Middle East rising: The Gulf branches out

The $7.5 billion cash injection that Citigroup received from Abu Dhabi's state investment fund has been presented as a vote of confidence in the capital-starved bank, which has suffered heavy losses from subprime lending.

But the deal, which will eventually give the Emirate state an equity stake of as much as 5 percent, is also further evidence that oil-rich Arab countries are succeeding in their strategy to reduce dependence on oil revenue. Paradoxically, while Arab sovereign funds are taking advantage of what appears to be low valuations to snap up shares in international blue chips - like Sony, Carlyle Group and MGM-Mirage - international investors are seizing on growth opportunities in the Middle East. Flows of foreign direct investment have quadrupled since 2002, and are expected to top $80 billion this year, according to the International Monetary Fund.

These are boom times for Middle East stock markets. The MSCI United Arab Emirates domestic benchmark has risen 34 percent since May, while Kuwait's financial market has moved up more than 40 percent over the same period. Even small and relatively illiquid exchanges, like that of Bahrain, have posted double-digit gains in recent months.

International investment powerhouses like Barings, Goldman Sachs, DWS and Allianz Global Investors are stepping up coverage of the 15 markets that make up the Middle East region, with a combined market capitalization of $1 trillion. More and more asset managers are planning, or have already started, Middle East equity funds. Front-runners include T. Rowe Price, JPMorgan and Fidelity Investments.

Haissam Arabi, managing director of Shuaa Asset Management, whose flagship equity investment product is the Arab Gateway fund, suggested that all emerging markets funds should have some exposure to Middle Eastern stock exchanges. "Historically, the region has always had a zero-to-low correlation with the rest of the world, so at the very least the Arab markets are an important diversification tool."

Twelve months ago the investment picture in the Middle East was very different. In 2006, the average Arab stock market lost nearly 50 percent of its value, with many taking much harder hits. Dubai's financial market, for example, plunged 68 percent. Speculative domestic investors drove these markets higher, and when sentiment turned bearish, these same investors took the first opportunity to bail out - a textbook definition of "hot money."

Middle East bulls seem confident in their assertion that enough safeguards are in place to minimize the risk of another major crash. Analysts at Barings and DWS believe the region's stock markets are on an upward trajectory for at least 18 months.

Buoyed by petrodollars, the six Gulf Cooperation Council countries - the United Arab Emirates, Bahrain, Kuwait, Oman, Qatar and Saudi Arabia - are flexing their financial muscle and transforming the region's infrastructure and services. A significant portion of the investment capital is filtering through to the neighboring non-oil producing states of Jordan and Egypt. Lehman Brothers estimates that there are nearly 2,000 projects in progress across the region worth more than $1.3 trillion.

A major area of investment is the power sector, where improvements in generation capacity will require infrastructure spending of $150 billion before 2020, according to the World Energy Council. Companies in banking, transportation, real estate and basic materials are reaping the benefits of this spending splurge, with many posting triple-digit growth rates.

All of this makes fund managers like Nick Price, who manages a Middle East equity fund out of London for Fidelity Investments, extremely optimistic.

"What differs from previous oil booms is that, firstly, the oil price move appears to be secular, driven by Chinese and Indian demand," he said. "Secondly, more money is being recycled into Middle East economies than in the past, which should help diversify the economies."

Claire Simmonds, client portfolio manager for JPMorgan Asset Management in London, agreed with Price that oil was no longer the only factor in the region. "Around 40 percent of the Arab population is under 30 years old, a statistic that will ensure investment in infrastructure and services continues for some time yet," she said.

There are other reasons why investors are prowling for a stake in the Middle East: Arab markets are trading at attractive price-earnings multiples compared with other developing markets. Dubai is trading on a forward price-earnings ratio, or price as a multiple of projected earnings, of 13, compared with 45 in China and 22 in India.

Secondly, the Gulf Cooperation Council currencies are pegged to the U.S. dollar, which means that European and Asian investors can get a lot more for their money at present.

The flip side of any emerging market, though, is lack of control. The price declines in 2005 and 2006 were attributed in part to lax regulation: Companies were investing in one another's shares and pushing up valuations to extraordinary levels. Even assuming safeguards are now in place to prevent another major crash, inflationary pressures could lead to bubbles.

The downside to the dollar peg is that the regional monetary authorities have little leeway with regard to interest rate policy. The rate cuts that the United States initiated recently are stimulating growth in the Middle East region and fueling inflation, at a time when the financial authorities should in fact be tightening monetary policy.

"Yes, inflation is a problem; but any move away from a dollar peg would be gradual and in small increments," Price said. "We are certainly not expecting fireworks." Among Price's stockholdings is Aldar Properties, a real estate company based in Abu Dhabi.

Perhaps the greatest frustration for international investors is a relative lack of choice and access. Gulf markets, which are heavy on property and financial stocks, impose limits on the number of shares foreigners can own.

Not surprisingly, many so-called Middle East funds have to look outside the region for their core holdings. JP Morgan Middle East equity fund has more than 70 percent of its assets in Turkey, Egypt and Israel. Less than 10 percent of the fund is invested in Jordan, the UAE markets and Qatar. Its top ten holdings include Teva Pharmaceuticals, of Israel, Turkiye Is Bankasi and Migros Turk Pharmaceuticals.

T. Rowe Price's Africa and Middle East fund, started in September, has around 20 percent in Gulf markets. Holdings include Gulf Finance House, Commercial Bank of Qatar and Bank Muscat, which is domiciled in Oman. Around 50 percent is invested in Africa.

Emerging-market fund managers with a wider purview sometimes avoid the Gulf altogether. Glen Finegan of First State Investments in London said he was finding enough to buy in more established markets like Turkey and Egypt. "I need very strong reasons to be invested in the Gulf states," he said. "My primary concern is that the performance of these markets may be based on the high oil price rather than strong company fundamentals."

Finegan prefers Turkey because of the Turkish entrepreneurial talent. "Turkish companies run with an idea and make full use of their cultural links to expand into neighboring markets," he said. "I am not getting that sense of dynamism from companies" in the Middle East. Finegan's stock picks include Anadolu EFS, a leading brewer and Coca-Cola bottler in Turkey, and Lecico, an Egyptian company that makes ceramic sanitary ware.

Rather than compete for a shrinking slice of the Middle East pie, Bedlam Asset Management in London has opted to invest in international companies that derive a significant portion of their profits from the region. Ian McCallum, manager of an emerging markets fund for Bedlam, cited Komatsu, which makes and sells mining equipment to companies in the Middle East, and Isuzu Motors.

Investors looking for a pure play on Gulf markets might want to consider a homegrown fund. The National Bank of Abu Dhabi's UAE Growth fund has been going for seven years and is open to international investors.

Following the U.S. rate cuts, David Sanders, the portfolio manager, has bought into companies that stand to benefit from inflation or be unaffected by it. Holdings include Orascom Construction in Egypt; Industries of Qatar, a building materials firm, and Sabic Industries, a Saudi company with interests in petrochemicals, plastics and basic materials. Sanders also holds EtiSalat, an Emirates telecommunications company, and Abu Dhabi's global energy company Taqa - two stocks that outside funds cannot access because of share ownership restrictions.