Editor’s Note:
The Saudi Capital Markets Authority announced last week it would open index funds to foreign investors by the end of the month, but investment in individual companies was not yet on the horizon. Last week our friends at the Arabianomics blog posted the question, “Would you buy index funds in Saudi Arabia?,” accompanied by a description of the Saudi economy’s strong points: undertaking the world’s largest stimulus package by GDP; gained on the UN’s “Ease of Doing Business Report” every year; and has over $400 billion in net foreign assets as a safety cushion. Arabianomics cautioned that many Saudi stocks underperformed last year but noted in an update, citing FT’s Robbin Rigglesworth, that “Saudi Arabia’s stock market, the largest in the Middle East, has recovered more swiftly than most of its peers this year, justifying its position as the first choice in the region of almost every analyst and fund manager.”
Given these developments today we received a timely addition to our business and finance reference file in the form of a new Jadwa Investment report, “Steady Gains Ahead for Saudi Stock Market.” This report provides a comprehensive review of the Saudi Stock Market (TASI) with discussion of market performance and valuation; foreign participation in the market; economic assumptions for 2010; sector overviews; investment recommendations and a market outlook.
SUSRIS thanks Jadwa Investment authors Paul Gamble and Gasim Abdulkarim; and Chief Economist Brad Bourland, for providing this insightful product for your consideration.
Steady Gains Ahead for Saudi Stock Market
Jadwa Investment
Since the start of the year the Saudi stock market index (TASI) has made steady gains. It has just exceeded its 2009 high and stood at 6,700 on March 20, 62 percent above the fiveyear low it reach in March 2009. This rally has taken place with low volumes and investors remain cautious. Based on our forecasts for earnings in 2010, we put the fair value for the market at the end of this year at 7,400, implying a gain of 10 percent from the current level, which may not be enough to trigger a significant rise in volumes.
The TASI has underperformed leading global and emerging markets in large part because of the damage to confidence caused by defaults at two large private sector companies and tight credit conditions, though it has outperformed other markets in the GCC. So far in 2010 performance has picked up independently of conditions on global markets, an encouraging sign that investor confidence in the prospects for corporate earnings may be improving.
We forecast that earnings per share will rise by 8.2 percent this year. The multiinvestment and petrochemical sectors are anticipated to record the strongest gains, as they recover from low prices for petrochemicals, equities and other assets in 2009. Most of the expected gains in these sectors have already been priced in to the market. In contrast, we think worries about bad loans in the banking sector and land prices for the real estate sector are overdone and view these as two of the most attractive sectors for investors in 2010.
The other sectors that we favor (telecoms, retail and the food processors within the agricultural sector) are consistent with a revival of consumer spending. Consumer spending was held back last year as consumers were affected by stock market losses, but unlike in most other countries there were not a significant number of redundancies or pay cuts and it appears that much of the slowdown in consumer spending was precautionary. Government spending remains the main factor driving forward the economy, but we think that this is already reflected in share valuations.
Historically, the TASI has tended to overshoot fair value and there is a chance that this could happen again this year. The key to how far the market deviates from fair value is investor sentiment. This is improving, but given the modest gains we expect for the TASI over 2010, we do not see foresee an overwhelming surge of enthusiasm for the market as has happened in previous years. A consistent flow of new listings and a possible revision to the method of foreign investor participation in the market that would lift inflows would boost confidence, but this could be offset by a fairly weak performance by global markets and a weakening global economic recovery. The clearest sign of a recovery of investor confidence would be the TASI continuing to rise amid consistently higher volumes.
Market performance and valuation
It was little over one year ago that the TASI touched its medium–term low. The TASI hit 4,130 on March 9, 2009 its lowest level since November 2003. At that time global markets were at or around multi year lows, oil prices were around $45 per barrel and the global economy was at its weakest. Subsequently, the TASI has climbed by 62 percent to stand at 6,700 on March 20.This ascent has not been smooth. Until the middle of May the TASI surged in line with other global markets as it became clear that the worst had been avoided for the global economy, rising by 46 percent until May 13.
