GCC For Fundamentalists

Kuwait Financial Centre “Markaz” R E S E A R C H

GCC For Fundamentalists A Top-down Framework

GCC investors will most likely close year 2006 bruised, with losses averaging 44% for the GCC market as a whole. It is time to assess the situation in order to strategize investment thinking for the year 2007. While a static call for one full year is neither feasible nor recommended, nevertheless the importance of assessing future direction remains paramount. As we have been stressing through our research, asset allocation probably explains majority of investment performance and hence the need to focus on this critically important issue. Analysts attribute various reasons for the happening in year 2006. However, the key question is: whether year 2006 can be seen as a healthy correction/consolidation or is it the start of a long-major bear phase? Asset allocation for year 2007 will to a large extent depend on the answer to this question. We believe that the former is more aligned to GCC economic conditions than the later. This is not to forget that bear phases for stock markets have lasted longer than expected and is excruciating. However, such instances of prolonged bear phases (Nikkei for e.g.) has been accompanied by economic recession and banking system weakness. Neither of those conditions is forecast for GCC region in 2007. Hence, the firm belief that year 2006 is a consolidation. In this paper, we suggest and develop a framework involving fundamental variables affecting the GCC stock markets. This is aimed to form a quantitative-driven view on the region as well relative attractiveness of GCC stock markets.

December 2006 Research Highlights: Establishing a framework involving fundamental variables affecting GCC stock markets.

By M.R. Raghu CFA, FRM Head of Research +965 224 8280 (Dir) [email protected] Kuwait Financial Centre “Markaz” P.O.Box 23444, Safat 13095, Kuwait Tel: +965 224 8000 Fax: +965 242 5828 www.markaz.com

Valuation

Attraction

Moving

AverageEarnings

Growth

Economic

Factors

Fund

Manager's Av

PoliticsInvestor

Sentiment

Economic

Liquidity

GCC Stock Markets– The Jigsaw Puzzle

R E S E A R C H December 2006

Kuwait Financial Centre “Markaz” 2

Methodology Our framework considers the following as parameters for arriving at the allocation: ♣ Economic Factors: While there are various factors that can be considered, in

order to simplify the exercise, we have considered four key sub-parameters: ♣ Real GDP growth ♣ Inflation ♣ Budget Surplus/Deficit & ♣ Current Account surplus/deficit

♣ Valuation Attraction: Three important factors are considered: ♣ Price to Earnings ratio (P/E) ♣ Price to Book ratio (P/B) & ♣ Dividend Yield

♣ Economic Liquidity: We believe that liquidity is an important factor fuelling asset market appreciation as has been proved in many academic studies. We have considered the broad money (M-2 growth) for our study.

♣ Fund Manager’s Average: The consensus actions/estimates of fund managers managing GCC funds may contain important information. We consider it prudent to incorporate this as a parameter.

♣ Earnings Growth Potential: Future asset price appreciation is most likely to follow earnings strength (though there may be a lag).

♣ Moving Average: This is a technical tool and evaluates current market position vis-à-vis their short-term and long-term moving average.

♣ Investor Sentiment: Unlike other developed economies, where this can be quantitatively measured through consumer confidence index or CRB index, absence of such tools renders it difficult to gauge this very important parameter. Given this limitation, we have considered the growth of IPO market in various GCC economies as a distant proxy to investor sentiment and confidence. We realize and appreciate this is not a proven index for measuring investor sentiment.

♣ Geopolitical Developments: We consider the country risk ratings provided by Economic Intelligence Unit for this purpose.

♣ Market Liquidity: Sharp market correction is often followed by drying up of market liquidity. Hence, we consider this factor through value of shares traded.

All of the above parameters are assigned weights as follows:

Parameters Weights 1 Economic Factors 20% 2 Valuation Attraction 15% 3 Economic Liquidity 15% 4 Fund Manager's Average 15% 5 Earnings Growth Potential 10% 6 30-Day Moving Average 10% 7 Investor Sentiment 5% 8 Geopolitical Developments 5% 9 Market Liquidity 5%

100% All of the above parameters and sub-parameters are assigned a score ranging from 1(lowest) to 5 (highest). Legend Score (1-5)

Positive 5

Neutral 2.5

Negative 1

The framework considers nine different factors that impact valuation attraction. These factors are assigned weights and scored on a scale of 1-5.



1. Economic Factors (20% Weight) a. Real GDP Growth: We have considered the average rate of growth for the period 2000-2005, estimated growth for 2006 and forecast growth by various international agencies of repute for 2007. It appears that after recording fantastic growth during 2005 and 2006, 2007 may be headed for lower real GDP growth due to expected fall in oil production. While in absolute terms, the growth is expected to remain strong, in relative terms they may record lower growth than 2006 or 2005. This is especially true for Kuwait and UAE, where the predicted real growth for 2007 is lower than the growth recorded in year 2006 as well as long-term average. Qatar is the only GCC economy that is expected to maintain its scorching pace of growth. Oman and Bahrain will record lower growth relative to year 2006 but higher than their long-term average.

