The Ability to See Through Oil: A Case for Middle East and North Africa Equity

Transcription

1 Investment Focus The Ability to See Through Oil: A Case for Middle East and North Africa Equity Asia, South America and Eastern Europe dominate the portfolios of emerging market investors, relegating the Middle East and North Africa (MENA), despite its size, compelling growth story and exceptional performance, to something of a footnote. We are of the opinion that this is an oversight on the part of investors. MENA is an increasingly prosperous and diverse region, where governments are committing large amounts of capital to driving growth and an increasingly educated middle-class population signals a key change in spending habits. This is no longer a region where wealth and economic growth are only measured in barrels of oil. Against this backdrop, the Lazard MENA Equity team use their investment experience and knowledge of the region to find undervalued companies with untapped potential. Coverage in MENA is still very low and we believe now is the time to take advantage of inefficiently priced, quality companies benefitting from the MENA story.

2 2 The Reality of the MENA Region Today Some see MENA as closed, reliant on oil and politically unstable, dismissing the region in favour of more established emerging markets. However, we are at the point where there are few true opportunities to find inefficiencies in these markets, the coverage being as comprehensive as it is. Conversely, MENA is an underresearched region currently engaged in a number of structural changes, many lowering the region s correlation with oil, which should greatly improve the region s risk/return profile. Such changes ought to benefit equity investors with the ability to uncover undervalued stocks with growth potential. Revenue, Spending and Debt MENA economies are among the richest and fastest growing in the emerging world and growth is not just driven by the oil profits of a small percentage of the population, but by the increased spending power of governments and citizens. This allows for wider participation in broader economies, calling on the services of the many sectors that create the diversity a successful equity market demands. Ironically, governments have succeeded in liberating themselves from a reliance on oil through rising oil profits during the past decade. Higher oil prices in recent years have allowed governments to build budget surpluses and pay off debts. This has led to a steady increase in spending, particularly over the past five years (Exhibit 1). This spending comes with a high level of visibility. These economies are in a transitional period, with an increasing amount of accountability built into their systems, as regimes hidden behind closed doors increasingly become open-market economies. Money has pervaded a number of sectors over recent years, with capital more readily available for start-up businesses, housing and education, in addition to large infrastructure investments. The latter is likely to be sustained by Dubai s successful bid to host the 22 World Expo and Qatar s hosting of the FIFA World Cup in 222. There are also strong signs in MENA countries of revenue increasingly coming from other parts of the economy. Looking at Exhibit 2, we can see the MENA region s correlation with Brent oil break down over a five-year period. The ensuing diversification has made the region less of a risk to investors portfolios than it would have been only 1 years ago. Oil-related growth in the Gulf Cooperation Council (GCC) countries, which are made up of Kuwait, Saudi Arabia, the UAE, Oman, Bahrain and Qatar, was only.9% in 213 and is expected to drop to.4% in 214, while growth not including oil is expected to grow from 5.4% in 213 to 5.7% in 214. Such pro-growth measures contrast starkly with the austerity agenda that has taken hold across the developed world over the past five years. While an increase in spending in Europe could trigger concern in the markets and the possibility of a credit downgrade, this is an unlikely scenario in MENA, where current-account balances are high and many countries credit ratings are catching up to those in the West. External reserves are substantial, even compared to large emerging markets, such as China (Exhibit 3). Given the favourable fiscal position of governments and the large surpluses accumulated in recent years, current growth levels are sustainable and also have room to improve as investment continues in the coming years. Such substantial budget surpluses and primarily internally-driven revenue mean lower levels of leverage and lower levels of risk for investors. According to the IMF, the GCC countries had debtto-gdp levels of just 9.2% as at year-end 213. To put this into perspective, euro zone debt-to-gdp was 92.7% at year-end 213. Exhibit 1 GCC Government Expenditures ($ billions) Saudi Arabia UAE Kuwait Qatar Oman Bahrain Source: Government Official Data, EFG Hermes, LGL Research Exhibit 2 GCC Index Six Month Correlation with Brent Sep 8 Sep 9 Sep 1 Sep 11 Sep 12 Sep 13 As of 31 July 214 Source: Bloomberg Exhibit 3 External Reserves % of 214 GDP Kuwait UAE Saudi Arabia Qatar Bahrain Oman China As of 31 December 214 Source: GCC Central Banks & SAMA, SWF Institute, EFG Hermes

