MENA Q2 2023 Manager Letter

Gulf equity markets broke a streak of four consecutive negative quarterly returns in the second quarter of 2023, and materially outperformed the MSCI Emerging Markets Index.  

In Saudi, the market performed impressively, with the MSCI Saudi Index posting a 5.5% gain in the second quarter, despite the backdrop of softer oil prices and lower production through OPEC+, muted earnings expectations from the banking sector (~35% of the Saudi index), and weak Chinese data that tempered hopes of a recovery in petrochemical earnings (~15% of the Saudi index).  

The mid-cap run in Saudi that we highlighted in our last letter continued to gain strength in the second quarter, with the MSCI Saudi Midcap Index up 9.9%, building on a 7.7% gain in the first quarter. The Saudi mid-cap space has been responsible for a significant proportion of the market’s year-to-date returns, as large index sectors like banks and materials underperformed. The sustainability of the mid-cap rally is currently the subject of intense debate. On the one hand, the bar for earnings to meet the expectations embedded in the price of many mid-cap securities has meaningfully risen. On the other hand, there is increasing evidence that the opportunity for multi-year earnings growth – underpinned by Vision 2030 reforms – is most visible in mid-cap sectors such as education, healthcare, tourism, transport, and technology. This setup is a challenge for our investment process, as we aim to balance growth expectations with a price at which we believe this growth will generate attractive returns on our cost basis. 

We talked in our previous letter about our willingness to make bold decisions to preserve a relatively attractive return profile for the strategy. During the second quarter, this involved the following actions: 

1. Continuing to back companies that trade at high near-term multiples, but that we believe will grow into those multiples over time. The best example of this is Abdullah Al Othaim Markets, the discount grocery retailer that is capturing significant share of its ~$40 billion market by doubling down on its value-for-money proposition to take advantage of weakening competition, a shift in shopping behavior to more value-for-money options, and the general growth in population in the central region, to which Al Othaim is over-indexed.
2. Reducing or exiting positions where we believe valuations have all but caught up with the blue-sky scenario in our forecasts. This is a painful but necessary decision, as it often means parting ways with companies (and management teams) we admire, but which we can no longer justify owning at current valuations. A good example here is National Company for Learning and Education, a K-12 owner/operator with a market capitalisation of $1.2 billion based on an operating income of less than $30 million. 
3. Buying companies with highly defensive characteristics, or those where we believe the market has left valuation room for earnings to surprise to the upside in the next six to 12 months. A good example of the former is Qatar Gas Transport, the sole distributor of Qatari liquified natural gas exports, whose vessels are chartered on long-term fixed-rate contracts, with growth optionality from Qatar’s North Field expansion project. While we will refrain from sharing examples of the latter at this stage, our focus is on high-quality businesses where near-term growth rates are moderate, but whose characteristics support a high level of free cash-flow generation relative to market capitalisation.   

Our outlook statement from the last letter remains largely unchanged, but we have introduced new language in the last paragraph regarding our thinking around valuations. We continue to see favourable opportunities for the strategy. The macroeconomic backdrop remains supportive, with healthy FX reserves and balance-of-payments positions across most of the Gulf. While still early days, the Saudi-Iranian reproachment is a key event that warrants our attention, as any progress there can lead to a lower geopolitical risk premium on regional assets. OPEC+ remains committed to maintaining high oil prices to support government spending plans, which could benefit equity markets. We also note that positioning from global emerging market funds remains light and governments in the region are intent on growing their share in the emerging market capitalization, which we believe will end up manifesting itself in a quasi-short squeeze on those funds.  

We believe that valuations in the region – particularly in Saudi – will continue to remain elevated relative to their historic levels. The political will to push through an unprecedented and transformative socioeconomic agenda, coupled with enormous financial capacity, is likely to unlock significant growth opportunities for public market companies for years to come in our view. Furthermore, governments in the region have never been more vocal about the role that their stock markets will play in crystalising their growth agendas. This is a powerful combination that, if successful, can reduce the historical oil price-induced economic and asset price volatility that has long been a characteristic of investing in the region, and consequently underpins above-average valuations through cycle. We do not, however, believe this is a tide that will lift all boats. Adhering to our investment principles will be key to identifying winning companies that can deliver attractive returns to our investors. 

Vergent Asset Management LLP