Saudi Arabia Kuwait UAE Qatar Oman Bahrain

Real GDP Growth (2000-2005 Avg) % 4.17 6.43 7.80 7.47 4.98 5.75

Real GDP Growth (2006 e) % 5.75 6.20 11.50 6.70 7.10 7.10

Real GDP Growth (2007 f) %-IIF 5.82 4.09 9.74 10.56 8.29 7.20

Real GDP Growth (2007 f) %-IMF 6.50 4.70 5.80 4.70 5.70 6.30

Real GDP Growth (2007 f) %-Standard Chartered 5.00 4.80 5.20 8.10 5.50 6.30

Real GDP Growth (2007 f) %-EIU 5.00 4.90 8.20 8.90 4.70 5.70

Average 5.58 4.62 7.23 8.07 6.05 6.37

Score 2.50 1.50 1.50 3.50 2.50 2.50 b. Inflation


Inflation (2000-2005 Avg) annual change -0.05 1.67 3.87 3.54 0.33 0.70

Inflation (2006 e) annual change 1.00 3.50 7.70 9.00 3.00 2.60

Inflation (2007 f) annual change-IIF 1.80 3.17 6.88 7.51 2.77 3.49

Inflation (2007 f) annual change-IMF 1.00 3.00 5.00 8.00 2.00 3.00

Inflation (2007 f) annual change-Standard Chartered 1.70 3.20 9.60 7.00 1.70 2.80

Inflation (2007 f) annual change-EIU 0.70 2.00 8.00 6.20 3.50 2.40

Average 1.30 2.84 7.37 7.18 2.49 2.92

Score 3.50 2.50 1.00 1.00 2.50 2.50 Strong demand growth coupled with supply bottlenecks lead to inflation turning higher than long-term average for all the GCC countries. UAE and Qatar are notable examples with inflation approaching near double-digit numbers. Saudi Arabia scores well on this parameter with expected consensus inflation at just 1.3%. It must be said that the Consumer Price Index (CPI), the barometer for gauging inflation, does not fully capture all price pressure points and hence we believe that the actual inflation experienced by GCC economies is much higher than the reported inflation. However, generous government subsidies and low-cost labor (thanks to expat population) are acting as dampeners. We expect the supply bottlenecks to continue especially in sectors like construction.

2007 may be headed for lower real GDP growth according to international forecasts. UAE and Qatar vulnerable to inflation threat as inflation is close to double-digit



c. Fiscal Balance


Fiscal Balance (2000-2005 Avg)-% to GDP 5.12 27.11 13.22 7.87 5.70 2.20

Fiscal Balance (2006 e)-% to GDP 19.21 40.12 33.70 5.05 12.48 7.56

Fiscal Balance (2007 f) - % to GDP-IIF 13.40 37.48 32.90 2.48 10.68 3.15

Fiscal Balance (2007 f) - % to GDP-IMF NA NA NA NA NA NA

Fiscal Balance (2007 f) - % to GDP-Standard Chartered17.20 40.60 25.40 13.40 4.70 2.70

Fiscal Balance (2007 f) - % to GDP-EIU 22.10 38.10 5.70 6.80 5.90 7.50

Average 17.57 38.73 29.15 7.56 7.09 4.45

Score 2.50 4.00 4.00 2.00 2.00 2.00 GCC economies enjoy surplus budgetary position, thanks to higher oil prices. While expenditure has been growing, they did not expand too rapidly to threaten the surplus situation. Fiscal surplus enables governments to pursue aggressive expenditure strategy, coupled with ability to repay debt. Year 2006 recorded significant surpluses for most of the GCC economies, far higher than their long-term average. Notable among this is Kuwait with significant surplus (40% of GDP for year 2006), followed by UAE (34% of GDP for year 2006). Projections indicate another strong year for these economies1. Saudi Arabia and Qatar are expected to maintain their position while Oman and Bahrain are expected to report a fall in fiscal surplus during 2007. d. Current Account Balance


Current Account Balance (2000-2005 Avg) - % to GDP 13.67 28.13 10.68 22.03 8.55 5.20

Current Account Balance (2006 e) - % to GDP 32.90 52.50 21.00 49.10 19.40 20.60

Current Account Balance (2007 f) - % to GDP-IIF 28.34 41.55 24.76 21.56 18.13 17.71

Current Account Balance (2007 f) - % to GDP-IMF 31.9 51.9 21.3 48.4 19.6 18.9

Current Account Balance (2007 f) - % to GDP-Standard Chartered 27.6 45.6 24.1 28.7 18.6 6

Current Account Balance (2007 f) - % to GDP-EIU 28.2 47.5 4.2 17.9 16.7 13.7

Average 29.01 46.64 23.39 29.14 18.26 14.08

Score 4.00 4.50 4.00 4.00 3.50 3.00 Following strong fiscal situation, the current account balance recorded extraordinary growth during year 2006. This is supported by trade balance, with exports showing strong growth, thanks to global demand growth. Kuwait is again leading the pack having recorded 52.5% of GDP as current account surplus during year 2006, followed by Qatar at 49%. Except Bahrain, all other GCC economies score very high on this front. e. Summary


Economic Growth

Inflation

Fiscal Balance

Current Account Balance

Overall Score 3.13 3.13 2.63 2.63 2.63 2.50

1 Projections by EIU for UAE and Qatar has not been considered for average as we feel that the projections are not in alignment with other agencies.

