The Capital Markets Authority of Saudi Arabia recently announced its intention to open the local equity market to direct investment by qualified foreign investors at some point in 2015. These investors must be reputable and substantial financial institutions that manage a minimum of US$ 5 billion in assets. While foreign investors have obtained economic exposure to Saudi stocks through swaps via brokers for some time (so-called P-notes), the change to allowing direct shareholdings is an important step for two reasons.

First, the Saudi market is the heavyweight market in the Middle East & North Africa (MENA) region. The local Tadawul All Share Index (TASI) is composed of 162 stocks. With the exception of Egypt, this is the only regional market with enough breadth of sectors to provide some diversification, and enough liquidity to accommodate institutional investors in a meaningful size. To compare market capitalization, we look to MSCI’s indexes, where Saudi Arabia ($188 billion) is comparable in size to emerging markets such as Malaysia ($155) and even Russia ($180) using MSCI’s free-float methodology for adjusting market capitalization. Saudi Arabia is home to a rapidly growing young population that is relatively underpenetrated in terms of many products and services, and a government free of debt. Mortgage lending is in its infancy and households tend to be very conservative in managing their finances. Finance is the largest sector (37%) of the market (as measured by TASI), followed by materials (29%). Banks are conservatively run, with low leverage ratios, and the central bank’s vast accumulated reserves provide an ample safety net. The ability to invest directly will remove the counterparty risk of dealing through swaps and so should broaden the investor appeal.

Second, the expectation is that, if all goes according to plan, the Saudi market’s importance would put it on the fast track for inclusion in the MSCI Emerging Markets Index by 2017. This event would attract serious money flows from passive emerging markets portfolios to the extent that Saudi equities could eventually represent up to a 3.5% to 4% weight in the index (according to local managers).

Of course, it would be wrong to conclude that now is a good time to initiate exposure to Saudi stocks ahead of these market upgrades. The TASI has already jumped about 10% on the news, although it has subsequently given up some of these gains. Further, two years is a long time these days in any market, and fundamentals would need to look compelling to justify exposure so far ahead of a possible index inclusion.

From a valuation standpoint, the picture is more cloudy. The market is expensive but becoming cheaper. The current price-earnings (P/E) ratio stands at 17.6, with a dividend yield of 3.1%. Adjusted for return on equity (ROE), the P/E ratio is 15.8. This is lower than the mean since 2006 of 19.9, but this is obviously a short history and is distorted upward by the 2005–06 local bubble conditions. Compared to ROE-adjusted P/Es of 13.6 and 12.9 for frontier markets and emerging markets, respectively, the Saudi market does not look like a bargain today. However, expectations for double-digit earnings growth compare favorably with other regions so that any dip or at least period of treading water by the index would improve relative valuations.

The other major considerations are, of course, oil prices and geopolitics. The recent slide in oil prices to below $80/barrel is in fact a helpful catalyst to take some froth off the Saudi equity market, and could soon provide a relatively attractive entry point. Although the country’s oil assets are not quoted, there is undoubtedly a link, with a lag, between oil revenues and the rest of the economy through the transmission mechanism of government expenditure. Growth and company earnings have been boosted in recent years by various government expenditures on infrastructure, as well as generous pay raises in the public sector, financed by high oil revenues. The recent drawdown in oil prices is unlikely to have occurred without the acquiescence of the Saudi authorities. With a budget breakeven of around $75/barrel, and virtually no debt, the Kingdom can probably withstand oil prices in the 70s for much longer than many of its competitors (who face higher marginal costs of oil production or more pressing budgetary needs). At some point, the squeeze is likely to encourage production discipline within OPEC and reduce supply from other sources.

In conclusion, while Saudi valuations and sentiment are likely to continue to be negatively impacted by oil prices staying low for some time, there will come a point where gaining exposure to a big new emerging market will make sense on diversification and fundamental grounds ahead of its inclusion in mainstream global indexes. The fact that the currency has been pegged to the US dollar for decades, and that the market has greater potential for alpha given its retail-denominated nature, simply add to the attraction.

Stephen Saint-Leger is a Managing Director on the Cambridge Associates Global Investment Research team.

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