Gulf stocks present significant potential for gains with limited downside risk, Bahrain-based Securities and Investment Company (Sico), said in its latest research document.

"Considering the weak improvement in the global and regional macro picture, the panic selling in GCC markets in 2008 and partial recovery thereafter, and a seemingly increased risk appetite, we believe that investors should look more favourably at increasing their measured exposure to GCC equity markets," said Sico analyst Jithesh Gopi in the document emailed to Emirates Business.

"After a 20 per cent hike in the MSCI GCC index, we feel that one should be very selective in picking significant upside stocks."

The investment bank has highlighted several factors that present a positive outlook for Gulf stock markets, as well as some factors that may prove to be party-poopers.

The upside

Global cues: World equity markets saw a reversal in fortunes during Q209, after a turbulent first quarter and an unprecedented dismal 2008. World equity market capitalisation increased by 13 per cent year-to-date, or $4 trillion (Dh14.69trn), but gained 41 per cent from its low of $25.5trn on March 9.

"However, the market is still substantially below its all-time high of $62.5trn (October 2007). The revival in equity markets was sharper in emerging countries, which had also witnessed a steeper fall when global markets were contracting.

"The GCC equity markets followed the trend, though at a slower pace and with a lag, fuelled by oil price recovery, and underpinned by a seeming improvement in the global macroeconomic outlook," said Gopi.

Post Q109, Sico said, a mild revival has been observed in the global macroeconomic picture, which has led to an improvement in global business confidence. This has led to significant overall reductions in bank borrowing costs, improvement in liquidity and an increase in investor risk appetite, which has increased interest in equity markets.

"However, recessionary fears and their potential effects are far from over, even though the unprecedented stimulus packages and concerted efforts seem to have succeeded in averting further weakness in the global economy," warned Gopi.

Corporate performance: Sico believes Gulf investors are now better equipped to make investment decisions having glimpsed the quarterly results while factoring in the likely bottoming out of property and commodity prices and an improvement in broader markets.

"We believe that Q109 results provide a fair representation for the remaining part of the year for the GCC region. Our sample of listed GCC companies reported profits of $8.1 billion in Q109, compared to a loss of $4.6bn in Q408, indicating a significant improvement in performance on a quarterly basis," said Gopi.

"However, profits are still significantly lower compared to the first three quarters of 2008, which saw an average quarterly profit of $15.1bn."

Crude effect: A steady increase in oil prices have improved sentiment in the region that exports the largest chunk of crude globally, but Sico believes the stock markets have yet to price in this factor.

Reflecting the improvement in the global economic outlook, oil prices have more than doubled after touching a low of $33 per barrel in December 2008. This has alleviated concerns about budget deficits, liquidity, government support, and major slowdowns in development activities by regional governments. Sico research shows that each dollar increment in average oil price results in more than $5bn in additional annual revenues for the Gulf countries.

"We have become more positive for future prospects of the Gulf markets, as we believe that the regional equity markets have yet to price in the additional liquidity emanating into the region driven by the higher oil prices. Stability in oil prices during a period of uncertainty and economic slowdown bodes well for long-term prospects for the region," said Gopi.

"We see any fall in the market due to weaker Q209 results or the summer lull as a good entry point for investors as we expect more affirmative triggers from global markets during H209."

The downside

Summer doldrums: The summer season has always affected GCC market activity over the past few years. In four out of the past five years, average quarterly volumes and values have dropped in the summer months.

Average monthly traded value in this period has been lower compared to the preceding quarter. During the past two years, average monthly traded values have also been lower than the average monthly value for the year, showed Sico research.

"We do not foresee a major sell-off and exit from markets during this summer, as the YTD traded value is significantly lower than the preceding four years. However, a short-term correction and a moderate decline cannot be ruled out," said Gopi.

"We believe that the seasonal impact on the markets is driven more by sentiment than by any fundamental factors.

"If we continue to see more signals that are positive globally, regional markets will react positively in the absence of any significant weakness in Q209 profits and increase in banks' non-performing loans, or NPLs."

Asset quality: Following recent loan defaults by two prominent Saudi groups, market participants have become concerned about the solidity of other regional family-owned corporations.

"A lack of transparency and disclosures by family groups and their significant influence on the overall economy and banking system has raised red flags to already sceptical investors. We take comfort from the fact that most of the prominent family groups are far more conservative compared to the recently defaulted groups, which leveraged their balance sheet excessively to grow its asset base by more than four times – from $7bn in 2005 to $31bn in 2008 – in a span of four years." said Gopi.

"We believe that regional banks in general have the ability to absorb a few of these events with the help of their sovereign wealth funds. However, lack of clarity regarding such exposures and potential impact will continue to negatively affect investor sentiment," he added.