Then news emerged about the defaults at two highprofile local businesses. Though neither company was listed, the unexpected defaults had a serious impact. They raised concerns about the health of other private sector companies and the exposures of the banking sector, and badly damaged investor and consumer confidence. After a period of trading sideways while other markets continue to rise, the TASI dipped and spent the bulk of the summer below its level of May and June. An opaque partial settlement of the debts of one of the defaulting companies with its local creditors, combined with reasonable third quarter results, lifted the TASI through September and October to a high for the year of 6,568 on October 24.
The market then slipped back as the ongoing lack of availability of credit hindered businesses, concerns emerged over dollar weakness and tension with Yemeni rebels intensified. From early November until the end of the year the TASI traded in a fairly tight range aside from a blip at the time of the announcement of the Dubai World debt standstill. The TASI remained reasonably stable over the first two months of 2010, though this came against a backdrop of a decline in global markets and suggested an improvement in investor sentiment. Rising oil prices and renewed vigor in global markets have supported a consistent rise throughout March and on March 13 the TASI surpassed its 2009 peak.
Recent gains come amid low volumes, a clear indication that investor confidence remains fragile. The total volume of transactions over the three months to the end of February was on par with the monthly average for the first eight months of 2008. The average daily number of transactions in January was the lowest for five years, at just over 73,000. Indicators such as mutual fund ownership and the reduction of the proportion of trading accounted for by retail investors also point to a lessening of local investor interest in the market.
Rising share prices have pushed valuations up. From a longterm low of 9.6 in the first quarter of 2009, the 12month trailing pricetoearnings (P/E) ratio reached 17.8 at the end of last year. The pricetobook (P/B) ratio also made a strong recovery, from 1.55 in the first quarter to around 2 at the end of the year. The bulk of the rise in valuations came in the second and third quarters, as fourth quarter earnings were affected by large provisions for bad loans at many commercial banks. The modest gain in the market so far this year has pushed the P/E ratio to 18.2 and the P/B to 2.15. Eight companies are currently trading below book value compared to 27 one year ago.
In comparison to global developed and emerging markets, the TASI has underperformed. The TASI jump of 62 percent from its low last March compares with gains of 71 percent for the US S&P 500 and 107 percent for the MSCI emerging markets index over the same period. Yet on a valuation basis, the TASI is on a par with leading emerging markets. It is also trading at a large premium over regional markets (the TASI was the best performing stock market in the GCC last year). The high valuation of the Saudi market is not a cause for concern. It is in line with historical trends and reflects the home bias of the large domestic investor base and the high level of dividends awarded by local companies (the dividend yield is around three times higher than that in leading emerging markets).
Foreign participation in the stock market
The Saudi stock market was opened to foreign investors in August 2008, via the swap agreement. Inflows from foreign investors have been less than many were anticipating; foreigners were net buyers of shares worth $792 million between March 2009 (when the data was first published) and February 2010, 2.3 percent of total market capitalization. In part this is due to unfortunate timing, as global markets crashed when the financial crisis intensified in September 2008. It is also because foreign investors are not comfortable with the method of market access, as it does not give them the ownership of the shares (simply the rights to the profits or losses from their transactions).
There is a chance that a new method of market access will be opened to foreigners during 2010. One possibility being touted is a qualified foreign institutional investor system similar to that used in China. Under this, foreign institutional investors that meet certain requirements (in areas such as financial standing and internal structures, systems and controls) are entitled to invest directly up to a fixed amount in the stock market. The impact this will have on the market depends upon how much access the regulator wishes to give them; in China, foreign investment accounted for less than 1 percent of total stock market capitalization at the end of 2009. In addition, exchange traded funds are in the process of being launched. It is not clear whether foreigners will have access to these funds and until the full details are available it is not possible to judge what impact this will have on the market.
Earnings per share growth declined by 16.6 percent in 2009. The media and publishing sector experienced the largest fall owing to a downturn in advertising revenues. Much lower average prices caused petrochemical earnings to plunge. The insurance sector recorded another loss in 2009, though this was well down on the previous year as more of the new startups moved into profitability, as did dominant provider Tawuniya, which suffered major losses on its investment portfolio in 2008. Banks ranked around the middle of the sectoral earnings table.
Hotels and tourism recorded the largest gain in 2009, the result of a onetime land sale by one of the two listed companies in the sector. Telecoms recorded the next strongest set of results owing to surging demand for mobile phones and a strong take up of related applications. The multiinvestment sector returned to profitability after notable investment losses in 2008 by the dominant player, Kingdom Holding. The other two sectors where earnings per share rose last year were energy and utilities and agriculture; consumption of products from both sectors is little affected by an economic slowdown.
