Saudi Arabia is the new China for investors hunting down growth

Throngs of consultants wearing Western attire have become a common sight in the lobbies of Riyadh's plushest hotels as Crown Prince Mohammed Bin Salman embarks on a multi-trillion dollar plan to wean Saudi Arabia off oil.

In recent months they've been joined by another cohort of besuited individuals: fund managers, keen to get an early foothold in the next big emerging-market growth story.

The kingdom, which only joined the MSCI Emerging Markets index in 2019, has historically attracted very little from the billions of dollars that stock investors allocate to global stock markets. Fund managers were put off by the lack of liquidity in the Tadawul All Share Index, which limits full foreigner ownership, and by the nation's over-reliance on fossil fuels.

Now, with Russia sanctioned out of the benchmark index and China losing its allure due to an economic slowdown, some investors are starting to view Saudi Arabia in a new light, attracted by a steady stream of reforms designed to encourage more foreign investment and the vast sums being thrown at MBS's Vision 2030 transition plan. The increased interest has helped the Tadawul rally more than 11% this year, more than double the return of the MSCI benchmark.

"Saudi Arabia now feels like China in the noughties," said Fergus Argyle, who helped launch a new emerging-markets fund for EFG New Capital two years ago that has an 8% allocation to the Saudi stock index.

Argyle says Saudi Arabia is still "very underrepresented" in investor portfolios even after the Tadawul index attracted net foreign inflows of over $3 billion this year. That's a fraction of the $24 billion that poured in when the index joined the MSCI benchmark four years ago, but analysts say the volume will grow as reforms get under way.

Still Underweight

The Saudi bourse is the biggest and most liquid in the Middle East and is home to the world's largest oil producer - Saudi Aramco - after it raised almost $30 billion in a 2019 share sale. Over the past few years the exchange, traditionally dominated by banks and petrochemicals firms, has added large healthcare, retail and power companies. The Tadawul trades at 12-month forward price-to-earnings ratio of 17.5 times, giving it a premium of over 50% to the MSCI Emerging Markets Index.

Saudi's weighting in the MSCI Emerging Markets index has climbed to nearly 4.1% from about 1.5% when it was originally included in the benchmark as foreign interest grows and Saudi encourages more companies to go public. Saudi companies have raised $11.5 billion from listings since the start of 2022 at a time when initial public offerings have slowed elsewhere.

Passive investors could deliver inflows of $7.3 billion if Saudi Arabia lifts the level of maximum allowed foreign ownership to 100% from just under half currently for most stocks, according to Elia Alchaar, associate analyst at Arqaam Capital. That could also lead to a "substantial increase" in its weight on emerging-market indexes, he said.

Rising interest in Saudi Arabia mirrors the decline in foreign participation in the Chinese market. While India has emerged as one major beneficiary of the shift, Russia's absence from the index means investors don't have many other alternatives. The choice will become even more limited if South Korea is upgraded to developed-market indexes, which could happen at some point next year.

"We do see Asian institutional investors showing more interest in seeing and meeting companies from the Middle East because as an EM fund, you have to look at diversifying your investments," said Harish Raman, Head of Asia ECM Syndicate at Citigroup Inc. "Latin America is relatively less interesting for Asian investors but they are seriously considering the Middle East."

Political Risk

It's not always easy to make an inroad though. The market is still geared toward locals and many of this year's IPOs, including MBC Group's $222 million listing and ADES Holding Co.'s $1.2 billion float, have been heavily oversubscribed.

"A number of the stocks that have IPOed have not been sold at all to foreign investors," said Dominic Bokor-Ingram, a fund manager at Fiera Capital, whose bullish stance on Saudi helped him outperform 99% of peers this year. "There are three or four IPOs that we've been involved in in Saudi where we've been the only foreign investor."

Geopolitical uncertainty is another potential challenge. The gruesome murder of Saudi dissident journalist Jamal Khashoggi in 2018 overshadowed the Tadawul index's promotion to the emerging-market benchmark. Now it's the Israel-Hamas war that's causing jitters. The index erased all of its 2023 gains in October as the fallout rippled across the Middle East, before rebounding as investors judged that the conflict would probably remain contained.

Foreign Funds

There are 147 emerging-market funds with over $127 billion of assets under management that have never invested in Saudi Arabia, according to Copley Funds Research. But in a sign portfolio managers are following up research trips with higher allocations, the portions of active EM funds investing in the kingdom has more than doubled since the start of the year, the research shows.

Daniel Difrancesco, a US-based portfolio manager and analyst at BNP Paribas Asset Management, recently visited Riyadh to meet with some listed Saudi companies and is now considering increasing his investments.

"We are currently underweight, but continue to identify opportunities to deploy capital," Difrancesco said. "Visiting the country to meet with local business managers and witness the social and economic transformation that is underway has made us more constructive on the return potential for Saudi equities."