Wish you were here!

Dubai: Whereas in the more developed stock markets institutional investors account for 85 per cent of the value of shares traded, the figure is much smaller in our region. Most of those trading the markets here are retail private investors, going in with relatively little information on what they are buying and with small amounts invested, hoping to make quick profits.

It has become clear that without greater participation of institutional investors, whether local or foreign, it will take our markets much longer to gain the much needed depth, breadth and sophistication.

Regulators in the Gulf are relaxing restrictions on foreign ownership of equities. The UAE increased the proportion of shares that investors from beyond the six Gulf countries can hold in a company to as much as 49 per cent. Saudi Arabia has recently allowed citizens of Gulf countries to trade shares of financial institutions freely for the first time, moving closer to opening that market, the biggest in the Middle East, to all foreign investors.

While institutional investors tend to follow economic and market fundamentals and base their investment decisions on proper stock valuation and equity research, retail investors normally target speculative small cap shares that tend to be highly volatile and are often overvalued compared to the large cap blue chip shares.

For example, the top 25 companies listed on the Saudi stock exchange, which account for around 90 per cent of market capitalisation, constitute a small percentage of daily trading volume and have an average PE of 15. On the other hand, the speculative small cap shares which account for the bulk of daily trading have an average PE of 30.

Increasingly more institutional investors, both domestic and foreign, have been investing where permissible in the region's stock markets, pushing UAE and Oman to new highs while counter-balancing the exodus of retail investors in other markets. To the institutional investor, the region's stock markets present today a good buying opportunity and provide a case for careful stock selections and evaluations.

The economic fundamentals are equally supporting. With oil prices at an all time high, the economies of the region are bound to benefit. Not only will oil sector GDP grow at record levels once again this year, but also non-oil GDP will benefit from higher government expenditures and a buoyant private sector embarking on a strategy of growth and expansion. The projected current account and budget surpluses of the oil exporting Gulf countries will help boost domestic liquidity in these economies.

Remittances

The non-oil Arab countries will benefit indirectly from higher remittances of their expatriates working in the Gulf, greater capital inflows seeking profitable investment opportunities in their respective countries, more exports to the booming Gulf states and flourishing regional tourism.

The outlook for the region's stock market is positive on the back of attractive valuation, strong economic growth feeding into higher corporate profitability, and improving market access encouraging the flow of increasingly more institutional money into these markets. The region has not been affected by the recent turmoil in the credit markets.

The huge correction seen in 2006 brought PE valuations in most markets towards the 13-14 level, making them quite competitive compared to other global emerging markets where the MSCI emerging market index is trading at around 18.

For the third year in a row, economic growth in 2007 will be higher than the world average and corporate profitability is forecast to exceed 15 per cent. This should place the region's stock markets at the very top of the emerging market universe.

The combined current account surpluses of the six GCC countries are projected to exceed $250 billion this year, higher than those of China and adding to the existing foreign assets of $1.5 trillion.

Private liquidity will also be on the rise and we are seeing an increased retention of wealth in the region. This is being mostly channelled into the real estate sector, but increasingly more of it will seek investment in the local capital markets.

Although private pension schemes do not yet exist in the Gulf, nevertheless there is growing expectation that they are likely to develop in the coming few years. This will bring in institutional funds to the region's stock markets and create a wealth of opportunities for local and regional fund managers.

The arrival of the international investment banks to Saudi Arabia and other Middle Eastern markets and the additional human and capital resources that some of these institutions have been allocating to the region's financial markets are indications of things to come. Their local presence and the sophisticated services they provide will encourage greater institutional participation, both local and foreign, in our markets.

Most hedge funds and emerging market portfolios which wanted exposure to the various Arab stock markets could not do so, either because the counterparty risk of local brokers and/or custodians is not acceptable, or creditable research on listed companies is not readily available or simply because they do not have direct access to some of these markets. For example, Saudi Arabia is closed to foreign investors, while a 50 per cent capital gains tax in Kuwait (although not implemented in practice) has largely kept many foreign investors away.

Besides promising to offer acceptable counterparty risk, more credible equity research and superior execution capabilities, the international investment banks operating in the region are well positioned to develop structured products that would serve the hedging requirements of their institutional clients. The added depth and sophistication of the Middle East stock markets will encourage Sovereign Wealth Funds of the region's oil countries to have larger exposure to these markets.

Best practice

For the international investment banks to be able to deliver on this promise and attract additional institutional funds, both from within and outside the region, the regulatory framework of capital markets needs to be upgraded to international best practice in terms of proper corporate governance, quality and frequency of financial disclosure, prohibition of insider trading and above all allowing foreign investors direct and easy access to the region's stock markets.

With more institutional participation, the local stock markets will gain depth and sophistication and will be driven more by market fundamentals rather than speculative pressures.

The majority of the IPOs from the region will opt to list on the local/regional stock exchanges as they will be able to tap institutional funds, and attract retail investors familiar with the companies going public. It is worth mentioning that more than 90 per cent of companies worldwide choose their primary place of listing in the market where they operate.

However, as foreign institutional investors end up having greater exposure to the region, the correlation between the Middle Eastern and the international stock markets will rise, making our markets more vulnerable to developments abroad.

This will add a new source of volatility to the region's stock markets and render them less of a diversification play to international portfolios.

But I guess this is a reasonable price to pay in order for our markets to join the global league of sophisticated emerging markets.

- The writer is CEO, Deutsche Bank, Middle East and North Africa.