Kuwait and UAE enjoy very high fiscal surplus relative to other GCC countries All GCC countries enjoy excellent current account balance



2. Valuation Attraction (15% Weight)

P/E (07e) P/B(07e) Div Yld (07e)

GCC 13.1 4.1 2.2

EMEA ex. GCC 10.7 2.2 1.8

Asia 11.6 1.8 3.4

LATAM 9.9 2.1 5.9

Source: Credit Suisse The sharp correction in year 2006 has enabled most of the GCC stock markets to reach reasonable valuation levels from unreasonable levels that prevailed during the start of year 2006. While at the beginning of year 2006, emerging market valuation metrics looked very attractive compared to GCC, the reverse is true now. While emerging market P/E (trailing) is estimated at approximately 18, most of the GCC markets except Saudi Arabia enjoy lower valuation than emerging market average making it an attractive bet. It is important to note that some of the leading emerging markets have run up significantly in terms of P/E. Notable among these are China (31), Czech Republic (26.3) & India (23.5). However, going forward, earnings growth in emerging markets is likely to outstrip that of GCC and hence forward P/E, P/B and dividend yield looks attractive for emerging markets than GCC, albeit with a narrow margin. a. Price to Earnings (P/E) Probably the most important stock market indicator, but the least understood! This is because, there are many versions to a price to earnings ratio. It can be historical (trailing) or prospective (forward). Even in the historical P/E, it can be based on previous year end earnings or previous four quarters earnings. Hence, we see different estimates by various research agencies on this important parameter. The good news is that we do not see serious differences between various estimates enabling us some sort of visibility. P/E


12-m Trailing 17 11 13 20 11 15

2006 E 16 15 14 15 NA NA

2007 F 14 12 12 11 NA NA

Score 1.5 4.0 4.0 3.5 4.0 2.5

Source: Credit Suisse Markets that have significantly corrected during year 2006 are those that have experienced sharp run-up in terms of P/E during 2005. This includes Saudi Arabia, UAE and Qatar. It is noteworthy that Kuwait, Oman and Bahrain showed steady trend in their P/E behavior thus escaping the brunt during year 2006. Going forward, we feel that even though Saudi Arabia has softened significantly in terms of P/E, it still probably is higher than other GCC markets and emerging markets. Hence, it scores negatively in our analysis compared to other GCC markets. Estimating forward P/E is laden with practical difficulties due to difficulties in estimating earnings. This is due to poor disclosure standards and research coverage.

Except Saudi Arabia, all other GCC markets enjoy attractive valuation in terms of P/E. GCC valuation is looking attractive compared to emerging markets.



b. Price to Book (P/B) Price to book almost always reflects trends in P/E, but is more consistent. However, it is limited by a parameter that is book-value based. As is the case with P/E, there is inconsistency in estimates released by various agencies. However, it is clear that during year 2005 most of the GCC markets experienced sharp run-up in their P/B ratios. Significant among this are Saudi Arabia and UAE with P/B ratios of 9 and 6 respectively. This is nearly three times their long-term average. While UAE has since corrected sharply and therefore the P/B ratio looks closer to long-term average, Saudi Arabia still looks expensive by this yardstick. Forward P/B for Saudi Arabia and UAE still looks expensive. All other markets look attractive by this measure. P/B


12-m Trailing 3.9 3.0 3.1 2.9 1.0 2.2

2006 E 4.9 3.2 4.9 2.8 NA NA

2007 F 4.5 2.3 4.3 2.6 NA NA

Score 1.5 4.0 1.5 3.5 4.0 4.0

Source: Credit Suisse c. Dividend Yield (%) Stock markets provide returns in two forms: Dividends and Capital Appreciation. Companies listed in GCC stock markets are mostly “dividend plays”, meaning that good measures of their profits are normally distributed as dividends. However, sharp stock market appreciation during year 2005 has reduced this measure to very low levels. In other words, low dividend yield will force investors to seek gains only through capital appreciation, which may be uncertain. The correction in year 2006 has restored the historic dividend yields for many of the GCC markets making it attractive. Notable among this would be Kuwait, Oman and Bahrain. Dividend Yld


12-m Trailing 3.7 3.0 2.0 2.2 3.8 12.7

2006 E 2.4 2.3 0.6 2.5 NA NA

2007 F 2.5 2.3 0.7 2.6 NA NA

Score 1.5 1.5 0.5 1.5 4.0 4.0

Source: Credit Suisse d. Summary

Summary Saudi Arabia Kuwait UAE Qatar Oman Bahrain

P/E

P/B

Div Yld

Weighted Score 1.50 3.50 2.30 3.10 4.00 3.40

Current P/B ratios for all the countries look attractive except Saudi Arabia. Dividend yields have improved in year 2006 after sharp market correction.