On a quarterly basis the earnings data were more encouraging. After five consecutive quarters of decline in yearonyear terms, earnings per share were up in the final quarter of 2009. Not surprisingly, the main gains were recorded in petrochemicals and multiinvestment, the sectors most immediately and severely impacted by the financial and economic crisis of oneyear earlier. With the impact of the plunge in prices of petrochemicals, equities and other assets dropping out of the annual comparison, both of these sectors are expected to be among the leading performers in 2010.
Key economic assumptions for 2010
- Global economy: The global recovery that is underway will be pretty strong until the middle of the year. Economic growth will moderate in the second half as economic policy is tightened, inventory replenishment runs its course and deleveraging continues. Risks to the weak outlook are on the downside.
- Oil prices: Assuming no major shocks to the global economy or events that would disrupt supply, we expect the recent stability in oil prices to carry on. Global demand will continue to rise owing to the growing global economy, but this will be offset by a gradual increase in supply as Opec’s commitment to agreed production cuts weakens. Our forecast is for WTI to average $75 per barrel in 2010.
- Saudi economy: The Saudi economy is expected to improve in 2010. Real economic growth is forecast to rise to 3.8 percent this year from 0.15 percent in 2009, credit will become more readily available and the government budget will return to surplus. High government spending will be the main engine of growth, with the private sector making a greater contribution as credit conditions improve.
Overview by sector
After a tough year in 2009, the banking sector is expected to perform better this year, with earnings per share growth forecast at 10 percent. Owing to high profile defaults by two private sector companies and concern about the health of other borrowers, banks greatly increased their provisions for bad loans during 2009. It seems likely that most banks did the bulk of their provisioning last year, though total provisions as a proportion of bad loans are below 100 percent, compared to an average for the previous five years of over 160 percent, so there is still likely to be a significant amount of additional funds set aside in 2010. Uncertainty about borrower creditworthiness also caused banks to scale back lending last year (when credit to the private sector fell for the first year since 1990) and build up huge deposits with SAMA that are currently earning interest of just 0.25 percent. As the economic recovery gains traction we think that bank lending growth is likely to pick up, which will further support earnings.
Earnings per share for the petrochemicals sector will benefit from higher prices and production and are forecast to grow by 55 percent this year. Recovering global demand should ensure that prices are well above their average for last year. Higher prices alone are likely to result in a sharp jump in earnings per share growth in the first two quarters of this year. In addition, production is expected to commence or be ramped up at Yansab, Saudi Kayan, Petrorabigh and Sabic joint ventures in the Kingdom (Sharq) and in China (Tianjin).
Higher output and intensifying competition among existing and new cement producers will push prices down and as a result earnings per share are expected to fall by 10 percent in 2010. While strong investment spending by the government should stimulate demand for cement, two new plants and expansions at existing producers are scheduled for completion this year. Furthermore, margins will be squeezed by the clinker inventory, which is currently at an alltime high. High levels of inventory freeze resources and force companies to borrow to meet shortterm working capital needs, incurring more financing charges in the process, while suspending old kilns to minimize the buildup of inventory causes fixed production costs to increase and erodes earnings. Some producers will start to post revenues this year from their investments in the production of premixed concrete and precast panels.
Earnings per share for the retail sector are set to rise by 10 percent as listed retailers continue to expand their number of outlets and consumer spending picks up. Stronger spending will be driven by the ongoing economic recovery and the growth in local population and expatriate workers. Competition is forcing suppliers to offer retailers better terms and discounts; retailers have also cut costs to increase margins.
We expect earnings per share for the energy sector to fall by 10 percent in 2010. Saudi Electricity Company (SEC), which dominates the sector, is undergoing major restructuring in an effort to maintain profitability in the face of a stateimposed electricity tariff. The government’s decision in late 2009 to give up its share of SEC’s dividends for another 10 years should help the balance sheet. But high plant utilization to meet demand (growing at around 8 percent annually) is accelerating the depreciation of machinery and equipment and the high cost of servicing a growing debt is taking a toll on earnings. Shareholders are almost certain to receive dividends regardless of the company’s performance.
