Why Foreigners Will Buy Saudi Stocks, Like It or Not

(Bloomberg) -- Four years after Saudi Arabia first let foreigners into its stock market, many overseas investors will soon have little choice. That’s because MSCI Inc., the U.S.-based index compiler, is about to classify the kingdom as an emerging market, meaning some global funds will have to adjust portfolios to include Saudi equities. The biggest market in the Arab world comes with caveats, including lofty valuations, a sputtering economy, the presence of influential funds with ties to the government and a heavy dose of geopolitical risk. It’s also got a potential jewel.

1. What is happening and when?

MSCI will add the kingdom to the MSCI Emerging Markets Index in two steps. It will identify the first batch of Saudi stocks on May 13 and the second batch on Aug. 8. That’s a huge deal since about $1.8 trillion in assets were benchmarked to the MSCI Emerging Markets Index as of June 2018. Arqaam Capital estimates the first phase alone could result in inflows from passive investment funds of about $7.1 billion, with Saudi Arabia representing 1.46% of the emerging-market benchmark. Mohamad Al Hajj, an equities strategist at EFG-Hermes, foresees about $12 billion of inflows plus another $5 billion from Saudi Arabia’s inclusion in British compiler FTSE Russell’s equivalent index, which was announced in March 2018.

2. How important is this for the Saudis?

Very. The regulator and the stock exchange first allowed so-called qualified foreign institutional investors to trade in 2015 and have since relaxed rules to lure more of them (with limited success), as well as ticking the boxes necessary to earn upgrades by the major index compilers. It’s all part of a Saudi master plan to diversify the economy away from oil and implement social reforms, spearheaded by Crown Prince Mohammed bin Salman.

3. What’s the Saudi stock market like?

Its market capitalization -- about $560 billion as of May 8 -- is greater than that of Singapore or the Netherlands. The Tadawul All Share Index, the main equities gauge, has 191 members, with financial and materials stocks making up about three-quarters of the benchmark. Two companies -- Al Rajhi Bank and Saudi Basic Industries Corp. -- account for almost a quarter. Once fully included in MSCI’s index, Saudi Arabia will have a bigger representation than the likes of Thailand, Malaysia, Poland, Turkey or Colombia.

4. Have foreigners been buying?

They owned about 5.7% of the market -- relatively low for emerging markets -- on the eve of the MSCI change. Foreigners were net buyers of stocks in Riyadh every week this year, in anticipation of the MSCI inclusion. That’s despite the fact Saudi shares trade at expensive levels both when compared to historical values and to other developing nations. (Some analysts commented that only “dumb money” is buying.) The excitement could surge if the country’s crown jewel -- the giant oil producer Saudi Aramco -- rekindles plans for an initial public offering.

5. What happened to the Aramco IPO?

It’s on hold. The kingdom’s original plan, announced in 2016, was to sell up to 5% of Aramco, either on the Saudi bourse and one or two overseas exchanges, or solely on the domestic exchange. The plan got delayed, but Aramco Chairman Khalid Al-Falih said in April that the IPO -- potentially the biggest in history -- could happen before 2021. The stock exchange chief also reiterated that the bourse is primed for the offering. Aramco shared its financial results for the first time in April, just before a debut bond issue that raised $12 billion and attracted bids of more than $100 billion. It revealed the company to be the most profitable on the planet.

6. What are the risks of the Saudi market?

Largely political. Foreigners sold off stocks after the killing of Saudi journalist Jamal Khashoggi in the country’s consulate in Istanbul in October (some four months after MSCI announced Saudi Arabia’s elevation). Funds tied to the government stepped up stock purchases to support the market, underlining their influence. Foreign investors were also caught by surprise when the crown prince implemented what he called a crackdown on corruption and detained dozens of ministers, billionaires and executives for months. Also on the list of geopolitical concerns are Saudi Arabia’s war in Yemen, tensions with arch-rival Iran and an embargo against neighbor Qatar that’s lasted for about two years.

Why Foreigners Will Buy Saudi Stocks, Like It or Not

7. What are the selling points?

Some investors see Saudi Arabia becoming too big to ignore, with representation in indexes run by MSCI and other compilers -- such as FTSE Russell and S&P Dow Jones Indices -- raising the Middle East’s prominence within the global investing community. The Saudi stock exchange expects to launch derivative contracts this year and four IPOs are in the pipeline. Additionally, after a slump in oil prices that led to the scaling back of many subsidy programs, the Saudi economy is showing signs of recovery.

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