Pain and Gain?

Labour market reforms in Saudi Arabia have heralded a high degree of economic and social change in the GCC's largest market. Will the policy of 'Saudi-isation' hinder the otherwise optimistic picture for investors in Saudi equities?

30 March 2014

Labour market reforms in Saudi Arabia have heralded a high degree of economic and social change in the GCC's largest market. Will the policy of 'Saudi-isation' hinder the otherwise optimistic picture for investors in Saudi equities?
There are many reasons for investors to be bullish on Saudi Arabia. While oil continues to dominate its economy, efforts have been made to reduce the link between the oil price and the level of fiscal spending, and progress has been made in achieving diversification.

Meanwhile, the country continues to look at reforms which may open up the market to foreign institutional investors; the appointment of Mohammed bin Abdulmalik Al-Sheikh as head of the Capital Markets Authority (CMA) in February last year was a further signal of how seriously the Kingdom was taking this, and a host of regulatory reforms were subsequently introduced with the intention of reducing speculation and the influence of wealthy individual investors in the market, and making Saudi Arabia more appealing to institutions.

However, the Kingdom's labour market has recently been a focus for many watchers of the Saudi economy. Last year, the Saudi Arabian government giving foreign workers in violation of residency or work regulations a November 2013 deadline to correct their status. A campaign was launched to search for any remaining workers who did not meet with regulations, and during this correction period in excess of one million foreign workers either left Saudi or were deported, with a further three million changing their status.

This push by the Ministry of Labour to reform the structure of the labour market, reduce the flow of cheap foreign workers and push more Saudi citizens to enter the private sector represents a radical change in the form of the Saudi economy. The change is likely to have not just an economic impact, but will extend to affect social and political issues.

In recent months the reforms appear to have checked growth in some sectors of the Saudi equity market. But will it be a case of short term pain for long term gain?

Zaherruddin Khalid, managing director and chief investment officer, asset management at Jadwa Investment, says the most important thing to note is that the measures implemented under the "Nitaqat" program primarily affected individuals who were working illegally in the Kingdom. "There has been a slight negative impact in the short term, in the form of a slowdown in the small and medium-scale construction sector and therefore slightly lower cement sales," says Khalid. "However, these reforms are likely to contribute positively to the economy in the longer run through the creation of jobs for locals, who tend to spend more domestically, rather than expatriate workers who tend to be more saving-orientated. Improving household disposable incomes for locals will, in turn, help many domestic consumption-oriented businesses." The reforms have not materially impacted Jadwa's investments in the region, he added.

There has been a definite effect from the "Saudi-isation" of the labour market, in the view of Yazan Abdeen, lead fund manager at SEDCO Capital. "You have to take that theme into consideration. There are some capacity utilisation problems that are affecting not just industrials but also services. We think that when investing in Saudi Arabia you have to look at companies which have a natural hedge to that theme and can grow regardless."

'Lenders and Spenders'

Abdeen says one of last year's major themes in Saudi Arabia was of buying what he calls "lenders and spenders"; in other words retail companies. "This year I don't think Saudi will be a beta play. It will be more stock specific. It's hard to pick themes on a sector basis, but there are some stocks in the real estate sector which look interesting value propositions. Likewise in the service sector, education companies and some other small and medium-sized businesses (SMBs) have made significant changes to their business models."

Saudi Arabia's fund market is split approximately 80/20 between Shariah-compliant and conventional vehicles, with money market funds representing around two thirds of all funds. Equities account for most of the remaining funds, with fixed income and Sukuk making up just a very small percentage of the total assets of $23.5 billion.

The country remains the largest and most diverse economy in the Mena region. "The Kingdom's economic growth since the financial crisis has been impressive to say the least," says Khalid. "The Saudi market gives exposure to strong economic growth fuelled not only by strong government spending, but also due to rapidly growing consumer spending, attractive demographics and growing corporate profitability at reasonable valuations. We expect government spending on infrastructure, housing, education and healthcare to continue, with greater bank lending and high consumer spending supporting the government's initiatives. We believe that the Saudi market can continue to perform due to its strong fundamentals."

The CMA has played an exceptional role in the development of capital markets in Saudi Arabia, says Khalid. "The new reforms introduced by CMA have improved disclosures by companies and curbed speculative activity in the market. The CMA has also played an important role in improving institutional participation in the market, and we expect further progress in this area. Moreover, investor confidence has improved as the CMA is playing an active part in increasing market efficiency. This is also one of the reasons for the market's strong performance in 2013."

Underlying value

The promotion by MSCI of the United Arab Emirates (UAE) and Qatar to emerging market status has had a relatively limited impact on Saudi Arabia, says Abdeen. "Even if you open up the market to foreign investors you will not change the underlying value of the companies [in the stock market]. Market sentiment and accessibility should provide more liquidity, but from a value creation perspective it doesn't need to happen. From a planning perspective it's a political decision. The question is what value is added if you open up the market to foreign investors?" While making the Saudi market more open may generate further institutional asset flows, Abdeen is not convinced it would have a material impact on the underlying investments.

Many of the investment issues affecting Saudi Arabia today are the same as those impacting global equities in both developed and other Mena markets, in Abdeen's view. "Beta is not the right place to be. You need to identify businesses with delta, with change, in their business model. The value proposition of that business will then change. That needs hard work and rolling up your sleeves."

Nigel Sillitoe, chief executive officer of Dubai-based market research specialists Insight Discovery, is positive on Saudi Arabia. "The Saudi economy continues to expand, with banks lending, and government and citizens spending.  Strong oil prices mean continued budget surpluses, and the Saudi Arabian Monetary Agency's (SAMA) official foreign assets, mostly US Treasury bills, is expected to pass three quarters of a trillion dollars this year, up from about $220 billion in 2006. In the past eight years, with the global financial crisis, slow global economic growth, and increased spending from both Arab Spring and from catching up on infrastructure spending after the slow-growth 1990s, the Saudi government has still managed to put away half a trillion dollars."

Sillitoe suggests there is some anecdotal evidence retailers are struggling with labour cost issues. "The recent decision to shift to a female Saudi workforce in some types of retailers has created new issues, such as the lack of qualified female trainers to train new employees." Overall, though, he finds it "staggering" how few asset management companies target Saudi Arabia for new business. "Whilst this might in part be because visas are so difficult to come by, I believe they are missing a great opportunity."

SEDCO Capital - a new approach
Yazan Abdeen's appointment as lead fund manager for liquid assets at SEDCO Capital represents a seismic shift in policy for the asset management firm. The company was originally set up as a family office responsible for managing the wealth of Sheikh Abdelalah Salem Bin Mahfouz, founder of the National Commercial Bank in Saudi Arabia. Having previously outsourced its fund management, SEDCO is now bringing this expertise in house for the first time.

Prior to joining SEDCO, Abdeen was a fund manager at ING, covering Middle East and frontier markets. "In 2009 SEDCO started doing manager selection," says Abdeen. "Today we have the largest Sharia-compliant platform in Luxembourg with $3 billion in assets under management. In 2013 we took the final step by having internal [fund management] capabilities." SEDCO has completed the team on the equities side, with two analysts covering the region from a buy side perspective and an investment process driven by stock selection.

The firm is currently running regional liquid asset and real estate vehicles. "We're launching a Mena fund in April, and we're already managing discretionary mandates and a fixed income regional fund," says Abdeen. "We're also launching a money market fund in Q3 this year. I'm also building my track record, which goes back to 2005."

© MENA Fund Manager 2014


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