3 3 Coping with Falling Oil Prices Concerns over the sustainability of investment have been raised following the fall in oil prices towards the end of 214. However, we are now at a stage where even if oil fell to US$3 per barrel in Saudi Arabia, current spending could be sustained using assets accumulated by the Saudi Wealth Fund (Exhibit 4). Similar financial reserves exist across the MENA region and have become increasingly important in the face of sustained oil-price declines towards the end of 214. In addition, post-arab Spring, there is no turning back from the promises made by MENA governments to address growing calls both for investment in once underfunded sectors, such as education and health care, and to alleviate various economic and social challenges. Saudi Arabia, the UAE, Kuwait and Qatar all have the means to continue with spending programs, while Oman and Bahrain will need to tighten their fiscal budgets in the face of lower oil prices, primarily due to lower fiscal surpluses and the rising need for infrastructure spending. Either way, there is little to suggest that MENA governments will renege on the commitments they have made. Focusing on Saudi Arabia, according to official numbers, reserves stand at over US$732 billion, which will be of further benefit to the economy, given that debt-to-gdp is very low, at 1.6%, not to mention the strength of the Government s deposits within the banking sector, which amount to US$435 billion as at 31 October 214 (Exhibit 5). 1 To put things into perspective, Saudi Arabia would be able to sustain a similar deficit, assuming it keeps to current spending levels and oil remains at US$6 per barrel, for 19 years using its accumulated financial reserves, and an additional 19 years assuming the government taps the debt market to reach a debt to GDP level of 1% (still below most developed countries debt-to-gdp levels). These numbers are based on the official oil production of 9.5 million barrels per day, compared to a higher actual production level (averaging 1.5 million barrels per day) over the past three years. Exhibit 4 Number of years SWF can support spending program Oil Price $3 Oil Price $4 Oil Price $5 Oil Price $6 As of 31 December 213 Source: EIA, CIA World Factbook, Government official data Exhibit 5 Saudi Public Debt ($ billions) (%) 9 Outstanding Public Debt (LHS) 4 8 % of Nominal GDP (RHS) As of 31 December 213 Source: Saudi Arabian Monetary Agency 5

4 4 Changing Populations, Changing Priorities and Changing Dynamics MENA populations are young, growing and increasingly middle class. In contrast, the developed world has seen populations age, while even the BRICs (Brazil, Russia, India and China) cannot keep pace with the positive demographic changes taking place in MENA societies. In part a consequence of government investment in education, the region has seen literacy rates increase substantially over the past 25 years from 51% to 79%, reaching the world average (Exhibit 6). MENA also has the highest proportion of people on the planet aged below 3, with 3% of the population below 14 compared to 23% for the BRIC countries. 2 A growing population with a large number of educated middle-class citizens is a cornerstone in the path to economic prosperity (Exhibit 7). Exhibit 6 Literacy Rates Across the MENA Region Over the Past 25 Years % The importance of population growth, which is now off its recent highs, and should continue to come down as the population becomes ever more prosperous, cannot be underestimated. This is known as the demographic dividend, which should give the region a sustained period of labour-force growth, exceeding population growth, and lead to further demand for investment in education, health care and technology. The demographic dividend is defined as a period of 2-3 years where fertility rates fall due to lower child mortality rates. As offspring are expected to survive, people will have fewer children, lowering the number of dependents. The fall accompanies an extension in life expectancy that increases the number of people of working age. With fewer dependants, workers have more disposable income and can help spur economic growth. This disposable income should provide opportunities for businesses in the consumer sectors. Sector diversity has become increasingly pronounced too during the past six years (Exhibit 8). Retail, industrial investment, and agriculture and food have all grown in Saudi Arabia since 28, while the petrochemical industry has fallen by more than 5% to now only make up a quarter of the market. As this process continues, it will allow the region to further de-correlate from oil as the economy branches off in myriad directions. Another indicator of the importance of non-oil sectors on economic growth is the sustained outperformance of consumer companies versus the S&P Pan Arab Composite Large Mid Cap Index (Exhibit 9). 4 2 Kuwait Morocco Oman Egypt Tunisia UAE Saudi Arabia MENA World Exhibit 8 Sector Distribution % Source: HDR, UNDP Exhibit 7 A Growing Population % Birth rate to remain higher than BRICS 5 Banking Petrochemical Source: Bloomberg Telecom Cement Real Estate Agriculture and Food Retail Industrial Investment Other YoY Population Growth BRICS YOY Population Growth MENA As of 31 December 214 Source: IMF An important point to raise in any argument about diversification is that the MENA region is not a homogenous entity, but a collection of economies that represent a number of very different investment opportunities. The MENA region, as it is defined for equity investment purposes, consists of 11 countries, all at different stages of economic development, all containing governments and businesses with differing agendas, and markets with varying sector emphases. Exhibit 1 gives an impression of the equity market breakdown in each economy.

