The middle east has the potential to become the newest emerging-market frontier for investors.

The region has one of the largest equity markets in the world, bigger than South America and eastern Europe, but it remains risky and largely closed to foreign investors. However, as its markets begin to open up, it may be worthwhile to take a serious look at opportunities in the Middle East.

“The Middle East is currently off the radar screen,” says Chuck Bastyr, managing director and portfolio manager in the Toronto office of BPI Global Asset Management LLP. “The region is certainly interesting; if you’re living there it is okay, but for all practical purposes it is not widely available to international investors.

“It is presently risky, largely overvalued, and poorly covered by analysts and brokerage houses,” he adds.

Barring Turkey and Israel, which are relatively widely followed, the core markets in the Middle East are Saudi Arabia, United Arab Emirates (UAE), Kuwait, Qatar, Jordan, Pakistan and Egypt. Other markets in the region include Iran, Morocco, Bahrain, Oman, Lebanon and Tunisia.

The total capitalization of the region is more than US$900 billion, which is equivalent to 20% of the total cap of all emerging markets. And that’s without the oil sector being listed in all countries. It is listed in Pakistan, where investors can gain direct access to the oil and gas production and exploration sectors.

Comparatively, Latin America has a market cap of about $720 billion and Europe and Africa combined have US$850 billion. “Because the Middle East is way off the beaten path, most investors don’t realize how big it is,” says Bastyr. “However, as the perception of the region improves investors may begin to take it seriously.”

Saudi Arabia, with a capitalization of more than US$400 billion, is by far the largest market in the region and one of the largest emerging markets altogether. It’s bigger than China, India and Brazil. However, it does not currently permit portfolio investment by international investors outside of the Gulf region. The UAE, which is also closed to foreign investors, Kuwait and Qatar are the other three largest markets.

A May 2005 strategy report by Deutsche Bank AG, entitled The Middle East: Oasis or Mirage? , notes it is easy to participate in four markets in the region that are already part of the Morgan Stanley Capital International index: Egypt, Pakistan, Jordan and Morocco.
Qatar also opened up to foreign investors earlier this year but interest has so far been limited. While Kuwait is nominally an open market, bureaucratic barriers make investing difficult.

“Egypt is currently among the most favoured markets among international investors in the region,” says Mark Grammer, vice president of investments at Mackenzie Financial Corp. in Toronto. “It is relatively stable compared to other countries in the Middle East.”
The telecom sector is dominant in the country, comprising more than half of its total market capitalization.

Of the four Middle East countries that are part of the MSCI global emerging markets index, Egypt has the heaviest weighting at 0.7%, or half the total weighting of 1.4% for the region, on the index. The Deutsche Bank report calculates that the MSCI captures only 2% of the entire capitalization of the region “as opposed to 30% of the total potential capitalization of the rest of the emerging markets, presenting an interesting opportunity as the region opens up.”

Since the oil sector is not open to investors, the three main sectors across the region are financials, which are more than a third of total cap, followed by petrochemicals and telecom. The financial sector is the largest in each country except Egypt and Pakistan.

Other key sectors are industrials, real estate and utilities.

Grammer sees opportunities emerging from the “multiplier effect” of the boom in the region, which has been fuelled by high oil prices and increasing oil revenue. The growth of the petrochemical industry will be driven by “downstream activities” in liquid natural gas and chemicals that are directly linked to the oil industry, he says. As wealth is created, the “trickle-down effect” will begin to positively affect spending on infrastructure development and construction that will, in turn, drive related industries such as cement and real estate.

“Market growth in the region is being fuelled by a liquidity boom or a sheer flow of funds,” says Bastyr. “The core driver is high oil prices.” In fact, since 9/11, capital outflows from the region have been restricted, forcing spending within the region. The consequent liquidity boom, combined with restricted foreign participation, has sent valuations to historic highs. Trading volumes have on average increased 25-fold in the past few years and are significantly higher than in other parts of the emerging world.

@page_break@Consensus opinion is that the bubble will burst if oil prices fall and as the markets open up. This will lead to buying opportunities for foreign investors. Nonetheless, the Deutsche Bank report argues that Kuwait and Egypt are relatively cheap and less volatile but may eventually be drawn into the orbit of the other more expensive regional markets.

The opportunities in the Middle East, however, also come with risks. Barring a sharp decline in oil prices, says Grammer, “most countries in the region probably have a higher sovereign risk than emerging markets elsewhere.

It is a region whose politics always seems to be garnering international attention, although Egypt and Jordan stand out as being more stable.”

Bastyr adds social, valuation and informational risk to potential pitfalls in the region. “There is not much information to support decision making; accounting standards are not comparable, making comparative valuations difficult,” he says.

Transparency improving

Corruption is also relatively high, with Pakistan ranked as the most corrupt in regional terms by the Paris-based organization Transparency International, which publishes an annual corruption perception index.

“Transparency is improving, but is still significantly below levels in most other emerging markets,” says Deutsche Bank, which also says that some management teams have little experience working with investors.

The Middle East has probably reached the point at which most emerging markets were during the late 1980s. Yet the region is unique in terms of its relationship to the Western world.

Whether or not forces of democratization will lead to more openness is anybody’s guess. The potential for wars and internal conflict is high. Whether the U.S. would invade Iran is another wild card. For now, it is a high risk/high reward play.

At the end of the day, it’s a matter of time before the Middle East zooms in on the radar screen of investors. Deutsche Bank puts it appropriately: “As the markets continue to open up, we would expect that the MSCI weighting will increase, as new stocks are included and as new markets are added to the index. As this takes place, we expect that investors will need to understand the region more thoroughly than they have hitherto needed to do.” IE