail investors in Saudi Arabia account for a higher proportion of traded volumes when compared to other large emerging market indices. In China, retail investors account for 60 per cent of stock market volume, down from around 90 percent in 2003, prior to opening the market, while Indian retail trade volumes account for around 34 per cent, with retail investor volumes much smaller in the US, where they account for less than two per cent.
Retail investors, in general, tend to have larger risk appetites and shorter investment horizons compared to their institutional counterparts. In the Saudi stock exchange, retail investors look to make shorter term profits by focusing on smaller sectors in the stock market, which are more susceptible to price movements, and, by doing so, have added to volatility within these sectors.
Oil prices and the stock market
Although the recent correlation between oil prices and TASI is low, major trends in the price of oil nevertheless impact upon local investor sentiment, which can have corresponding movements in the TASI. In chronological order, a major drop in oil prices following the global financial crises saw the TASI fall, although it was not alone, with reverberations felt throughout global equity markets.
Secondly, the fallout of the Euro-zone crises, particularly the Greek debt crisis, resulted in oil prices dropping, the TASI also dropped to below the 6,000 mark around the same time, but again this was also the case in global equity markets.
Finally, in the last two years a sustained period of high oil prices was witnessed, above $100 per barrel, largely due to geopolitical events in the Middle East and Ukraine. This period of elevated prices has added to positive sentiments and helped lift the TASI benchmark by 38 per cent since August last year.
With such a strong sentimental link between oil prices and stock market performance, there are obvious implications, perhaps in more faster and sharper movements in the TASI, once it is open to foreign investors. More specifically, a key question is how foreign investor’s sentiments are likely to react to oil market movements that are dictated by regional geopolitical developments.
Due to the centrality of Saudi Arabia to global energy markets, and the global economy, major investors will continue investing in the country regardless of regional instability. Indeed, global investors have been provided with ample evidence, through continued stability and sustained economic growth, to be able to differentiate Saudi Arabia’s outlook from other troubled regional economies.
Saudi Arabia’s willingness and ability to honour its spending commitments and deliver economic growth, through its own resources, has become apparent. In any case, even in instances where regional political uncertainty negatively effects investor confidence and the Saudi stock market, such sentimental impact will not only be short lived, but also have the effect of driving up oil prices and Saudi crude oil production, thereby supporting both sovereign and external positions of Saudi Arabia, and ultimately having a positive impact on the stock market.
Towards increased efficiency & transparency
An improvement in the overall efficiency in the way companies are run was seen, particularly through the more efficient use of assets, as a possible benefit of opening up the stock market.
Since the financial crisis, return on equity (RoE) of Saudi listed companies has trended downwards. Profit margins have also declined but still remain higher than the US and Europe, whereas RoE is comparatively average, while in Saudi Arabia are propped up by the lack of competition in certain sectors, some of which also benefit from government support, either directly or indirectly.
In this context, low RoE and high profit margins suggest assets are not being used effectively to maximise sales. In the longer term, as foreign investors take up stakes in Saudi companies, and hold management accountable for strategic decisions, this will, in turn, promote improvements in efficiency, including an improvement in the use of assets in generating sales and ultimately increasing RoE. Therefore, when the Saudi government does eventually decrease the level of support to some sectors, such companies will be better placed to maintain profits, as the higher level of RoE will attract more investors. - TradeArabia News Service