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How the Gulf can beat the index paradox

09 Jun 2010

How the Gulf can beat the index paradox
By David Sanders, Chief Investment Officer-Asset Management at Invest AD

The paradox for Gulf equity markets is that, to attract international interest, they need greater liquidity and transparency. And both would happen much faster if there were an influx of demanding global institutional investors.

So how do you get from status quo to virtuous cycle?

There’s a chance international investors will just start to notice what most are now missing – rapid earnings growth at cheap valuations, and attractive long-term fundamentals such as solid government finances, strong infrastructure spending, and youthful demographics.

But a strong nudge by the likes of MSCI, FTSE and S&P would be very helpful.

Index providers currently regard Gulf equities markets as “frontier”, on a par with Sri Lanka, Romania and Vietnam, despite the region’s high per-capita wealth and outward modernity. Many investors therefore tend to consider the Gulf as a niche, or “off benchmark bet”.

Re-categorization as “emerging market” would accord credibility as a mainstream investment destination and ultimately bring in considerable capital. Institutional investors with emerging markets allocations would be forced to take a view on the region.

In the wider Middle East and North Africa (MENA) region, only Egypt and Morocco are included by MSCI in its emerging markets index, although the index provider is reviewing the case for the United Arab Emirates (UAE) and Qatar, and is due to publish findings next month.

So the MENA region is currently underrepresented, accounting for 6 percent of emerging market gross domestic product and market capitalization, but only a 1 percent weighting in the index. By contrast, Russia’s 6 percent weighting is in line with its share of GDP but out of whack with its 3 percent share of emerging market capitalization. A better balance is needed.

For index providers, some of the criteria for inclusion in emerging markets indices are fairly technical. For example, MSCI cited a lack of simultaneous payment and stock delivery on the Doha exchange as a concern. In the UAE, the firm would like to see a separation of custody and trading accounts – something that better fund managers are now doing in practice, and that regulators are looking to mandate.

But the main issues revolve around transparency and market liquidity – and here, companies and authorities are starting to be proactive.

Executives across the Gulf realize they need to show they are taking corporate governance and transparency seriously. Some have learnt the hard way in the last year, punished by investors demanding a risk premium for firms they believe fall short.

But aware that much of the “hot money” of the mid-2000s came from local retail investors, punting on one IPO after the next, listed companies are now keen to draw institutional investors who take a longer term view on fundamentals and help curb volatility.

In a corporate landscape traditionally dominated by secretive family businesses, management teams are becoming more professional, and making themselves accessible to portfolio managers and building proper investor relations functions.

Companies are improving the composition of boards, with director appointments based on the need to focus time and resources to properly oversee a company’s development, rather than status and prestige.

Regulators in the region are also upping their game, for example by properly defining what they mean by “independent director”. The UAE applied new rules from the beginning of this month on the composition of boards, formation of audit committees, disclosure to investors, and appointment of external auditors.

Improving corporate governance requires a change in business mentality, and will be gradual, but at least it is in the hands of market players.

Increasing market liquidity may be tougher. Liquidity draws investors, and encourages more liquidity – it’s a chicken and egg scenario – and the Gulf markets compare poorly with most emerging markets.

In the last 12 months, daily turnover on the region’s seven main bourses hit a high of US$4.5 billion in June last year and touched a low of US$879 million in December. Taiwan, with a slightly higher market capitalization than the Gulf, has seen daily turnover top $7 billion in the last year.

But governments and regulators can help by encouraging the free float of stocks and more initial public offerings. Abu Dhabi government-owned investment firm Mubadala, for example, said this month it plans to list some of its portfolio companies in coming years to help deepen the UAE’s equities markets.

This sentiment bodes well, because governments and related entities can play a direct role to increase market liquidity. By reducing their high holdings in the region’s largest listed companies, they can increase free floats, and set a good example for smaller tightly held companies -- showing that higher liquidity produces stock price premiums.

The Gulf is heading in the right direction, and has shown it wants more inward investment. Saudi Arabia took a first step to opening its stock market to foreign investors in 2008 through a swaps mechanism. Qatar and the UAE are both moving to relax restrictions on foreign holdings in companies.

Some investors are already taking the view, that entering the region early will reap rewards, not if, but when the markets become a fixture in global portfolios.

David Sanders is chief investment officer – asset management, at Invest AD, which manages private equity and listed equities funds investing in the Middle East and Africa. He has held senior positions in asset management at Abu Dhabi Investment Authority and the National Bank of Abu Dhabi, and also managed Proctor and Gamble’s global pension portfolio in Japan and the United States.