Iraq: can a dusty war zone become a golden opportunity?

Citigroup, JPMorgan and Standard Chartered have all unveiled plans to open bank branches in Iraq. The Starwood, Sheraton and Wyndham hotel groups are also venturing into the country.

The staunchly Muslim nation of 33m will soon even see a $2bn casino resort, if plans hatched by Dubai’s Emaar Properties come to fruition.

Yet, understandably, the news agenda is instead dominated by daily tales of tragedy, as the civilian death toll from the violence in the country rises to its highest level since 2008.

So is Iraq descending back into chaos and anarchy, or are portfolio investors missing out on a golden opportunity that banks, hotel chains and property developers have already spotted?

Perhaps unsurprisingly, the hardy band of fund managers who have already set up shop in the country believe the latter.

“Corporate profits are booming despite the security backdrop. Can you imagine what will happen if things actually get better?” asks Sanjay Motwani, president and portfolio manager at Sansar Capital, which runs the $30m Frontier fund, entirely invested in Iraq.

Geoffrey Batt, manager of the $82m Euphrates Iraq fund, adds: “The security situation is misleading. Baghdad is booming in a good way, it is very difficult to get a reservation in a restaurant. There are parts that are extremely dangerous that I wouldn’t go into, but it’s the same as Baltimore. The murder rate is higher in Chicago or Miami than Basra.

“Some local managers have become quite skilled at making money in decidedly unfriendly conditions. It’s not ideal, but we haven’t seen any impact on operational business. The third quarter is shaping up to be a record [in terms of earnings].”

Much of the optimism is driven by a recovery in Iraq’s oil industry, which accounts for around two-thirds of gross domestic product and 80-90 per cent of government revenue. Last year Iraq surpassed Iran to become the second-largest Opec producer for the first time since the late 1980s, although technical problems and bomb attacks are stopping the sector from reaching its full potential.

Nevertheless, the partial recovery provides a sweeter backdrop for some consumer companies, such as Baghdad Soft Drinks, the local Pepsi distributor, universally lauded by those FTfm spoke to.

“Years ago people were demanding fake soft drinks and know they are demanding the real thing. Earnings were up 400 per cent last year,” says Mr Motwani.

Mr Batt, whose fund owns around 10 per cent of the company, adds: “It’s one of the hottest places on earth. If you can focus on making your distribution system efficient, it’s a story about volume growth, [aided by] very strong demographics and rising per-capita GDP.”

Of course, the fact that fund managers tend to alight on the same stocks point to the relative thinness of the market, with only around 90 listed stocks, many of which have a market capitalisation in the range of $10m-$20m and limited liquidity.

Sherif Salem, manager of the $21m Invest AD Iraq Opportunity fund, says a lot of other consumer and industrial companies “are being held back by the fact that they need a capital injection, and some of them need some foreign expertise or knowhow”, particularly former government-owned companies that now have to compete in a capitalist environment.

“These companies are not operating as well as they could. So there is a lot of potential.”

The country’s 20 listed banks are among those most favoured by fund managers; importantly they have demonstrated their ability to tap investors, with all completing rights issues in the past year or so under a plan to raise industry-wide capital adequacy levels.

Indeed, Mr Motwani cites the rights issues as the reason the Rabee Securities Iraq index has risen just 5.4 per cent in local currency terms this year, following gains of 7.2 per cent in 2012 and 49 per cent in 2011.

“A lot of paper was hitting the market at a time when there have been little foreign inflows, so there has been a disconnect between share price performance and corporate performance, but from the end of this year that will change,” he says.

According to Mr Motwani, some banks boast a return on equity of 20-24 per cent with only three times leverage, and are expanding rapidly, but still trade at book value or below.

“The banks are a macro play on the economy. Net profits are up 200 per cent between 2010 and 2012 but people don’t know about it. How many reporters are there on the ground in Baghdad to talk about corporate profits? Probably none.”

Amid the surge in violence, Mr Batt takes solace from the fact that bank deposits are rising. “It is a fairly reliable indication that the situation is not having an adverse effect on business. People would not be building up their bank balances if they were concerned that the country was going to fall apart,” he says.

Telecommunications are another potential bright spot. Asiacell, the industry leader, floated in February and rivals Zain Iraq and Korek Telecom are likely to follow suit in 2014.

Mr Batt, who also holds property and construction stocks, believes a number of Iraqi family-owned conglomerates will float in the next two or three years.

One obstacle to greater portfolio inflows is the lack of custody services in the country. As a result, large institutional investors remain absent. Mutual funds are instead reliant on wealthy private investors and family offices, alongside the odd endowment and Swiss private bank, as well as Iraqis themselves, the majority investors.

Mr Motwani is confident a custodian will emerge in the next 12-24 months, attracting fresh investors, although Mr Batt is more sceptical.

Despite the difficulties, the managers all believe in the long term prospects for the country.

Mr Motwani says Iraq’s market capitalisation is just 4 per cent of its GDP, compared with levels nearer 45-50 per cent in many other Middle Eastern countries. If this rises to 50 per cent and nominal GDP rises fivefold in the next decade, which he believes is possible, this could, at a stretch, deliver a 50-fold return, he argues, although returns of 10-15 times are more likely as existing shareholders are diluted.

Mr Salem fears the market is still seven to 10 years away from reaching its potential, but believes there is money to be made in the interim.

“This sort of situation is probably the best time to make money. The country is essentially starting from zero. There are so many opportunities – it is just having the risk appetite to do it.”