Gulf stocks offer alpha, if you know who to ask

By Matt Smith

DUBAI (BestGrowthStock) – When Kuwait investors received anonymous text messages in the dead of night urging them to buy shares in telecoms operator Zain, they did something not many people in developed markets do. They paid attention.

Their demand helped the company’s stock soar 23 percent in five February trading days, before the firm announced it would sell African assets in a $9 billion deal.

It’s just one example of the risks an investor expects in any “frontier” market, but particularly the Middle East.

“Kuwait has some well recognized companies, but it has a number of challenges in terms of Western perceptions,” said Daniel Broby, chief investment officer at London-based Silk Invest. “One is that locals are selective with their information and favor friends and family.”

Kuwait may be the trickiest market. Last July, Kuwait financier Khalid Al-Braikan committed suicide after being sued for fraud by the U.S. regulator, alleging he was importing shady practices into the United States. But the hazards are similar across the region.

Wealthy local investors in traditional white dish-dash robes and sandals congregate in stock exchange pits, chatting with friends and calling in bids on the back of the latest rumors. It’s a challenge to profit in markets largely populated by excitable small-time day traders, where stock moves can seem totally random and company news can come first not by official announcement, but in a nod from friends and family.

For those who have the guts and the resource to venture in and do their own research, however, some argue that Gulf markets may have potential to offer foreign investors returns that are uncorrelated to global stocks.

Looking beyond the shock of Dubai’s debt crisis, investors in the world’s top oil exporting region see some of the most compelling stories globally, especially in Saudi Arabia and Qatar whose benchmark indexes surged early in the year.

A May sell-off has wiped out these gains, with Qatar now down 4.5 percent year-to-date and Saudi Arabia down 5.9 percent, but both have outperformed a near-13 percent decline in the MSCI emerging markets index.

TEMPTING FUNDAMENTALS

The region’s young population, flush with cash from this century’s oil price boom, gives much of it an enticing demographic and economic outlook: Qatar’s economy is forecast to grow by more than 18 percent in 2010 according to an April estimate from the International Monetary Fund (IMF); Saudi Arabia has embarked on a $400 billion infrastructure spending program as it seeks to diversify from energy.

Universities, science and technology parks and supermarket chains are among the projects attracting foreign investors to an investment story that, while it may be underpinned by oil, runs from infrastructure to finance and consumer goods.

“Gulf markets do not command a valuation premium because the transparency is not great,” said Ghadir Abu Leil-Cooper, Head of EMEA Equities at Baring Asset Management.

“We believe that in the next decade, because of these demographics and the infrastructure spend, these markets should open up and there should be better corporate transparency.”

After trading at a discount to the developed world since late 2008, the MSCI Arabian markets index trailing p-e ratio of just over 20 times at end-April was a nose ahead of developed markets.

Where the global crisis has brought equity markets crashing down in unison, some analysts believe Middle East stocks could return to a historic trend that is — at least to a degree — decoupled from world and emerging markets.

For this to happen, oil prices would have to arrest a recent sharp slide. The strong link between Gulf equities and oil, itself closely tied to the world economy, means Middle East stocks are to an extent driven by global fundamentals.

Haissam Arabi, chief executive and fund manager at Gulfmena Alternative Investments in Dubai, argues that today’s investment environment is similar to that of early last decade. Then developed economies slashed interest rates to stimulate growth in the wake of the dot-com crash, and Saudi stocks surged as oil prices rallied.

“Bank deposit rates were at 0.5 percent, so investors chased dividend yields,” Arabi said. “Nothing has changed, it’s just that the magnitude of this crisis was higher and more prolonged — it’s the same boom-bubble-burst scenario.

“We are correlated to major news on global markets — at any point there will be a correlation, but it’s the magnitude of correlation that matters.”

U.S. crude oil is expected to average $81.06 a barrel in 2010, according to a Reuters poll in April: oil is trading at around $68 now. Growing demand in emerging economies, especially China, are prime drivers.

“Qatar leaves China in its dust,” said Daniel Tubbs, co-manager on Blackrock’s emerging market fund, which handles in excess of $2 billion in emerging markets and whose investments include Qatar and Saudi stocks.

