JEDDAH, 19 December 2007 — The “law of round numbers” will prevail in 2008 for the Saudi stock market, whereby the Tadawul All-Share Index (TASI) will spend much of the year testing the psychological 10,000 level which was witnessed in mid-December of this year, the Riyadh-based Jadwa Investment said in its latest monthly bulletin.
It said that the rally that has lifted share prices over the second half of the year was an act of going past beyond a point, making the TASI “currently undervalued”.
“TASI will spend much of the year testing the psychological 10,000 level and struggling to move decisively above it. The index, which we currently view as about 20 percent overvalued, should thus end 2008 roughly where it starts it. If we are wrong, it is likely that the TASI would be higher, as the growing optimism about the economy could sustain the current momentum and keep the market overvalued,” Jadwa said.
It said the third quarter’s generally strong corporate results and oil prices that have been on an upward trend with a series of record highs achieved in recent months bode well for the recent jump in share prices.
Moreover, full opening of the market to GCC investors has encouraged capital inflows from elsewhere in the region, particularly as the TASI had significantly underperformed other GCC markets over the first nine months of the year.
The continued strength of the economy coupled with lower interest rates have increased the attractiveness of equities relative to bank deposits, it said.
It observed that oil prices are likely to come off recent highs of close to $100 per barrel. In the final quarter of 2007 oil prices hit a number of all-time highs, creating an optimistic tailwind for the Saudi market. Such a strong performance is unlikely in 2008. Oil prices may well touch $100 per barrel on occasion, but in the absence of a crisis that takes substantial crude oil production off the market, they will not move decisively above this level. Again, the law of round numbers comes into play, with $100 per barrel an important psychological barrier for the oil price, Jadwa pointed out.
Further, Jadwa said IPOs have been an important factor in adding optimism and buoyancy to the market. This is likely to continue through 2008. So far in 2007 there have been 24 IPOs. The bulk were start-up insurance companies, but there have also been high profile new listings such as petrochemical company Saudi Kayan and Kingdom Holdings. In every case the 2007 IPOs are trading above their offer price, reinforcing the impression that investment in IPOs is almost certain to be profitable. The pipeline for IPOs is large, so the number of new listings in 2008 is likely to exceed the 2007 number.
There is as yet little sign that liquidity is drying up for IPOs as nearly all remain substantially oversubscribed.
“However, a concern we have about the Saudi market is that it could remain bubble-prone for several years. After a crash stock markets tend to remain in a period of consolidation for many years and we believe the Saudi market will move generally sideways with an upward bias for the next few years. After a crash in 2000 the Chinese stock market experienced five years of downward trending consolidation even as the economy was booming. However it is now experiencing another sharp rise in the market, arguably a bubble. We believe Saudi Arabia will behave similarly in the sense that economic strength will sooner or later create another stock market bubble. The current run-up has created an overpriced market, but it is not prolonged enough or high enough to consider it a second bubble.”
The TASI reached nearly 21,000 in 2006, almost double where it is today.
While the market overall has become overpriced, there is still value in some sectors. “We continue to like the cement sector: The eight cement companies on the market trade at a P/E ratio of 17 and pay an average dividend yield of 3.09 percent. The fundamentals of the industry are strong and should remain so for the next few years with the construction sector forecast to grow by around 8 percent per year, although there are concerns about possible excess capacity in a few years. Cement companies have enjoyed strong price increases in final sales. The government has temporarily removed the five percent tariff on imported cement to alleviate the tightness in the market. This will not hurt local cement company earnings, in our view,” Jadwa said.
In the telecommunications sector, only two companies trade — Saudi Telecommunications (STC) and Etihad Etisalat. Of the two, STC is reasonably priced (P/E ratio of 13) and pays a high dividend (6.8 percent). In contrast, Etihad Etisalat is expensive, with a P/E ratio of 30. “Concerns that new entrants in the market for both wireless and fixed line phone services will harm STC’s profitability are keeping its price relatively low, but we believe these are overblown.”
Although there are several individual hidden gems within the broader industrial and services sectors, most of the other sectors of the market are “too expensive at current prices,” it said, in particular, the banking sector. “Overall the banks trade at a P/E ratio of 19, but the two Islamic banks that we follow trade at a P/E of 20 (Al- Rajhi) and 113 (Bank Al-Bilad),” it pointed out.
As with elsewhere in the world, the impact of the squeeze in the global credit market has still to be fully reflected in the earnings of local banks. Even Saudi banks hold portfolios of loan bundles that will need to be written down. In addition, the listed banks face growing competition from new banks and investment houses. “As a result, we are cautious about investing in the sector.”
The industrial sector contains companies in a wide variety of industries including food processing, petrochemicals and building materials.
The sector trades at a relatively expensive overall P/E of 29, but there is value to be found. For example, petrochemical giant SABIC trades at a P/E of 16 and pays a 2 percent dividend. “It is both a growth and income story, and we see it as reasonably valued.”
Fifteen companies are currently listed in the insurance sector. All but NCCI (the National Company for Cooperative Insurance) are new, small, and not profitable. All of the new insurance companies receiving licenses under new insurance regulation in the Kingdom must list on the stock market.
The industry will certainly go through a consolidation phase and it will be some years before it is clear who the survivors will be.
In the meantime, the sector is highly speculative. “We suggest avoiding it, with the exception of NCCI.
The nine companies listed in the agriculture sector are similarly small, speculative and generally over-priced. “As fundamental value investors, we advise avoiding this sector as well,” Jadwa cautioned.
At 10,000, the TASI is trading at a Jadwa-calculated price-to-earnings (P/E) ratio of 25.7, excluding the 14 profitless new insurance companies. Putting these into the equation and assuming that they record flat earnings as opposed to losses (a generous assumption as all are start-ups and thus likely to lose money for their first few years in business), then the TASI P/E ratio is 31, meaning that the shares of all the companies on the market trade at a cumulative price that is 31 times their total earnings per share.
“This is well below the level the market was trading at when it hit its all-time high in February 2006, but makes it expensive when compared with other GCC markets and global emerging markets,” it said.
Noting that the current fair value for the TASI is around 8,500, equivalent to a P/E ratio in the mid-to-high teens, Jadwa felt that “the market is overvalued by about 20 percent. Euphoria about the economy and a comeback for the market after the downturn of 2006 may result in P/E multiples higher than justified by the fundamentals, so we can see the market trading at above fair value in this boom environment for a prolonged period, but ultimately we expect a correction.”