3. Economic Liquidity (Broad Money) (15% Weight)

Currency

Outside

Banks

Demand

Deposits

Time &

Savings

Deposit

Other

Quasi

Monetary

Deposits

M1

M2

M3

Money Supply Structure

Money supply simply refers to the stock of money in the form of currencies and deposits that floats around in the economic cycle. Deposits (demand and time) probably constitute the largest portion of money supply. Sharp increase in money supply almost always results in asset price appreciation and hence the importance of liquidity for determination of capital market and other asset market directions (like real estate). However, money supply data comes with a lag and hence cannot be used as an advanced indicator for predicting stock price movements. Also, there is a time lag between flow of money and its impact in the stock market. Hence, a broad direction (increase or decrease) is what is possible when estimating liquidity increase. In the case of GCC economies, oil price will mostly determine the liquidity levels. Also, for specific markets we could observe strong relation between liquidity and stock market movements (Saudi Arabia illustrated). Saudi Arabia

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

120%

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Sep-

06

-10%

-5%

0%

5%

10%

15%

20%

Liquidity Growth (RHS) Stock Market Growth

As an example, we have provided data on Saudi Arabia liquidity and stock market movement. The surge in years 2003-2005 can easily be explained by extraordinary growth in liquidity.

Saudi Arabia exhibits strong sensitivity to economic liquidity



Broad Money Growth


Average (1998-2002)-% change 7 5 13 8 6 10

2003 8 8 16 16 3 6

2004 17 12 24 21 4 4

2005 13 12 30 43 21 22

2006-Sept/June 11 17 9 20 18 8

Score 2.5 4 1 2.5 3 1.5 GCC economies have been experiencing very strong liquidity growth during the period 2003-2005 as against long-term average. For e.g., UAE recorded M2 growth of 30% in 2005 as against long-term average of 13%. Similarly, Qatar experienced a growth of 43% as against long-term average of 8%. However, UAE experienced significant moderation in liquidity growth during the current year as per indications available as of the date of writing this report. While most of the countries have witnessed a drop in liquidity growth during year 2006, Kuwait proved to be an exception. Oman is also experiencing liquidity growth far higher than its long-term average. 4. Fund Manager’s Average (15% Weight) Asset allocation pattern of fund managers have important information buried in them. Realizing this, we have recently started compiling information/data on 21 GCC equity funds in order to decipher information contained in this parameter. Our recent study of fund managers reveals that managers have increased their cash allocation given the tumultuous GCC stock market. Even for the equity portion, managers have significantly reduced their allocation to Saudi Arabia (exhibiting high volatility) and increased their allocation to markets like Kuwait/Oman/Bahrain whose volatility ranges are more acceptable. However, this should also be viewed in the context of “home bias” that funds exhibit. In other words, we observe that funds domiciled in Saudi Arabia have high allocation to Saudi Arabia, etc. Fund Manager's Average


Aug-06 14% 37% 20% 11% 9% 6%

Sep-06 20% 32% 20% 9% 8% 5%

Oct-06 21% 33% 19% 9% 8% 4%

Score 4 1.5 2.5 1.5 2.5 2.5 Based on these limitations and information available, we find that fund managers have been increasing their allocation to Saudi Arabia, albeit slowly, given the sharp meltdown in the Saudi market. Allocation to Kuwait and Qatar has come down while that of UAE, Bahrain and Oman remained static. Given the low allocation to Saudi Arabia relative to its size and also given the sharp meltdown in its value, we feel managers have started increasing the allocation to Saudi Arabia. This, we see, is happening in the backdrop of reduced allocation to Kuwait and Qatar. Allocation to Kuwait was disproportionate to its relative share and this process is being corrected. We will continue to monitor manager allocation on a monthly basis to refine the model framework.

GCC economies are experiencing strong liquidity growth relative to their long-term trend. Fund managers have been increasing allocation to Saudi Arabia, albeit slowly.