5 5 Exhibit 9 Outperformance of Consumer Companies (%) 5 Consumer Sectors S&P Pan Arab Composite Large Mid Cap Index As of 31 December 214 Source: Lazard Asset Management, Bloomberg 214 In June 214, it was also announced by the Saudi Arabian Capital Markets Authority that the country s equity market will be opened up to foreign investors in the first half of 215. Though it will still be three years before it is considered for inclusion in the MSCI Index, this process of liberalisation is still a significant move. Outside investors have only been able to invest in the country through complicated participatory notes (P-notes) and many more will invest once freed of this encumbrance; Saudi Arabia has strong growth forecasts, a young population and encouraging signs of reform. In recent years, we have seen the market cap and the numbers of listed companies gradually increase (Exhibit 11). As the last major frontier market to open its doors, Saudi Arabia will be as liquid as Turkey and Russia combined, and just below Mexico in terms of market cap. In fact, if the country were to be considered by MSCI now, it would make up 6% of the capitalisation of the MSCI Frontier Markets Index and 4% of the main MSCI Emerging Markets Index. 3 Exhibit 11 Evolution of Market Cap & No. of Listed Companies MENA countries are also at different stages of openness regarding outside investment and transparency, and it is encouraging to see acceleration in their drive to be established in the open market, even if they are all starting from different positions. The more markets open up, the more foreign institutional investors will commit capital, and the more companies will practice better governance. Open markets are scrutinised and that means transparency and reform, which we have seen across MENA in recent years. We saw the UAE and Qatar upgraded to emerging market status by MSCI in June 213, opening the countries exchanges to global investment. Once in the MSCI index, passive funds will be obliged to invest and many active managers will commit capital too. Exhibit 1 MENA Constituents Market Data Market Cap (US$ billions) Weighted Market Cap (US$ millions) Price/ Earnings Dividend Yield (%) Bahrain 11,73 3, Egypt 25,492 3, Jordan 15,973 3, Kuwait 68,357 7, Lebanon 8,873 1, Morocco 35,476 6, Oman 14,631 1, Qatar 135,34 18, Saudi Arabia 46,613 17, Tunisia 4, United Arab Emirates 169,279 11, As of 31 December 214 Source: S&P Pan Arab Mid Large Cap Index 7 Market Cap ($ bln) Total Listed Stocks As of 31 December 214 Source: Bloomberg MENA Versus the Emerging Markets What does MENA offer equity investors that the more established emerging markets do not? Perhaps just as pertinent a question, are there risks inherent in MENA equity investing that do not exist in other parts of the developing world? Many will point to geopolitical tensions as an issue that affects the risk/return profile of the region. Of course, we cannot entirely dismiss such misgivings, considering the unstable nature of neighbouring countries Iraq and Syria, not to mention the military intervention in these struggles by MENA countries such as Saudi Arabia. However, these struggles have had little impact on markets in the key MENA countries. Another feature of the past few years has been the Arab Spring, which began in Tunisia, and quickly spread to Egypt and Bahrain, which are all in the MENA universe, though the latter government was not so tolerant of protesters and unrest was quickly extinguished. This did create volatility in equity markets; however, governments decided that the most suitable response to such unrest was to increase spending (Exhibit 12). As we have discussed, this decision has had a number of positive outcomes