“Qatar has been growing extremely rapidly. Although it may not sustain that rate forever, we think it is a lot more sustainable than a lot of other markets in the Middle East.”

The population of Qatar, already the world’s richest per capita thanks to its exports of liquefied natural gas, is expected to nearly double to 3 million by 2022.

Saudi Arabia’s economy is forecast by the IMF to expand 3.7 percent this year, while more than a third of its 29 million people are under 15 and its population is growing by nearly 2 percent a year.

“From our point of view, it’s an underdeveloped consumer story,” said Baring’s Leil-Cooper. “With high oil prices, there is enough cash to carry on with infrastructure investment to support the population growth.”

FRIGHTENING THE HORSES

Whatever happens with oil prices, the ride can get hairy.

“Liquidity for us is always a concern,” said Blackrock’s Tubbs. “We only invest in a company if we deem it is liquid enough that we can get in — and more importantly get out — within the space of a week. We typically only look at companies if they trade more than $5 million a day.”

To illustrate: the Abu Dhabi Securities Exchange reported average daily turnover of 279.9 million dirhams ($76.20 million) in 2009, while the Dubai Financial Market saw 694 million dirhams of trading daily, with about 130 stocks listed on the markets combined.

Like other investors in frontier markets, Tubbs says investing in the region involves a lot of work on due diligence and old-fashioned tire-kicking.

Then there’s the challenge of keeping a cool head.

In opaque markets where corporate governance is lacking, greed and fear reign supreme and the herd mentality is prevalent. Unlike in developed markets, sudden, inexplicable price moves only rarely generate company statements and with insider trader rife, nervous investors are easy to panic.

Kuwait has 17 newspapers competing for news, so financial pages are full of unsourced reports — the big ones could have up to 15 stories about takeovers, earnings, dividends. Some are accurate, some not, but most are market moving.

Investors can bid for shares without having the cash to buy them and offer stock for sale without owning it, while regulatory regimes across the region are typically weak.

One classic ruse is for a group of wealthy investors to target a particular small-cap stock. They will buy and sell an agreed amount of shares at increasing prices so they are each left with the same positions, only with the stock now at a higher price. This surge will tempt unwitting buyers, who get dumped on as the original players cash in.

“This happens every single day and we’re talking about stinking rich investors,” said one Kuwait broker, speaking on condition of anonymity.

MUSICAL CHAIRS

After years of stalemate, Kuwait’s parliament in February passed a bill to create a capital markets authority (CMA).

This will separate regulatory and trading functions and ensure more transparency to protect minority shareholder rights while it can also impose fines of up to 100,000 dinars ($348,600) and prison sentences of up to five years.

“The CMA (is) not going to slap big fines or prison sentences on these players because they’re too powerful,” the broker added. “Instead, it will give them a warning and hopefully eventually put an end to this practice.”

In Saudi Arabia, too, it’s easy for high net worth investors to manipulate stocks.

For example on May 8, the market fell 4.4 percent as the Greek debt crisis soured global sentiment, but some traders said big-buck players had exacerbated the fall with large sell orders which frightened the less well-informed retail investors who make up 90 percent of the market.

That bout of panic selling enabled the big players to pick up shares at a significant discount.

The Saudi capital markets authority is becoming more proactive — the country’s third largest retail investor, reputed to be worth some $2 billion, was last June ordered to pay nearly $1 million after being found guilty of insider trading — but analysts say it acts too slowly to create an effective deterrent. Corporate governance regulations are still voluntary for listed firms.

One Kuwaiti analyst said dealing in these markets is like a game of musical chairs: “When the music stops there’s a man left standing with all the shares,” he said.

“The biggest problem is that people don’t see anything wrong with this — it’s part of the investment culture and will take a lot to change.”

Stock Investing

(Additional reporting by Carolyn Cohn and Scott Barber in London, Ulf Laessing in Riyadh; Editing by Sitaraman Shankar and Sara Ledwith)

Gulf stocks offer alpha, if you know who to ask