5. Earnings Growth Potential (10% Weight) Earnings drive valuation, to a great extent. Corporate profitability recorded fabulous growth during 2004 and 2005, much higher than the long-term trend. Much of this growth is attributed to stock market growth as many companies derive their income from stock market appreciation either in the form of capital gains or through fee income from trading. Steep slump in the market during year 2006 saw a drop in corporate profitability for most of the markets. The slump in earnings is mostly concentrated on mid and small caps more than large caps. A study of results announced so far for nine months ending Sept 06 for GCC companies reveals this. A good example would be Kuwait, where the overall market reported a drop in earnings of 19%. However, the top companies recorded a growth of 20% while other companies earnings fell by 71%. Except Saudi Arabia and Bahrain, all other GCC countries reported this pattern. Results Analysis-9M Sept 06-Net Income

Overall

Growth

Top co's

Growth

Other

Co'sGrowth

Saudi Arabia 19% 15% 36%

Kuwait -19% 20% -71%

UAE 8% 16% -5%

Qatar 16% 25% 1%

Oman 16% 33% -5%

Bahrain 30% 31% 28%

Source: SICO GCC countries are expected to maintain earnings growth momentum though the rate of growth is expected to slow down. In some cases, like Kuwait, a reversal of fortune is expected. Qatar is expected to record strong corporate profitability growth while Saudi Arabia is expected to show considerable weakness. Our ratings also reflect this. Earnings Growth


2003 61% 105% 39% 73% 0% 121%

2004 46% 21% 51% 57% 31% 44%

2005 40% 78% 123% 46% 20% 34%

2006 E 19% -19% 8% 16% 16% 30%

2007 F 13% 26% 20% 35% NA NA

Score 1.5 2.5 2.5 4.0 2.5 3.5

Source: SICO & Credit Suisse Corporate profitability should be understood in the context of “dependency” factor for many investment/financial services companies being dependent on stock market for their performance. Any downturn in the stock market will have an immediate multiplier effect exposing them to capital losses.

Corporate profitability growth considerably lower in year 2006 compared to previous years. Mid and small caps take the brunt in FY06 while large caps are relatively less affected.



6. Moving Average (10% Weight) Moving average is often used and most popular among technical chartist. Hence, we decided to include them as one of our parameters. Moving averages smooth a data series and make it easier to spot trends, which may be highly helpful in a volatile market. They also form the building blocks for other indicators. All moving averages are “lagging indicators” and will always be “behind” the price. Hence, they are called trend following indicators. When prices are trending (meaning moving either up or down), moving averages work very well. However, when prices enter a trading range (meaning no clear direction), then moving averages may give misleading signals. There are many types of moving averages like simple, exponential, etc. We prefer to use simple moving average, as it provides a better framework in spotting long-term trends, while exponential moving average may work better for shorter time spans. Rules we apply:

♣ Rule 1: If the moving average is rising, the trend is considered up and vice-versa

♣ Rule 2: If the price is above the moving average, the trend is considered up and vice-versa

♣ Rule 3: If the shorter moving average is above the longer moving average, the trend is considered up and vice-versa.

Saudi Arabia Kuwait UAE(Dubai) UAE (AD) Qatar Oman Bahrain

09-Dec 7906 502 4238 3018 6109 5427 2143

30 DMA 8674 535 4306 3136 6552 5547 2174

100 DMA 10390 518 4520 3412 7377 5225 2170

Rule 1 Bearish Neutral Bearish Bearish Bearish Bullish Neutral

Rule 2 Bearish Bearish Bearish Bearish Bearish Neutral Neutral

Rule 3 Bearish Bullish Bearish Bearish Bearish Bullish Bullish

Score 1 2.5 1 1 1 3.75 3 For a scrutiny of technical charts, please refer Appendix. Except for Kuwait and Oman, all other markets have failed the first and second rule test. For the third test, Bahrain joined the list along with Kuwait and Oman. Saudi Arabia, UAE and Qatar consistently exhibit negative trend on all the three rules and hence scores poorly on this parameter. As emphasized earlier, moving averages work well in a trending market. Hence, if GCC stock markets enter a trading zone (unlikely given the past pattern), then we should read moving averages with caution. Also, as the very name indicates, moving averages constantly move and hence these trends are applicable on the day of their analysis. We will revisit this as soon as we can.

We prefer to use simple moving average to predict long-term trend. Saudi Arabia, UAE and Qatar score weak on technical indicators.



7. Investor Sentiment (5% Weight) As explained in the introductory note, measuring investor sentiment is a qualitative process and is highly subjective. Nevertheless, it is a key gauge of the shape of things to come. Various factors (external and internal) affect investor sentiment. Investor sentiment fluctuates between greed and fear and more often gets exacerbated, leading to irrational investment decisions. Unlike other developed economies, where this can be quantitatively measured through consumer confidence index or CRB index, absence of such tools renders it difficult to gauge this very important parameter. Given this limitation, we have considered the growth of IPO market in various GCC economies as a distant proxy to investor sentiment and confidence. We realize and appreciate this is not a proven index for measuring investor confidence. We measure the sentiment through two parameters: Monies raised through

