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There’s a burgeoning bull case for Saudi Arabia stocks. The iShares MSCI Saudi Arabia ETF (KSA) is up more than 8% year to date and almost 20% over a three-year period. By comparison, the iShares MSCI Emerging Markets ETF (EEM) has climbed just 4% in 2023 and 7% in the last three years. The Tadawul All Share Index, the country’s benchmark index, is also outpacing the EEM, up 5% year to date. Saudi Arabia’s high exposure to robust energy prices amid OPEC+ cuts and tightening supply from the Russia-Ukraine conflict have bolstered the country’s profile as a defensive emerging-market play. The oil-rich kingdom is also the largest equity market in the Middle East and North African region. Morgan Stanley estimates the Saudi equities market could reach $1.5 trillion by 2030, putting it on par with present-day South Korea or Australia. “It’s a very visible, long-term economic growth play that is tied to local country factors,” noted Carlos Asilis, co-founder and chief investment officer of Glovista Investments. “You also have the stability and very clear commitment of long-term capital investment projects. And then you have the growing relevance of Saudi from a geostrategic perspective, which will entail all these other positive factors for business opportunities.” However, Saudi Arabia remains the most underweight country among emerging markets. As of January, 46% of global market funds own zero Saudi stocks, according to JPMorgan — putting it on par with the much-smaller markets in Chile and Poland. Here’s a breakdown on why investors may want to consider getting exposure to the Saudi Arabian market — and some of the risks associated with it. Growing portfolio diversity The country is best known for its dominance in the oil industry, which remains an ongoing driver of the country’s outperformance. HSBC’s Global Research division wrote in a note earlier this year that it sees the Saudi market as “the best way to express a positive oil view.” However, the market is heavily dominated by financial sector stocks, particularly relative to other markets. The MSCI Saudi Arabia Index is composed of almost 45% in financials, followed by 22.1% in materials, mostly consisting of petrochemicals groups. This diversification is only expected to grow. In 2016, the kingdom introduced its “Saudi Vision 2030” framework to diversify its economy and reduce its dependence on oil, as well as moving to increase the number of women in the workforce and enhancing its international culture, entertainment and sports profile. Some investors are bullish on these diversification efforts, saying it will drive economic activity over the medium and long term as more public-private projects are created to increase industrialization — which could further benefit the country’s big banks that fund these projects. “The Vision 2030 has set the pace for the changes for modernization of the government,” said Ramzi Sidani, manager of HSBC’s Frontier Equity fund. “That’s why Saudi stands out — it’s basically the size and the pace of reforms that they’ve embarked on.” More foreign investment The kingdom’s Vision 2030 economic blueprint aims to raise foreign direct investment contributions to 5.7% by 2030 from 0.7% currently . Accordingly, a large number of initial public offerings have begun to come to market, many of which are from underrepresented sectors, said Sidani. “It’s also bringing new pockets of liquidity, and it’s something very positive for the market,” he added, noting this trend is expected to continue for the foreseeable future. To be sure, foreign-ownership limits remain in place for Saudi equities, contrasting with neighboring Qatar and the United Arab Emirates, which recently allowed for greater foreign ownerships. Andrew Miller, chief investment officer of emerging market equities at Mondrian Investment Partners, noted that some client funds may simply not be set up to trade in Saudi Arabia, creating a technical impediment to entering the market. Still, investors can get exposure to the market through the KSA ETF, which has an expense ratio of 0.74% and more than $900 million in assets. Another fund that does this is the Franklin FTSE Saudi Arabia ETF (FLSA) . The exchange-traded fund has more than $20 million in assets and an expense ratio of 0.39%. ESG and valuation concerns A key sticking point for investors is the country’s human rights issues. These social concerns are less of a headwind for top-down investors, who base their investment analysis on macro conditions. But investors that run a bottom-up strategy are unable to invest in many of the names in Saudi Arabia due to these environmental, social and corporate governance considerations, said Asilis. “It is a limiting factor — no question about it.” Corporate governance concerns also weigh heavily on investors’ considerations. Most of the country’s major companies are state-owned to varying degrees. The Saudi government holds nearly 95% of shares in Aramco, the world’s largest oil and gas company. “I think when one considers the valuations with the governance aspects, it’s maybe not one of the more attractive areas to invest [in] right now,” said Miller of Mondrian Investment Partners. To offset some of the governance risks and concerns, Glovista’s Asilis suggests investing in a “diversified manner,” such as across sectors and through a country index. The KSA gives foreign investors access to the Saudi equity space through a broad-based index. HSBC’s Sidani said as a longtime investor in the region, he has seen “a very good track record” on behalf of the government and companies in setting improved corporate governance structure as it opens up to foreign investors. He added that the government has been “very transparent” in pushing companies to report their ESG metrics similar to other large emerging markets. Valuation is another area of concern for some investors. The Tadawul All Share Index trades at a trailing price-to-earnings ratio of more than 18. The KSA also trades at a similar multiple. Al Rajhi Bank, which is the largest stock in the index, trades 3.7 times higher than its book value. “Not many banks in the world that trade on as high as 3.7 times price-to-book,” said Miller, giving an indication of the high multiples investors have to pay for Saudi equities. He also cited Aramco’s price-to-earnings ratio of 12.2, while Exxon’s trades at a multiple close to 7. “Saudi Arabia as a market doesn’t look particularly cheap to us, but we appreciate the positive top-down elements and the diversification benefits [it] can bring to us,” Miller said, noting that Mondrian is still “actively looking” for more names to add to its portfolio. — CNBC’s Michael Bloom contributed reporting.
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