6 6 Exhibit 12 Arab-Spring Related Spending % of GDP additional spending forecasted spending before the unrest Saudi Bahrain Oman Qatar Kuwait UAE Total As of 31 December 211 Source: BofA Merrill Lynch Global Research, IMF, LGL Research The MENA region, with the exceptions of Morocco and Egypt, benefits from a lack of currency risk, something which has caused a great amount of strain in other regions of the emerging markets universe. The majority of MENA currencies are pegged to the dollar, reducing FX risk considerably for investors comfortable with US dollar exposure. We have seen extraordinary bouts of volatility in Asian and Latin American markets and MENA equities being pegged to the US dollar shelters the region from such currency storms, offering risk/return benefits versus other emerging markets. When fears over the effects of US tapering on emerging markets currencies were at their most pronounced in the final quarter of 213, MENA equities, as represented by the S&P Pan Arab Mid Large Cap Index, outperformed the wider MSCI Emerging Markets Index by approximately 6%. Like many emerging markets, MENA countries are exhibiting strong growth, but unlike a number of those markets, growth is overwhelmingly the consequence of internal sources of funding. As with the currency peg, this allows MENA economies autonomy, harbouring them from some global shocks. Due to the cash reserves built up in recent years, there is little reliance on Foreign Direct Investment (FDI). In addition, despite such high levels of internal investment, leverage has remained low. However, this low level of overseas investment has not stopped IPOs in the region becoming more numerous and open to overseas direct investors. Investment in emerging markets has rarely been for the purpose of acquiring yield, as dividends, though growing, have a tendency to be much lower than in the West. Managements in developing economies are more likely to invest revenue back into their businesses, not reward shareholders. However, generous dividends have become an attractive attribute of MENA equities and offer a counterpoint to low interest rates and static or falling yields in the developed world. With an average dividend yield of 3.4%, MENA offers a better yield than the emerging-markets and the global average. 4 A culture of high dividends should provide some shelter from falling equity prices for those harbouring concerns that further geopolitical tensions in the region could adversely affect share prices. MENA companies are focusing on increasing their annual dividend to shareholders, something which should encourage investors to reconsider the region if they are under any illusions about the stability or maturity of MENA companies, as dividend paying companies tend to be stable enterprises with sustainable cash flows. In addition, sectors that traditionally pay high dividends, such as telecommunications, consumer sectors, financials and utilities, are all well represented and growing as a proportion of the market in MENA economies. Another benefit that enables the paying of substantial dividends is the tax-free environment found in the GCC countries, which makes up approximately 9% of the MENA region. Our Approach A Question of Coverage So how do we take advantage of such a strategically significant region? As MENA moves from being an oil story to a growth story, while still holding the security of 5% of the world s oil reserves, and more companies listed on exchanges, the opportunities increase. With a large pipeline of IPOs, the opening of the Saudi market and potential market upgrades, many are tuning into what the region has to offer. However, coverage is still lower than in more established emerging markets, which means a local team is still almost a pre-requisite to success. The Lazard MENA Equity team employs an investment strategy that focuses on the underlying fundamental drivers that help companies create value for their shareholders. We live by the mantra that it is best to invest in businesses, not stocks, and to do this in the MENA region requires a local presence with strong corporate relationships with local companies. It is through this bottom-up approach that the team can exploit market inefficiencies and generate superior returns. The team also looks to capture the right risk/ return profile through scenario analysis and stress testing of key valuation variables, which reach a valuation upside to downside ratio for each company covered. This local knowledge coupled with a bottom-up strategy approach focused on fundamentals is paradoxically why we are able to profit from the macro MENA growth story and get the best out of the strong market performance we have seen in recent years. When companies are not fully exploited in terms of coverage, this provides opportunities, especially in the small- and mid-cap space, which has substantially outperformed. As coverage of many parts of the emerging markets has grown over the past decade, they may no longer offer the inefficiencies that can still be found in MENA, providing the Lazard MENA team with an opportunity to add value. Conclusion The exciting changes taking place across the region point to a bright future for investors, as economies commit large amounts of capital to driving growth, while the emergence of an increasingly educated, middle class population signals a key change in spending habits. The evolution of MENA is one of the most compelling investment stories around and hands a bold invitation to investors who wish to allocate to a sometimes misunderstood, but increasingly prosperous market. Lazard s MENA Equity strategy is managed by a team with strong links to the region and an average of 11 year s industry experience. This is why we can provide coverage across the market cap spectrum, allowing investors to profit from this growing, but underresearched market. We are of the opinion that a strong local team with a bottom up investment process focused on fundamentals is the best way to identify undervalued and undiscovered companies with quality earnings growth in a fast-growing region of the developing world.

7 7 About the Lazard MENA Equity Team Lazard MENA Equity is an actively managed strategy driven by a bottom-up investment process that focuses on the underlying fundamental drivers of individual companies. The team looks at what helps companies create value for shareholders through fundamental analysis that identifies sustainable visible returns and superior management. It is physical businesses that drive investment, not stock names on a terminal screen. The portfolio managers have been managing mandates in the MENA region, together as a team, for seven years, and have a strong track record of delivering positive absolute and relative returns for clients. With an average of 11 year s industry experience, the team, led by Portfolio Manager/Analyst Fadi Al Said, consists of five investment professionals, including two portfolio managers and three analysts. Notes 1 Source: Saudi Arabian Monetary Authority 2 US Census Bureau International Database 3 Source: Forbes, Saudi Markets to Open to the World: How, When and Why, Chris Wright (28 August 214) 4 Source: S&P. As at 3 June 214. dividend yield calculation takes into consideration the trailing data (last four quarters) related to any dividend announcement Important Information Published on 26 March 215. Certain information included herein is derived by Lazard in part from an MSCI index or indices (the Index Data ). However, MSCI has not reviewed this product or report, and does not endorse or express any opinion regarding this product or report or any analysis or other information contained herein or the author or source of any such information or analysis. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any Index Data or data derived there from. 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