For the agriculture sector as a whole, earnings per share growth is forecast at 10 percent, though this masks a significant distinction between food processors and agricultural producers. The former are expected to enjoy another year of strong performance in 2010, with the largest (AlMaraei and Savola) set to benefit from expansion through organic growth, diversification into new product lines and synergies from mergers and acquisitions. In contrast, agricultural companies will continue to suffer from the withdrawal of subsidies and a likely increase in the costs of agricultural inputs and labor.
Tough competition means that earnings per share for the telecoms sector are expected to shrink by 5 percent. Growth in mobile phone take up will slow given the very high penetration rate (162 percent at the end of September). Instead providers will compete through applications (some of which have reasonably high margins) and aggressive promotions. The already fierce competition will intensify if a decision by the regulator to allow subscribers to move numbers between carriers is implemented (it is scheduled for this year). This would push rates down further, with earnings following suit. Income from international investments should benefit from the recovering global economy, but gains are not expected to be sufficient to offset the loss of revenue from the decline in domestic rates.
Greater use of insurance and the move of more recently founded companies into profitability will cause earnings per share for the insurance sector to rise. Competition is growing in the sector, but we feel that the opportunities are large; take up of medical insurance is increasing and insuring capital equipment at the large numbers of megaprojects is a new line insurers are pursuing. The recent floods in Jeddah drew attention to the importance of insurance against natural disasters, a market that is set to grow considerably. Three of the new insurance companies moved into profitability last year, bringing the total to eight. We anticipate that more will become profitable this year and the sector as a whole should break even.
The recent restructuring of Kingdom Holding, which accounts for nearly 90 percent of the market capitalization of the multiinvestment sector, is expected to resulting in earnings per share growth for the sector of around 85 percent. Actions including the receipt of a donation of Citigroup stock worth SR2.2 billion, a 41 percent reduction of capital and the use of the company’s general reserves to write off losses incurred in 2008 should transform the financial fortunes of Kingdom Holding. Growth, albeit small, in the value of direct and portfolio investments locally and internationally will provide further support to the sector.
Recommended sectors for investment
Just because a sector is anticipated to record strong growth in earnings per share it does not mean that it is among the most attractive to invest in and vice versa. This is because future earnings growth is a key factor in investor decisions and the likelihood of strong gains may already be factored into share prices. This is the case for the two sectors we expect to perform best in earnings per share growth terms, multiinvestment and petrochemicals. In contrast, one of the sectors we find the most attractive for investors—telecoms—is expected to record negative earnings per share growth in 2010. We favor telecoms because it looks appealing on a valuation basis even if lower earnings are factored in.
Banks are real estate are also among our favored sectors. In both cases we feel that market concerns about future performance are overdone. Most banks have the bulk of their provisioning behind them and with the economy picking up and lending likely to resume the outlook is promising. Real estate companies are attractively valued even assuming a fall in land prices. In addition, we like the food processors within the agriculture sector and retail, reflecting greater buoyancy in consumer spending after a year in which spending was held back. Consumers were affected by stock market losses, but unlike in most other countries there were not a significant number of redundancies or pay cuts and it appears that much of the slowdown in consumer spending was precautionary.
A recovering local and global economy should lift prices and sales volumes of manufactured products resulting in earnings per share growth of 15 percent for the industrial investment sector. Mining company Maaden, which constitutes almost half of the sector by market capitalization, gained significantly from the surge in gold prices last year and should benefit from higher average prices and production this year. A better outlook for local and external demand is expected to reflect favorably on this year’s result across the sector. The strengthening economy is expected to generate earnings per share growth of 15 percent for the building and construction sector in 2010. Eleven of the 13 companies in the sector made a loss last year owing to a decline in the number of new contracts awarded, the suspension of some projects and delays to the implementation of others. Each of these problems is expected to fade this year, though tight credit conditions will remain a problem for many contractors.
Earnings per share growth of 10 percent is anticipated for the real estate sector owing to ongoing strong demand. Our projection is tempered by concerns about land prices, which look likely to fall. The second and third largest companies in the sector (Jabal Omar and Emaar Economic City) are still working on their specific projects and their preoperating losses will undermine the performance of the sector as a whole. Tight bank credit will continue to impact on both developers and their clients. Even if it is approved this year, we do not expect that the mortgage law will have an immediate impact as it will take time for lenders to become comfortable with procedures.