Credit growth slowdown: Private sector credit growth in the GCC region, which showed an extraordinary boom of 25 to 40 per cent in the past three years, slowed sharply during Q109. In-quarter credit growth in Bahrain and Saudi Arabia plunged into negative territory, declining by two and one per cent, respectively.

The UAE, Oman and Kuwait showed low single-digit credit growth of two to three per cent, compared to a five to 10 per cent quarterly average during the past three years. Qatar was the only outperformer with on-quarter credit growth of six per cent due to higher GDP growth and investments in the economy. "There are a few reasons for the slowdown/ contraction in credit supply. First, most banks in the GCC are facing asset quality problems due to a sharp rise in delinquencies during the past six to nine months. Hence, banks are more focused towards consolidation and rationalising their loan books rather than booking new loans," said Gopi.

"Secondly, credit demand in general has declined due to a sharp slowdown in economic activity and investments, especially in the broader real estate sector. Thirdly, most GCC banks, particularly in the UAE, Oman and Qatar, are over-leveraged with ADR ratios of more than 100 per cent. Therefore, in the light of global and regional tight liquidity, most banks are reducing their leverage and increasing liquidity rather than growing their loan books.

"Finally, the slowdown in deposit growth, due to a decline in liquidity and contribution from the public sector, has also reduced excess funds, thus curtailing loan growth."

Real concerns: Most regional real estate companies have seen, during the past two quarters, deterioration in their financial health driven by weak fundamentals.

"We continue to foresee substantial softness in regional property markets as developers shift towards restructuring projects and reallocating available resources. Despite a slight improvement in mortgage availability, the non-operating state of the two biggest lenders – Amlak and Tamweel – in Dubai is likely to maintain pressure on property transactions," said Gopi.

"The liquidity stretch felt by most developers because of a jump in past-due payments is likely to impact operations in the remaining half of the year. However, we feel that despite using considerably conservative estimates, several real estate stocks are trading at unjustified discounts to their fair value. We expect these companies to do well over the longer term."


Sector views

Petrochemical: Sico said it has not seen any significant delays in the announced petrochemical projects in the region, specifically in Saudi Arabia and Qatar, due to the availability of cheap feedstock and favourable financing by the governments.

"There had been some delays in commissioning of the plants, which we believe is more due to operational glitches and not because of unavailability of financing and/or concerns on the long-term viability of these projects. We believe this underscores governments' support to their regional petrochemical industries, while reflecting the long-term profitability of these projects," said Sico analyst Jithesh Gopi. "In the near term, we believe that trading in the petrochemicals sector will increase further, and the price movement will primarily be driven by the global market sentiment and oil prices."

Banking: Sico said GCC banks' asset quality will continue to remain a concern and NPLs will see a steady increase in the coming quarters. "However, in our view, most of the regional banks have the ability to absorb such losses and the potential downsides are more than captured by the current low prices. We expect banking stocks to be volatile during H209, and recommend long-term investors to accumulate value stocks – such as the leading banks in each country – at dips."

Real estate: Regional real estate stock prices rose in the range of 30 to 100 per cent from their 52-week lows during March-May 2009, yet continue to trade significantly below their highs. Out of the large-cap companies listed on the GCC indices, only four have provided negative returns on a year-to-date basis, Sico research showed.

Stock prices jumped from low levels on lower prices and outperformed relative benchmarks. "In the near term, we do not foresee significant improvement in the operating environment of real estate developers and recovery in prices from current levels. The unfreezing of mortgage markets will help in the process of price discovery and improve transaction flow. However, in Dubai, the restructuring of two major mortgage providers would continue to affect mortgage availability," said Gopi.

Construction: Sico expects the GCC construction sector to be under severe stress at least during the next four quarters. Payment delays, liquidity crisis, project delays, cancellations, retendering and lack of property investors appetite will continue to dictate the fortunes of the companies operating in this segment, it said.

"As the construction market shrinks and competition increases among the existing players, developers/clients will have higher bargaining power, which will lead to renegotiation of already tendered projects and lower margins for construction companies," said Gopi.

"In the near term, we feel that the operating environment for the construction sector companies will be challenging with liquidity issues hampering operational growth."

Telecoms: "On a relative basis, we find GCC telecom companies at attractive valuations when compared to the median of other large companies across the emerging markets," said Sico.

"We expect telecom companies to have a positive impact on their net profits from currency movements in Q209. However, we do not recommend investing merely based on currency movements but see the price movements in the short term as good entry/exit points for investors.

"In the case of telecom firms with operations in developing/emerging countries, more focus should be on growth potential in those countries as currency movements tend to be more volatile. However, we do believe that the positive impact of currency along with attractive relative valuation of the sector may result in outperformance of the sector in the near term."

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