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Mar 29, 2019

Submerging from emerging: The next stage – for some – in Saudi Arabia’s equity story

Despite the country’s upgrade in indices, Oliver Schutzmann argues that rather than emerging, the majority of stocks risk submerging into an abyss of investor indifference

At this stage in the story of Saudi Arabia’s equity market emergence, two of the world’s three most important index providers – FTSE Russell and S&P Dow Jones – have included the country in their emerging market (EM) indices. By the end of 2019, the country is hoping that its newly gained status will attract $20 bn of foreign investment, supporting its overall efforts to position it as a major destination for international capital, rather than just a source.

And yet investors appear to be adopting a cautious stance toward Saudi Arabia, especially with stocks trading at high P/E multiples and a decline in oil prices following global market wobbles.

Investor restraint toward Saudi is not a new phenomenon: figures collated by Copley Fund Research, a consultancy that analyzes 180 EM equity funds with combined assets of $350 bn, suggest that Saudi stocks accounted for just 0.11 percent of their portfolios at the end of 2018. So even though inclusion in EM indices has been well flagged, there appears to be no rush to get on board.

Arqaam Capital, a regional investment house, notes that foreign ownership of Saudi stocks this month ticked up to near its all-time high, at 2.06 percent of the total. But this pales next to the foreign ownership statistics of its neighbors Abu Dhabi (13 percent), Dubai (12 percent) and Qatar (8 percent).

The truth is that the hard work for Saudi Arabian issuers did not end with index inclusion – it has just begun.

While EM index inclusion promises to be a net-positive event for Saudi stocks, the benefits will not be equally shared. MSCI plans for only 32 Saudi stocks to be included in its EM index, and other providers are looking at a similarly limited universe. This fact is widely misunderstood: the bonus arising from EM inclusion is not equally shared. For the majority of equities, instead of emerging, they risk submerging into an abyss of investor indifference.

Indeed, the inclusion criteria used by the providers is highly technical and heavily opaque. Yes, there are elements such as liquidity, market cap and disclosure, but there are also complex rules of exception, whereby certain stocks may be included even if they fail to meet these strictures.

So even the process of index inclusion itself is complex. Firms need deep insights into how the providers work with investors and issuers, their rulebooks, their methodologies. One thing is certain though, navigating and understanding the new rules of the game requires an experienced guide.

Unfortunately, some organizations and leaders in Saudi Arabia believe the whistle they heard has signaled the end of the match when, in fact, it was only the kick-off to the second half. Any issuer that believes the game is over and fails to start playing at the expected level will also fail to attract foreign investment.

Saudi firms that continue with their current approach to the public markets will find that it comes at a significant cost in terms of market valuation and liquidity, and even dimensions that go beyond their capital market presence: reputation, management credibility, the ability to attract top talent and, ultimately, business performance. The Saudi market has been disrupted by index inclusion and for those issuers that will not make it into one of the indices it is now harder than ever to get onto investors’ radar screens.

Given that the world has changed but only for a limited number of issuers, the burning questions for Saudi boards and senior management must be: how can we achieve inclusion – and stay included? How can we give investors a reason to be interested in us? What is the competition for investor attention? And what do we need to do to get investors to hear our story?

Listed companies are just a few weeks away from the first-quarter reporting deadline. The way companies report their first quarter after EM index inclusion will serve as a litmus test of their ability to communicate professionally with the market. Those firms that announce their results with transparency and undertake strategic engagement plans with investors are likely to meet with a positive response. Those that fail to do so risk being ignored by investors and remaining irrelevant to foreign capital flows. 

Emerging market status has been achieved, and that is to be celebrated. But this is just the first stage of the game. The uptick in liquidity that it will bring has yet to be properly evaluated. By the end of this year, once MSCI has joined S&P Dow Jones and FTSE Russell, there will be greater understanding of the lessons, and a clearer set of indicators.

One thing is certain today, however: to reap the benefits of inclusion, Saudi Arabian firms have to embark on an investor engagement program – immediately. The hard work to stay afloat starts now.

Oliver Schutzmann is CEO of Iridium Advisors

Oliver Schutzmann

Oliver Schutzmann is CEO of Iridium Advisors