AMMAN, 6 December 2004 — While the outlook for the Gulf region’s stock markets is still positive, given the conditions of strong economic growth and excess liquidity, several of the companies listed on the region’s exchanges have become overvalued, especially those who enjoyed sources of revenues that may not be recurring next year and may not therefore be able to sustain current levels of profitability. This suggests that investors should become more selective focusing on shares of well-managed companies with a track record whose earnings are expected to continue to grow next year, in line with the growth of the economies of the region.
Investors might be willing to pay a relatively high price for selective growth stocks today, hoping that they will grow fast enough for investors to realize a good return. On the other hand, value investors usually buy stocks that are assessed to be below their fair value and hold them until the price gets back to where it should be. In the early stages of a market upswing, most shares tend to be undervalued, both in absolute terms (low P/E and price to book) and relative to other traded shares and markets. This is when value investing takes hold. However, before the market tops, growth investing becomes more popular and growth stocks with a proven track record tend to out perform the averages.
The Shuaa Capital Arab composite index for the region’s stock exchanges recorded a gain of 60 percent so far this year, on back of another solid increase in 2003. This boom was supported by the exceptional performance of most listed companies whose profits for the first nine months of 2004 was up by an average of around 45 percent on their year ago level. With an average P/E ratio based on 2003 earning of 31 for the Saudi stock market, 23 for the UAE market and 22 for the Jordanian market, several regional stock markets have become over valued. However, based on 2004 earnings, derived by annualizing the results of the first three quarters, the average P/E drops to 22 for Saudi Arabia, 20 for UAE and 18 for Jordan. This suggests that Arab stock markets still have room to grow given the region’s positive macro economic conditions.
The historical gap between domestic stock markets and global emerging markets has shrunk considerably, while the gap with the US and the European markets has dropped to almost zero. This is primarily the result of the surge in share prices, especially in the second half of the year. Good macroeconomic fundamentals and solid corporate profits were instrumental in supporting the regional markets. Profitability of listed companies has been on the rise in the past 24 months and the market’s high degree of liquidity, as reflected by the rise in the value of shares traded, supported the uptrend.
The high degree of liquidity in the market place continues to find its way primarily into real estate and listed equities, two asset classes that are relatively restricted in supply. Usually, in a booming equity market one would expect a surge in new public offerings, as issuers would be able to raise capital at a more favorable valuations.
This would help mop up excess liquidity and prevent the stock market from overheating. Despite restrictive regulations that limit new IPOs (initial public offerings) close to $2 billion were raised this year.
Regional stocks still maintain their relative value attraction compared to alternative investment opportunities in the domestic and regional markets. With average forward P/Es ranging between 15-20, based on expected 2004 results, the earning yields derived by taking the inverse of the price/earnings multiples (E/P) is still between 5 percent and 6.7 percent. This is higher than the yield on a 5-year government bonds issued by several government in he region of around 4 percent to 5 percent. The initiation of a tightening cycle by the Federal Reserve of the US has triggered similar moves by the region’s central banks that saw official interest rates rise by 1 percent in the past 5 months. Although this has led to higher interest rates on monthly bank deposits to around 2.5 percent – 3 percent, nevertheless it is still lower than the average dividend yields distributed by listed companies.
As valuation of listed companies continues to rise and before the market tops, investors are advised to concentrate at this stage of the upswing on growth stocks especially those with a proven track record. There are few stocks that have now become overvalued based on their expected 2004 results with forward P/E higher than 20. The higher revenues enjoyed this year by some of those companies may not be recurring. It is time for investors who made money in speculative stocks to book their profits. Nevertheless, because the economies of the region are expected to grow in 2005 at the same rate if not higher than what we have seen so far this year, emphasis should be on those companies that are likely to lead this growth process such as telecommunications, export oriented companies including petrochemicals and fertilizers, construction and related manufacturing (e.g. steel, cement, aluminum, furniture), transportation, hotels, and companies providing a wide range of professional services including brokerage and investment companies.
The gradual rise in domestic interest rates and the continuing surge in corporate and consumer lending are favorable for banks operating in the region, especially the well-managed ones implementing a clear strategy. International portfolio managers and pension funds are becoming increasingly more interested to have some exposure to the Middle East, a region that is likely to record the highest economic growth rate in the world this year.
Because not all the regional stock markets are open to foreign investors, one way to have a proxy exposure to the region as a whole is through buying shares of regional companies such as the Amman-based Arab Bank, the Mobile Telephone Company (MTC) of Kuwait and other companies that have a wide regional presence, and whose prices have not yet reached overvalued levels.
To conclude, it is important for investors in the region’s stock exchanges to become more selective, reducing their exposure to speculative stocks and concentrating more on well-managed stocks capable of maintaining historical growth levels. Behavior studies in finance have shown that investors in the stock market do not always behave rationally. They tend to have a set view and keep looking for evidence to confirm it, disregarding any findings that contradict that view. For example, they tend to have a certain target price and would refuse to sell unless that price is breached.
Investors are also reluctant to reverse their positions because that would force them to admit they had made a mistake. They also tend to be overconfident about their general knowledge of the market and would try to hang on to their holdings hoping that markets would prove them right. After such an upswing in regional stocks, investors are well advised to go back to fundamentals and to start listening to the professionals.
(Henry T. Azzam is chief executive officer at Jordinvest.)