Saudi Tadawul: an opening of sorts

The opening up of Saudi Arabia’s stock market to international investors – expected to go ahead in the coming months – will be a landmark event for the Saudi economy. But with questions over the level of investor interest, and regulations in place to limit foreign holdings, the impact on the market is likely to be muted at first. Published in Gulf States News, 2 April 2015

Plans to allow international investors to invest directly in companies listed on the Saudi Stock Exchange (Tadawul) have been around for years, but there is a growing belief that opening the market to foreigners will go ahead this year. The exact timing has yet to be confirmed. Some analysts suggest it could happen as early as April, though later in the year seems more likely; the new head of the Capital Market Authority (CMA), Mohammed Bin Abdullah Al-Jadaan, has said the CMA is committed to it taking place in the first half of 2015.

The latest speculation began in July, when the Council of Ministers approved a plan to allow foreigners to buy and sell shares in Saudi-listed companies. But while allowing direct investment represents an important moment in terms of the maturity of the Saudi economy, anyone hoping for a rapid and large influx of funds is likely to be disappointed.

Estimates of just how much money will flow in vary widely. Riyadh-based Jadwa Investment has suggested that as much as $40bn-$50bn could enter the market. Egyptian investment bank EFG Hermes suggests the figure is likely to be closer to $17bn. In either case, however, it will take time for the money to appear.

There are many reasons why initial inflows could be modest. For one thing, the opening up of the market is not quite as dramatic a move as it may at first seem. Nationals of the Gulf Co-operation Council (GCC) have been allowed to invest in the Tadawul since 2007, while other international investors already have indirect routes into the Tadawul via instruments such as swaps, in which a local broker buys shares on behalf of investors.

In August 2014, soon after the Council of Ministers’ announcement, Jadwa Investment estimated that foreigners owned $8bn worth of Saudi shares. They seem to have reduced their holdings since then, as EFG Hermes thinks the figure was closer to $5bn as of January. “It’s going to be an important event if they can capitalise on it, if they can create some momentum,” managing director and head of research at EFG Hermes Wael Ziada said. But he sounded a note of caution: “Already those who are willing to invest have invested by synthetic instruments like swaps. It will take some time for them to unwind these swaps and create a proper direct equity investment.”

In any case, the market will not appeal to everyone straightaway. At first, MSCI and other index providers are likely to classify the Tadawul as a ‘frontier’ market; it will take a couple of years at least before it is reclassified as an ‘emerging’ market – a status that brings with it greater investor interest, particularly from funds that have rules preventing them from investing in higher-risk frontier markets.

The experience of the Qatari and UAE stock markets over the past year demonstrates why a sense of realism should be maintained. At the end of May 2014, MSCI promoted these two markets from frontier to emerging market status. Achieving that enhanced status had taken several years while they dealt with issues around payments systems and foreign ownership limits. Similar issues may need to be ironed out in Saudi Arabia before MSCI is willing to classify it as an emerging market.

Being upgraded did boost international interest in the Qatari and UAE stock markets, and there is little doubt that the Saudi market represents a more enticing opportunity. The Tadawul is far bigger than any other Gulf bourse, has many of the region’s largest companies, and offers direct exposure to the largest economy in the GCC.

But while stock markets in Qatar and the UAE rose in anticipation of the reclassification, they subsequently fell back again. Qatar’s benchmark QE Index rose to a five-year high in early June 2014, but then dropped back. The Dubai Financial Market General Index dropped by 22% in June, according to Jadwa Investment.

Observers say the same thing could happen in Saudi Arabia. “I think foreign investors will be cautious, initially at least. I’d be surprised if there was a massive stampede to get in, particularly as prices will probably be bid up by locals prior to the opening, as happened in Dubai,” said an economist at one Gulf bank.

The likely caution of investors mirrors the caution of Saudi regulator the CMA. It has set out fairly strict draft rules about who will be allowed to invest, which will further reduce the potential pool of investors (see below). All of these restrictions should help the Tadawul avoid too much volatility and dissuade ‘hot money’ from quickly moving in and out of the market. That is something regulators are particularly wary of, and is one of the key reasons for delays, according to bankers in the Saudi capital.

“The authorities drew back in horror at what happened to places like Malaysia and Indonesia and even Hong Kong in the 1990s when hot money pulled out of that region very quickly,” one Riyadh-based banker said. “While they want to open up more, they want to do so in a prudent way.”

If the opening is well managed, the presence of more international investors could help reduce volatility on the Saudi bourse, which is dominated by retail investors. The CMA has said it wants to increase the proportion of new share issues sold to institutions, which are generally seen as more stable investors, willing to hold shares over longer periods of time.

Just as important as the inflow of money may be the impact of opening up the market on regulations and business practices within the kingdom. Exposing listed companies to the demands of international investors could and should lead to greater transparency and higher governance standards. “We have seen that, when foreign capital comes into a country, it improves the regulatory environment in that country, whether passively or actively,” Ziada said. “This is something that, in my view, is sorely needed in somewhere like Saudi Arabia.”

  • Tadawul: Market profile

In 2014, some 70.8bn shares worth a total of SR2.1trn ($572bn) changed hands in 35.8m transactions on the Tadawul, according to the exchange. The 168 listed companies finished the year with a combined market capitalisation of around $483bn.

Such statistics make the Tadawul easily the largest stock market in the region. The next largest, according to the Arab Federation of Exchanges, is the Qatar Stock Exchange, which has 43 companies and a total market cap of $185bn. The Abu Dhabi Securities Exchange has 70 companies and a market cap of $114bn, and the Kuwait Stock Exchange has 191 companies and a market cap of $100bn. All the other markets, including the Dubai Financial Market, are smaller.