♣ IPO’s & Privatization & ♣ Rights Issue

IPO's & Privitization


2000 No of IPO's

Amount Raised

2001 No of IPO's 1 1

Amount Raised 9 8

2002 No of IPO's 1 2

Amount Raised 9 50

2003 No of IPO's 1 2 2

Amount Raised 2720 70 678

2004 No of IPO's 3 4 5 3

Amount Raised 730 723 506 68

2005 No of IPO's 4 2 6 3 3 3

Amount Raised 1668 219 1682 1084 796 103

2006 No of IPO's 9 1 4 2 3

Amount Raised 2787 120 1354 1316 1037

Score 4 1 2 4 1 4.5

Source: Zawya Amount in $ millions Rights Issue


2000 No of Rights 1

Amount Raised 5

2001 No of Rights 1

Amount Raised 200

2002 No of Rights 1

Amount Raised 251

2003 No of Rights

Amount Raised

2004 No of Rights 1 2 3

Amount Raised 53 324 324

2005 No of Rights 3 5 11 6 2 2

Amount Raised 832 3362 8350 1500 714 114

2006 No of Rights 6 10 8 4 6 2

Amount Raised 1527 1978 1554 519 33 195

Score 4 3 2 2 1 4

Source: Zawya Amount in $ millions Year 2005 was special in that an astonishing USD 20 billion was raised from the market through IPO’s and rights, indicating high level of investor sentiment. However, that sum halved during year 2006. In spite of steep fall in Saudi Arabia, the market for IPO’s and rights continues to be strong indicating investor appetite. UAE and Oman witnessed substantial reduction.

Investor sentiment is measured through response to IPO’s. Saudi Arabia, Qatar and Bahrain score well on this.



8. Geopolitical Developments (5% Weight) Geopolitical risks are measured through

♣ Political risk: Political risk pertains to the risk of exposure stemming from the political environment. The factors in this category relate to the threat of war, social unrest, disorderly transfers of power, political violence, international disputes, regime changes, institutional ineffectiveness, but also include the quality of the bureaucracy, the transparency and fairness of the political system, and levels of corruption and crime in the country in question.

♣ Economic structure risk: Economic structure risk examines economic variables central to solvency. Among the subcategories of risk are growth and savings (growth performance, including volatility), the current account (deficit/GDP, magnitude and degree of sustainability) and debt structure (debt/exports, interest due/exports). We have relied on the ratings by EIU for this purpose. Political Risk


2002 C C C C B C

2003 D C C B B C

2004 D C C B B C

2005 D C C B B C

2006 B BBB BBB BBB BBB BB

Score 3.5 4 4 4.5 4.5 3.75

Source: EIU

A represents lowest risk and E highest risk GCC economies currently enjoy a stable political atmosphere as indicated by the current ratings. EIU has indicated improved risk assessment for all GCC countries for the year 2006. Qatar and Oman enjoy consistently high ratings indicating lower political risk, followed by Kuwait and UAE. Saudi Arabia experienced a major upgrade by EIU in 2006 from D to B. However, in relative terms this still represents the lowest among GCC economies. Economic Structure Risk


2002 B B B B B B

2003 B B B B C B

2004 B B B B B B

2005 B B B B B B

2006 BBB BBB A A A BBB

Score 4 4 4.5 4.5 4.5 4

Source: EIU

A represents lowest risk and E highest risk In terms of economic structure, all GCC countries enjoy very high ratings from EIU. Notable among these would be UAE, Qatar and Oman followed by Kuwait, Bahrain and Saudi Arabia.

GCC economies are experiencing stable and improving political trends. GCC economies score well on economic structure risk.



9. Market Liquidity (5% Weight) Liquidity plays a crucial role in financial exchange markets. Without the availability of counter offers, markets cease to exist. Liquidity indicates depth of markets or the ability to transform assets into cash without a significant discount. Liquidity takes two different appearances depending on whether the market is calm or in crisis. In calm markets, liquidity enables competitive bid-ask spreads. In crisis markets, liquidity is what keeps trading from drying up completely. Unpredictability of market liquidity is an important source of risk for investors. According to empirical studies, market liquidity may suffer due to reasons cited below:

♣ Market makers and investors face credit crunch reducing their ability ♣ Economy turns into a deflationary mode where savers were able to

earn real returns by simply holding money, reducing their incentive to take speculative risk

♣ External adverse shocks (unforeseen) Also, stock markets exhibit higher liquidity when investor sentiment is high. Saudi Arabia Kuwait UAE Qatar Oman Bahrain

CAGR (2001-2005) 136% 39% 214% 118% 45% 51%

Growth in 2005 133% 86% 663% 345% 85% 54%

Growth in 2006 46% -35% -9% -29% -25% 116% GCC stock markets witnessed rapid growth in value traded (the measure of liquidity) as exhibited above. However, the growth during year 2005 was significant relative to long-term average indicating heightened investor sentiment. However, year 2006 witnessed a sharp correction in liquidity for many markets including Kuwait, Qatar, Oman and UAE. Only Saudi Arabia and Bahrain showed increase in liquidity. It must be stated here, that though liquidity has improved, they are still concentrated among few stocks. Most of the mid-cap and small-cap stocks in the GCC region suffer from illiquidity for various reasons. In view of losses suffered during the current year, market makers and investors may face possible credit crunch thereby impacting liquidity in the market. However, the threat of deflation may not be applicable to GCC stock markets. Value Traded ($m)