We expect earnings per share growth for the transport sector of around 5 percent this year. National Shipping Company, which accounts for about 70 percent of the sector’s market capitalization, will benefit from higher demand for crude in the spot market, a stronger petrochemicals market and an improvement in freight rates. Other companies in the sector should experience a higher volume of business as economic conditions improve.
The improving economy should encourage businesses to lift their marketing and advertising budgets this year, which will contribute to 20 percent growth in earnings per share for the media and publishing sector. Tough conditions in 2009 encouraged some media companies to diversify into new lines or to cut costs, which are likely to be reflected in higher margins.
Performance of the hotels and tourism sector in 2009 was distorted by a onetime sale of land by one of the two listed companies; in the absence of these exceptional revenues we expect earnings per share to fall by 60 percent. Stripping out this effect, a modest improvement in performance is likely given the improving economy and probable increase in foreign business travelers.
Outlook
Using these forecasts we calculate that the fair market value for the TASI will be 7,400 at the end of 2010. This implies a rise of 10 percent over the remainder of the year. Share prices tend to over or undershoot fair value and the dominance of retail investors in the Saudi market means that momentum can build and subside quickly. Below are the factors that we think could generate this momentum; our expectation is that they will probably cancel each other out.
- Investor sentiment: Saudi investors remain cautious about the stock market. A dramatic shift in investor sentiment could propel the market well above our fair value estimate, but we do not think that this is likely. Although the TASI has picked up, it is still nearly 70 percent below its peak and many investors have suffered from two crashes in the last four years. We think the market is likely to record steady gains over the year, rather than the spectacular leaps seen over the period from 2003 to early2006 when many investors first entered the market. This means that investor sentiment should build over time, but will remain vulnerable to setbacks in the event of any further corporate defaults or adverse economic and political developments.
- Global markets: After a remarkably strong year for global stock markets, prospects for the remainder of 2010 are less buoyant. In the year since it bottomed on March 9, 2009, the US S&P 500 climbed by 69 percent. Research from Capital Economics shows that in the second year after hitting a low in a recession, the S&P 500 rises on average by only 5 percent. Given the likely slowdown of growth in the second half of the year and the ongoing risks to the global economy and financial system, performance this time around may be even weaker. Throughout 2009 the TASI generally responded to downturns in global markets (though it was much less sensitive to upturns). While the TASI was less impacted by the slide in global markets in lateJanuary and earlyFebruary and the correlation has eased in recent months, global market moves will have an important impact on those of the TASI.
- Foreign participation: As we have outlined elsewhere in this report, the way foreign investors can access the market may be revised. Any new approach is likely to remain cautious owing to concerns about speculative capital flows, meaning that there is unlikely to be a dramatic surge in foreign participation. Nonetheless, there remains healthy foreign interest in the Saudi market and the prospect of greater inflows over time would probably trigger a shortterm boost to the market (the TASI jumped by 5.2 percent the day the swap agreement was announced).
- New listings: Attractively priced initial public offerings (IPOs) encouraged a large number of retail investors to participate in the Saudi market during the boom years to early2006 and still arouse significant investor interest. There is a large pipeline of IPOs for 2010, but these are mostly fairly small (the largest announced to date is the SR1.02 billion Knowledge Economic City IPO), so individual investors are unlikely to be awarded enough shares to convince them to make a broader return to the stock market.
For the complete report with accompanying graphics
For comments and queries please contact the authors:
Paul Gamble, Head of Research – pgamble@jadwa.com and Gasim Abdulkarim, Associate Director: Research – gabdulkarim@jadwa.com or: Brad Bourland, CFA, Chief Economist- jadwaresearch@jadwa.com
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COMPLETE REPORT
About Jadwa Investment - Jadwa Investment is a Saudi Closed Joint Stock company operating under the supervision of the Saudi Arabian Capital Markets Authority (CMA). Under the CMA decision published on August 21, 2006, Jadwa was awarded a license to offer all types of investment services including dealing, managing, custody, arranging and advising. All investment services offered by Jadwa Investment are supervised by a Shariah Supervisory Board and are fully Shariah-compliant.
Related Material:
- Jadwa Chartbook – March 2010
- Jadwa Chartbook – February 2010
- Jadwa Investment – Home Page
- Index Funds in Saudi Arabia – Arabianomics.com
