Investors Anticipate Significant Surgei In Saudi Equity Market

The Saudi equity market is gaining momentum as it heads for possible inclusion in MSCI’s influential emerging market index in 2018, following the FTSE upgrade as an emerging market last month.

“This rally is underpinned by fundamental factors such as corporate earnings growth and supportive themes in a number of sectors,” said Shakeel Sarwar, head of Equities Asset Management at SICO BSC.

“The market was relatively quiet during 2017 but started to pick up towards the end of the year with the expansionary budget announcement.

This year, the market is up 15% mainly on the back of news surrounding the Saudi market’s upgrade by FTSE and MSCI, which is expected to result in passive fund inflows of $15 billion. Large capital liquid stocks, which are set to prominently feature in the indices, have been the main beneficiary of the rally.”

Although passive flows will start from March 2019 onwards, active funds benchmarked to these indices have already started positioning themselves ahead of the upgrade ($2.5 billion year-to-date), said Sarwar, adding that market participants estimate that total active inflows could be in the range of US$15 to 30 billion.

He explained: “We expect an approximately 25% market return in 2018 and 2019, with 10 percent resulting from a price to earnings expansion, which takes the market ratio of trailing price to earnings to 18 to 19 times, which is not very expensive.

Corporate earnings growth is another driver of returns which turned positive in 2017 after two consecutive years of contraction. We expect earnings growth will come primarily from the banking and petrochemical sectors.”

SICO expects many stocks to benefit from cyclical trends and structural changes such as: • Rising interest rate environment, which will provide a significant boost to profits in the banking sector; • Petrochemical sector profits, which could get a further boost from global growth and rising oil prices; • Retail sector companies which are gaining market share during a difficult operating environment (resulting from Saudization, subsidy cuts, taxes, etc); and • Regulatory changes in the insurance sector, such as enforcement of mandatory third party liability motor insurance. SICO’s own Saudi-dedicated country fund, SICO Kingdom Equity Fund, is positioned to capitalize on the above-mentioned themes.

The fund, which started in February 2011, has generated 60% returns over a five-year period versus a 10% return by the market. In Q1 2018 the fund was up 16% compared to a 9% rise in the market due to SICO’s focus on investing in companies that are expected to benefit from the Kingdom’s economic reforms, rising interest rates, and changing regulatory landscape.

“A significant amount of inflows were generated in the 12-18 months prior to Saudi Arabia’s inclusion on the emerging markets indices, which we are seeing evidence of now,” commented Sarwar. “Falling oil prices were tough on the domestic economy over the last three years. Astute firms have cut costs and gained market share.”

He added: “SICO’s investment philosophy is centered around fundamentals, so when we are selecting large capital liquid companies which are set to benefit from foreign flows, we look for well-managed companies with strong earnings visibility and growth potential.”

On the macro front, Saudi Arabia’s fiscal position appears to be significantly better compared to the past two years due to structural reforms undertaken by the government. OPEC’s strong output cut compliance, resulting in a significant drop in inventory, has helped to push oil prices up despite a sharp rebound in US shale oil output, which has also contributed to the improvement in the Saudi fiscal position.

“With the successful implementation of VAT and partial removal of fuel subsidies, the market will be closely following other anticipated reforms, as well as the listing of oil giant Aramco.

While Saudi Arabia’s financial position is still strong, with reserve assets of around $500 billion and significant capacity to borrow, these reforms and measures will further improve the financial flexibility of the government. The future for the Kingdom looks exciting as the government sets about modernising the economy by aggressively venturing into sectors such as tourism, entertainment, alternative energy, and transportation. Growth and development of capital markets will remain one of the government’s key priorities in order to ensure efficient allocation of capital,” said Sarwar.