2000 17,368 4,461 0 0 558 244

2001 22,238 12,385 413 413 425 196

2002 35,587 23,102 1,051 883 854 215

2003 158,672 56,199 2,031 3,220 1,540 271

2004 471,846 52,824 18,189 6,344 1,971 462

2005 1,100,893 98,288 138,818 28,251 3,655 711

2006 1,611,517 63,946 125,766 20,154 2,735 1,535

46% -35% -9% -29% -25% 116%

Score 4 2 3 2 2 4

Extraordinary liquidity growth observed during 2005, indicating heightened investor sentiment. Drop in liquidity observed during 2006, as per the last trends. However, Saudi Arabia and Bahrain reported increasing liquidity.



10. Prognosis for GCC Markets We would like to integrate our findings on fundamental variables discussed above in terms of answering certain questions:

a. Attractiveness of GCC markets as a region b. Asset allocation among GCC markets & c. Investment Themes

a. Attractiveness of GCC Markets

In light of weakness in the stock market in the region, we would like to assess the attractiveness of GCC markets based on various fundamental factors as below:

1. Economic Factors: (Assessment: Positive)

Thanks to robust oil prices, GCC economies are recording super normal growth in real terms. Forecast by international agencies point to another year of strong growth. Wildcard: Steep drop in oil prices due to unforeseen circumstances

2. Valuation: (Assessment: Neutral)

Steep correction during year 2006 has brought valuation metrics closer to reality. They look attractive compared to emerging markets. However, forward price to earnings ratio are projected better for emerging markets than for GCC. Wildcard: Continued strong performance by emerging and international markets may divert funds

3. Economic Liquidity (Assessment: Positive)

Strong oil prices will keep broad money growth strong Wildcard: Oil price may play spoilsport.

4. Earnings Growth Potential (Assessment: Neutral)

Companies may not repeat the scintillating performance recorded during the last three years. However, strong economic and investment climate will provide ample opportunities to report growth. Also, large caps which dominate the market, showed strong performance during year 2006 compared to mid and small caps. Wildcard: Nasty surprises from big blue chip companies

5. Investor Sentiment (Assessment: Weak)

Gulf investors will turn very cautious after suffering huge losses. Wildcard: Sentiment will also be affected by specific events within markets (like Kuwait or Saudi Arabia) where regulators take unexpectedly strong actions against companies and market participants



6. Geopolitical Developments (Assessment: Strong)

While Middle East may face political tensions, the rub off effect on GCC countries is expected to be minimal. Rating agencies also provide improved assessment of political risk. Wildcard: Unexpected turn of events in Iran or Iraq.

7. Market Liquidity (Assessment: Strong)

Even though year 2006 saw a drop in liquidity, they are still high compared to long-term average. GCC market liquidity has expanded quite significantly during the past few years. Wildcard: Concentration of liquidity among few stocks, especially small caps.

In summary, our assessment about the attractiveness of GCC markets for year 2007 is positive backed by strong economic factors, attractive valuations, strong economic liquidity conditions, stable economies and sound market liquidity. Corporate earnings growth may act as a surprise supported by weak investor sentiment.

b. Asset Allocation for GCC Markets

Having been convinced about the attractiveness of GCC region, we now focus our attention on individual markets within GCC region.

Economic

Factors

Valuation

Attractio

n

Economi

c

Liquidity

Fund

Manager'

