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Why Saudi Arabia's MSCI upgrade is only the beginning of the journey, not the destination

21 June 2018  |  Oliver Schutzmann

The decision is made. MSCI, the global index provider, has joined its peer FTSE Russell in elevating Saudi stocks to emerging market status. Congratulations must go to the leadership of Tadawul, the Capital Markets Authority and the Saudi Arabian Monetary Authority for their concerted efforts that paved the way to the upgrade.

The decision will not have an overnight impact: index inclusion will take place in two phases in May and August 2019, and the mobilization of billions of dollars of funds into Tadawul will take time. MSCI has been undertaking a consultation with institutional investors, allowing them to kick the tires of this market to ensure their cash is safe and liquid, and that the systems and processes all work smoothly. Much of the groundwork has been completed – inclusion in the index is now confirmed, and investors have another year to get used to the market, its constituents and its infrastructure. So far, so good.

But there is a widespread misperception among some commentators and listed firms that index inclusion is a no-lose bet. Simply follow the passive investment flows, they argue, and watch valuations rise. Such a guaranteed return looks too good to be true. And it is.

The parallel to this misguided logic sees an IPO as a sure thing. List on the equity markets, and watch your valuation soar: this is often the prevailing view in the Arabian Gulf region. The fact is that the hard work for a company in convincing investors to give them their trust and investment dollars begins after the IPO, not before. The same is true with an index upgrade. It is possible the news of inclusion will trigger some profit-taking in the short term.

Emerging market investors are used to taking risks. They are used to volatile environments, markets and economies. But what they demand, perhaps more than anything else, is a level playing field from the companies they invest in. Full and fair disclosure, impeccable compliance and management strategies that minimize volatility and remove surprises are minimum requirements. They understand the macro and geopolitical risks that come with emerging markets. They want to mitigate that risk with best practice in governance, transparency and disclosure. They also expect minimum investor relations standards.

Looking at the Saudi market today, only a handful of companies pass these tests. Some of the larger-cap stocks in the index already do a good job at assuming international best practices: Al Rajhi Bank and National Commercial Bank, to name just two. Some other companies are preparing to upgrade their investor relations standards. 

These standards are far from universal, however, and companies that do not pay attention to IR will find themselves on the wrong side of investor sentiment. Even passive funds will require some level of engagement to maintain their faith and allocations. Winning the trust of emerging market investors is going to be hard work, and will take time.

Even with these factors, inclusion in the new index is going to be for the few, not the many: MSCI confirmed that only 32 names will make it into the first iteration of the index. Inclusion criteria are strictly rules-based, and average traded value ratio and foreign inclusion factor are hurdles that are too high for most Saudi-listed firms. This gets to the real nub of the story: index inclusion is the beginning of a journey, not the destination.

The vast majority of listed firms will need to work much harder to generate the liquidity that will ensure their inclusion at some point in the future, and that can only be achieved if they create a strong IR program that systematically addresses shortfalls in these areas.

The spotlight has now moved away from the regulators and market infrastructure, and on to the market constituents. The onus is now firmly on Saudi companies to deliver what investors want, which means solid, realistic and transparent reporting and investor relations. Get it right, and they will reap the benefits. Get it wrong, and they will disconcert the regulators, the market and the nation they represent.

All being well, however, fast forward two or three years and Saudi Arabia should have cemented its place in the global emerging market universe, and be the recipient of 2 percent to 3 percent of all funds invested in emerging markets. This percentage is the weighting Saudi will receive among global emerging markets from MSCI, which ranks the kingdom between Malaysia and Mexico. 

Once Saudi companies have demonstrated a solid track record of disclosure, strong and well-communicated business strategies and sound corporate governance, they will be respected and admired by investors from Hong Kong to Houston. And the stage will be set for Saudi Arabia to lead the region’s markets toward the next stage of their development: to become developed markets.

Before that can happen, though, the boardrooms of the kingdom’s listed firms need to invest in their relationships with these new investors, and they need to start immediately. If they have not done so already, they must develop a clearly articulated strategy and investment case, convince investors that management teams will deliver on the strategy and create investor relations programs that are deserving of investors’ trust.

The rewards of emerging market status and winning investors’ trust are high. The risks of a breach of that trust are higher still. It’s time to get to work. Now.

This article originally appeared in IR Magazine on 21 June 2018 with the headline: "What Saudi Arabia’s MSCI upgrade means for IR in the kingdom"