The companies listed on the Tadawul are divided into 15 sectors, of which the most populous by far is the Insurance sector, with 35 companies. That is a consequence of regulations that oblige all insurance companies operating in the kingdom to list their shares. However, many of these companies are small and, as a result, the total value of the insurance sector is also relatively small, with a market capitalisation of some SR52bn, or 2.6% of the total.

In terms of value, the largest sector is Banking and Financial Services. The 12 banks listed on the market have a combined value of SR579bn, more than a quarter of the entire market. Also carrying significant weight is the Petrochemicals sector, with 14 companies and a combined market cap of SR439bn. Between them, the banks and petrochemicals firms account for more than half of the market’s total value.

The next largest sector is Telecoms and IT, which has a value of SR169bn, or 8.4% of the total. However, that is mostly down to one company, Saudi Telecom, which has a market value in excess of SR130bn. Most of the other sectors are worth less than 5% of the total market.

In 2014, the Petrochemicals sector was the most active in terms of trading, accounting for 15.5% of all trades by value. It was followed by the Insurance sector with 14.9% and the Banking sector with 13%. The least traded sectors included Energy and Utilities, Media and Publishing, and Hotels and Tourism.

The largest individual company on the market is the petrochemicals giant Saudi Basic Industries Corporation (Sabic), which is valued at just under SR255bn. It is followed by National Commercial Bank, Saudi Telecom, Al Rajhi Bank and Kingdom Holding, the investment vehicle of Prince Alwaleed Bin Talal.

Opinions vary as to which of these companies and sectors will appeal most to international investors once the Tadawul opens up, but companies that offer exposure to Saudi Arabia’s large consumer market look particularly promising. “Real estate looks attractive given the fundamentals,” said Samba Financial Group deputy chief economist James Reeve. “Other sectors of interest would be health, education and trade, in fact any sector which will benefit from population growth. Petrochemicals are less attractive now given the fall in naphtha prices and the likelihood of renewed competition globally.”

Others take a similar view. In a research report issued in August, soon after the Council of Ministers announced that it would open up the market, Al Rajhi Capital said that active investors were likely to be drawn to the retail, food and construction sectors given their strong growth potential. It added that high dividend-paying sectors such as cement could also prove attractive.

EFG Hermes said that companies dealing in consumer staples look most attractive, including food group Savola Group and air-conditioning company Al Hassan Ghazi Ibrahim Shaker. The current trends in oil prices make the petrochemicals sector less enticing, it said.

  • New listings on the Tadawul

The presence of more international investors in the market could lead to more Saudi companies choosing to list, as there would be a larger pool of available capital for them to draw on. The number of initial public offerings (IPOs) on the Tadawul has waxed and waned over the years. The busiest year for new listings was 2007, when 25 companies made their debut on the market, raising just under $4bn. The following year, there were fewer listings, but they were more valuable on average, with 14 companies raising $9.7bn in capital.

Since then, things have calmed down considerably and, in the last few years, there have been an average of just six new listings a year – there were seven in 2012, five in 2013 and six in 2014. In general, companies sell between 30% and 50% of their equity in any offering.

Although there are plenty of international investment banks operating in the kingdom, these IPO deals tend to get shared out among the investment banking subsidiaries of local banks. In recent years, Riyadh Bank, Samba Capital and Saudi Fransi Capital have been among the most active providers of advice to companies wanting to list on the market.

The most significant listing of recent times was National Commercial Bank. It joined the market in November, becoming the last of the local Saudi banks to do so. It sold 500m shares in the offering at a price of SR45 ($12) a share, raising SR22.5bn and easily outstripping any other recent offering.

It does not look likely that the number of IPOs will increase in 2015. To date, just two companies have issued prospectuses for new listings. The first was Jeddah-based Middle East Paper Company, which is selling 15m shares in an offer period that will run from 8 to 14 April. Those shares represent 30% of the company. It will be followed by the Saudi Company for Hardware, which is also selling 30% of its shares. The offer period will run from 22 to 28 April.

  • Who will be able to invest in Tadawul?

Gulf Co-operation Council (GCC) citizens already have the same rights as Saudis when it comes to owning and trading shares on the Tadawul. Although the market is now due to be opened up to those from outside the region, plenty of restrictions will remain in place as to who can invest and how much money they can put in.

Under the draft proposals set out by the Capital Market Authority (CMA) in 2014, only qualified foreign investors (QFIs) will be allowed to invest. These QFIs must be institutions rather than individuals, and can be banks, brokerage firms, fund managers or insurance companies. They will have to have a minimum of SR18.75bn in assets under management, although this figure may be reduced to SR11.25bn. In addition, they will need to have a track record of investment of at least five years.

There are a series of other restrictions that will ensure that Saudi companies remain in local control. Each QFI will only be able to own a maximum of 5% of a company’s shares, and all QFIs combined will be restricted to a total of 20% of any company’s shares. Including swaps, foreign investors will have a combined maximum holding of 49%. Overall, no more than 10% of all the shares traded on the Tadawul can be held by foreigners, whether directly or through swaps.

Such rules are similar to those adopted by other emerging markets when opening up their stock exchanges. In 2003, for example, China brought in similar rules for what it called Qualified Foreign Institutional Investors. It set a minimum of $500m of assets under management and a three-year track record for investors, with a 10% limit on the amount any single investor could own of a company. India, meanwhile, requires a minimum of $2bn in assets under management, and has a shareholding limit of 5% of a company for each international investor.