s Average

Earning

s

Growth

Moving

Averag

e

Investor

Sentime

nt

Geopolit

y

Market

Liquidity

Overall

Score

1 Saudi Arabia 3.13 1.50 2.5 4 1.50 1 4 3.75 4 2.66

2 Kuwait 3.13 3.50 4 1.5 2.50 2.5 1.75 4 2 2.84

3 UAE 2.63 2.30 1 2.5 2.50 1 2 4.25 3 2.18

4 Qatar 2.63 3.10 2.5 1.5 4.00 1 3 4.5 2 2.54

5 Oman 2.63 4.00 3 2.5 2.50 3.75 1 4.5 2 2.93

6 Bahrain 2.50 3.40 1.5 2.5 3.50 3 4 3.875 4 2.85

Fund Managers Average

Suggested

Framework Score Action

Strategic* Aug-06 Sep-06 Oct-06

Saudi Arabia 49.1% 14% 20% 21% 49% 2.66 Neutral

Kuwait 20.4% 37% 32% 33% 25% 2.84 Overweight

UAE 20.2% 20% 20% 19% 12% 2.18 Underweight

Qatar 6.5% 11% 9% 9% 7% 2.54 Neutral

Oman 2.4% 9% 8% 8% 4% 2.93 Overweight

Bahrain 1.4% 6% 5% 4% 3% 2.85 Overweight

Other Mena 0.0% 4% 5% 5% 0% No weight

Total 100% 100% 100% 100% 100%

* Based on Market Cap adjusted fof free-float as of 21st November 2006

Source: Markaz Study

GCC Geographic Allocation

Saudi Arabia: According to the framework, a neutral weighting is suggested. However, the current allocation by managers is way below the neutral allocation. This is due to various factors including “home bias”. Kuwait: Kuwait enjoys an overweight status from its neutral weight. However, the current allocation by fund managers is higher than the neutral allocation significantly. UAE: Our action will be to underweight. The current allocation is closer to neutral allocation. Qatar: Our action will be to maintain neutral weight. Current allocation is significantly higher than the neutral weight. Oman: Overweight suggested. Managers are already significantly overweight on this small market currently.

Overweight Kuwait, Oman and Bahrain Neutral weight to Saudi Arabia, Qatar Underweight UAE



Bahrain: Overweight suggested. Managers are significantly overweight on this small market currently. c. Investment Themes

GCC markets share some homogeneity in terms of profile. Almost all the markets are heavily concentrated on few big blue chip companies (large caps) whose movements generally influence the overall direction of the market. Banking and financial stocks form a good portion of these markets. While the earlier section enabled us to take views on markets based on geography, from a fund management point of view it will also be useful to take a sector approach or size approach to portfolio management process. Banking and financials constitute the bulk of the region followed by Industrials.

GCC Sector Allocation

Banks+Financials

34%

Telecom

16%

Real Estate

10%

Others

19%

Industrials

21%

Banking: We would take a positive view on banking sector in the region for the following reasons:

♣ Well capitalized ♣ Strong operating track-record ♣ Strong growth in loan book ♣ Good Dividend plays ♣ Benefits during rising interest rate environment with low-cost

deposit base However, increasing exposure to stock markets (through consumer loans ) and increased dependency on capital markets for generating fee income remains a source of concern. Industrials: We would take a neutral view on Industrial sector. The performance of the sector would depend on oil prices staying higher. Oil prices may not crash but is not expected to stay higher than what is prevalent now. Hence, large cap industrial companies in the region may post growth in line with economic growth. Some of them still suffer from high valuation. Hence, at best, the valuation may get reasonable but not bargainful. Real Estate: We would take a negative view on the sector. While real estate along with stock market benefited equally (if not more) during the liquidity driven bull market (2002-2005), it did not participate in the downfall along with stock market in 2006. Hence, going forward, the downside risk is higher than upside potential. Also, many real estate companies in the region look to stock market as an important source of income. Core operating income (comprising rental income, sale of



properties and management fee) is growing at a far lower rate than non-core operating income (comprising unrealized investment income). Hence, the quality of earnings is not of very high order. Telecom: We would rate this sector to be positive. It is a non-cyclical sector aided by economic growth. Telecom companies in the region have posted high growth primarily due to low penetration rate compared to other regions in the world. Aided by limited competition, this process is likely to continue with regional telecom entities looking for outbound acquisitions along with provision of more value added services. Others: This will include a host of sectors like services, capital goods, consumer durables, food, pharma, retailing, transport, etc. Most of the companies in this category belong to mid and small cap. As we have noted in the earnings growth section, mid and small cap companies showed considerable weakness in earnings compared to large cap companies. Hence, we express a positive rating on this sector primarily because of attractiveness of valuation. However, it will be stock selection intensive. Banks IndustrialsReal Estate Telecom Others

Saudi Arabia

Kuwait

UAE

Qatar

Oman

Bahrain

Overall In summary, we would suggest an overweight position for banks, telecom and services (others), neutral weight to Industrials and underweight to Real estate.

Overweight Banking, Telecom and Services Neutral weight to Industrials. Underweight Real Estate.



Appendix: Technical Charts



Note: The blue line indicates 30-day moving average while the red line indicates 100-D moving average.



Disclaimer This report has been prepared and issued by Kuwait Financial Centre S.A.K (Markaz), which is regulated by the Central Bank of Kuwait. The report is intended to be circulated for general information only and should not to be construed as an offer to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction. The information and statistical data herein have been obtained from sources we believe to be reliable but in no way are warranted by us as to its accuracy or completeness. Opinions, estimates and projections in this report constitute the current judgment of the author as of the date of this report. They do not necessarily reflect the opinion of Markaz and are subject to change without notice. Markaz has no obligation to update, modify or amend this report or to otherwise notify a reader thereof in the event that any matter stated herein, or any opinion, projection, forecast or estimate set forth herein, changes or subsequently becomes inaccurate, or if research on the subject company is withdrawn. This report does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each security’s price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance. Kuwait Financial Centre S.A.K (Markaz) does and seeks to do business, including investment banking deals, with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report.

GCC For Fundamentalists

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