Gulf states still offer good value as recovery continues

There has been cheap value to be found in Middle Eastern equity markets for some months now, but it kept getting yet cheaper as the local investors liquidated their stale positions. Now the recovery in the region’s share prices is becoming less fitful.

The encouraging news is that sentiment isn’t as black as it was at the various countries’ equity market bottoms of last year, but it isn’t so broadly exuberant that all the potential buyers are already in the market. Tristan Clube, a Middle East markets strategist with Tethys Advisors of Edinburgh, says: “Even with the excellent dividend pay-outs the trend has been to sell shares once they have gone ex dividend. That means sentiment is still quite depressed.”

The professionals are getting into more long-biased positions. Khaled Majeed, the London-based manager of Mena Admiral Fund, started in March 2006, managed to eke out an 8.5 per cent return in the bear markets by being net short most of the year. Now, he says: “We are 50 per cent net long, and anticipate getting up to 70 per cent net long. In the Kuwait market, we are 111 per cent net long. I think the markets that are most open to foreign money will rebound the most, since there’s good value to be found. Price/earnings ratios are in the low teens, while earnings are growing at a 30 per cent rate.” (A crude screen for value investing is to find stocks with p/e ratios below the earnings growth rate.)

Across the region, the operating earnings of listed companies, as a group, never collapsed, even as share indices plunged by 50 or 60 per cent. Reported earnings, particularly among investment companies, insurance companies and others with high ratios of portfolio investments to total capital were hit, but this was largely a function of the unwinding of the investment mania rather than poor economic conditions. The continuing increases in operating earnings are paying for dividend increases. In the Gulf markets, excluding Iran and Iraq, real dividend yields average over 3.5 per cent, higher than the local deposit rates.

Published disclosure by public companies isn’t bad by the standards of emerging markets, and is getting better, but managements are not easily contacted by foreign investors, or locals without good connections. Outright fraud is not as common as it is, say, in the former Soviet Union or in some Asian countries, though the exchanges do tend to be old boys’ clubs. As in many emerging markets, the potential equity universe is heavily weighted towards telecoms companies, banks and property companies.

Perhaps I’m overcautious, but I am inclined to leave property investing to those on the scene. Land and buildings are much harder to compare than minutes of mobile phone use, or net interest margins and loan losses.

John Niepold, who is responsible for the Middle Eastern strategy at Emerging Markets Management, a Washington, DC-area firm serving institutional investors, says: “I think the financial sector in the region will do well this year. The banks made a lot of money in 2005, then they reported negative to flat earnings for 2006. But operating earnings were really increasing at close to a longer-term annual trend rate of perhaps 20 per cent in both years. The 2005 results were inflated by lending related to initial public offerings. When those went away, the headline earnings went down. This year, the underlying trend will continue.”

Telecoms companies in the region have p/e ratios clustered in the mid to low teens, though their earnings growth rates range from single digits to a doubling for Mobile Telecommunications, a Kuwaiti company. The most expensive in the group, measured by its p/e of over 19, is Orascom Telecom of Egypt, whose earnings grew by less than 10 per cent last year. These inefficiencies are the stuff from which alpha is made.

The most serious threat to equity values in the region, not to mention human life, would be a US or Israeli strike on Iran’s ramshackle military and incompetently managed nuclear industry. For what it’s worth, I believe the chances of such a strike are close to one in three, higher than the markets’ apparent perception, which assumes rational leaderships. Based on past war outbreaks, this could lead to declines of a quarter to a third in stock indices, though the losses would probably be made up more quickly than one might imagine. Higher oil prices, even more government spending, more profits, more share purchases. Remember the last run-up came in the middle of the Iraq war.

Iran doesn’t have the ability to project enough military force to cause much direct loss to the US military, or to seriously disrupt the region’s lines of communication for more than a few days. Which isn’t to say a strike would be anything but bad for the long-term interests of the US, its allies and the many civilian victims. It probably won’t happen, but if it does, the region’s investment story wouldn’t be over.

johndizard@hotmail.com