Saudi Tadawul to go through correction after MSCI inclusion

Correction purely on basis of trading multiples is usual after major index inclusion, Al Rajhi Capital says

The Saudi Stock Exchange (Tadawul) in Riyadh, Saudi Arabia. Reuters

Saudi Arabia’s equities market, the biggest in the Arab world, is likely to go through a gradual correction after its successful inclusion in MSCI Emerging Market Index as investor focus will once again turn to market and company fundamentals, according to Al Rajhi Capital.

There is a case for correction purely on the basis of trading multiples, Mazen Al Sudairi, the head of research at investment banking arm of Saudi lender Al Rajhi Bank said in a research note to investors. The average price-to-earnings multiple before the inclusion of the stock market, commonly known as Tadawul, was 16.6 times the earnings which has climbed to 19.9 the earning times after it became a part of the MSCI emerging market gauge. Healthcare is the only sector trading at the same level as before the inclusion, he noted.

Historically, stock markets also tend to go through a correction following their inclusion in major benchmark indexes and that has been the case for Tadawul’s regional peers in the past.

“We have seen a decline in almost all the peer markets post [index] inclusion. Thus it is likely the same case for Saudi Arabia,” Mr Al Sudairi said. “Dubai and Abu Dhabi [stock markets] fell by 23 per cent and 14 per cent, respectively after the inclusion.”

Tadawul gained entry into MSCI Emerging Market Index in two phases, with August 31 marking the end of phase two of inclusion of 31 equities. Saudi Arabia accounts for 2.83 per cent weight of the index, which is tracked by global fund managers with trillions of dollars under management.

The foreign ownership levels in Tadawul increased to 5.38 per cent at the end of August from 1.78 per cent at the end of June 2018 when the decision to include Saudi equities in the emerging market benchmark was announced. This equates to an increase of about 70 billion Saudi riyals (Dh68.6bn) during the above period, pushing the benchmark Saudi index to 9,400 from around 8,150.

Saudi Arabia is expected to attract an additional $5 billion (Dh18.36bn) in equity inflows with the completion of the second phase of its MSCI EM inclusion, the Institute of International Finance said last month.

Investor appetite for Saudi equities spiked in August while during first eight months of this year, foreign equity inflows to the kingdom surpassed those of India and China - a "remarkable" development given that Saudi Arabia's economy is just a fraction of the size of the two other countries, the IIF said.

"In the absence of major domestic and external shocks and further deterioration in EM [emerging market] investment sentiment, Saudi Arabia can count on additional equity inflows from active investors whose portfolios are benchmarked to the MSCI EM index," Garbis Iradian, IIF's chief economist for Mena, said in a report at the time on Saudi equities.

Al Rajhi, however, in the short term is advising a “wait and watch approach”, saying the momentum would continue to be negative till around 7500 levels.

“While some investors are of the view that there would be a shift into non-MSCIs from MSCI names, we believe it may not be the case as the [trading] multiples are high for the whole market,” Mr Al Sudairi said. “Hence stock selection than sector allocation would be preferable.” Relatively, the domestic service oriented sectors are likely to be more attractive than the export or manufacturing oriented sectors, keeping in mind the challenges including global trade war concern, which has kept oil bulls at bay and continue to pressure the prices of petrochemical products.