If the volume of shares traded is an accurate measure of the Bahrain Stock Exchange's (BSE) health, the Manama bourse has little to worry about, even as global markets slide. The kingdom's stock market is defying the worst of the global financial downturn.

First-quarter trading volumes on the BSE were more than 800 per cent higher than for the corresponding period in 2007, while the value of shares changing hands over the period - BD311.4m ($826m) - represents a more than six-fold increase year on year.

The Bahrain All-Share index ended February at an all-time high of 2,880.8 and remained around the same level in March, ending the month at 2,789.9.

The burst of activity in the first couple of months of 2008 contrasts positively with the BSE's traditional trading pattern, under which the market usually falls in the first half of the year before new issues galvanise investor appetite in the second half.

Even so, the increased activity on the bourse is not yet increasing stock valuations. By the end of April, the Bahrain All-Share index was up only 3.2 per cent on the start of the year. Brokers say the market in April was down 30 per cent from its highest level in January, but given the difficult international conditions, this represents fairly robust performance.

"The lack of correlation plays to the benefit of Bahrain, but local factors are also having an effect," says Faisal Hasan, head of research at Kuwait-based investment company Global Investment House. "Corporate earnings are driving growth and with average price/earnings ratios of 11.8 [the lowest in the Gulf region], we feel Bahrain is in a strong position to attract foreign and non-GCC investment."

Corporate performances are holding up. Average earnings growth in the three months to February exceeded 20 per cent, which should allow the Bahrain market to deliver a healthy return over the medium to long term.

This upside is further supported by increasing merger and acquisitions activity, and foreign investor interest, according to a recent review of the market by Jitesh Gopi, senior analyst at Bahraini investment bank Securities & Investment Company (Sico).

Other indicators confirm the strength of Bahraini corporate performances. The 51 companies listed on the BSE reported a combined net profit of more than BD1bn in 2007, compared with BD774.3m in 2006, an increase of nearly 30 per cent. Assets under management by Bahrain's mutual funds industry surged by 73 per cent to more than $15bn in 2007, according to the Central Bank of Bahrain (CBB), while the investible assets of Bahrain-domiciled funds rose by 66 per cent to $4.5bn.

Institutions, rather than individual investors, dominate the bourse. Bahrain-based investors accounted for just over half of shares traded in the first quarter of 2008, with GCC investors making up the bulk of the rest, and non-Gulf investors taking a 5 per cent slice of share volumes. This low level of non-Gulf investment has helped Bahrain remain isolated from the international downward pressure on equities.

The BSE has other sources of strength on which to draw, even if regional conditions worsen. According to Sico, at 4 per cent, Bahrain's dividend yield is the highest in the region, while a price-to-book ratio of 1.8, the lowest in the region, limits the downside potential.

Attracting investors

Bahraini stocks are able to compete on price with others in the region. Local stocks offer attractive dividend yields compared with Gulf rivals, with total cash dividends paid out in 2007 yielding 3.8 per cent, compared with the GCC average of 2.3 per cent.

However, the BSE has yet to register an expansion in trading multiples that would match historical and projected earnings growth. The country's small size and lack of attractive liquid stocks means that investor appetite will continue to be skewed towards a handful of key equities. "There are only a few pivotal stocks that will attract investor attention, such as the banks and Bahrain Telecommunications Company (Batelco)," says Hasan.

The three most active stocks - Al-Salam Bank, Ithmaar Bank and Batelco - accounted for 82.4 per cent of the total volume of shares traded in March, highlighting the prevalence of stock-specific trading on the Bahraini market. The banks' strong showing follows a revival in lending in Bahrain last year. Banking profits are exceeding expectations. BMB Investment Bank posted record profit gains in the first quarter of 2008, with net income rising to $4.4m, an increase of 344.4 per cent on the previous quarter.

The strongest stocks on the BSE - the Al-Salams and Ithmaars - are also the most ambitious in extending their footprints outside the domestic market. Both have listed their shares on the Dubai Financial Market (DFM) in recent months, with multiple listings providing a broader investor base than the narrow Bahraini market.

IPO activity in Bahrain has been relatively quiet since the IPO of Seef Properties in July 2007. Analysts predict more IPOs this year, with Kuwaiti telecom major Zain confirming in late April that it will launch an IPO in June - a potential trigger for more public listings on the BSE.

The CBB maintains an active regulatory stance, issuing draft regulations earlier this year to govern the activities of licensed exchanges and other market operators in Bahrain. The draft regulations are part of the CBB's new capital market rulebook coming into force in the second half of this year.

According to Ali Salman Thamer, director of capital markets supervision at the CBB, the new rulebook will expand the capital market and encourage firms to list on the BSE, increasing trade volumes and providing greater liquidity.

Another new initiative to open up trading in securities on the BSE is online trading. "The BSE's introduction of online trading activities will allow many more people to trade in securities," says Aniruddha Vaidya, a broker at IndoGulf Financial Services. "The scheme is in the initial stages, but in a year's time it will be popular with investors."

The new electronic services are provided by the BSE's Settlement & Central Depositary Department. The BSE hopes such services will encourage investors with physical certificates to convert them to electronic ones.

The BSE also aims to maintain its openness through co-operation pacts with other regional bourses. In March 2008, it signed a memorandum of understanding with the DFM to strengthen co-operation and will allow investors to deal in shares listed in both markets, which have a combined market cap of about $80bn.

In 2006, the BSE struck a deal with the Dubai International Financial Exchange (DIFX) to facilitate trading in the shares of Al-Baraka Banking Group (ABG) on both markets, hinging on a technical connection between the central securities depositaries of the exchanges. ABG is at the centre of a major thrust for Bahrain to launch an Islamic stock exchange by 2009.

Adnan Yousif, chief executive officer of ABG, is one of the key promoters of the plan, the first stage of which will involve an Islamic investment bank being capitalised at $3bn. It will be the largest institution in the region to issue sukuk and will create a secondary sukuk market. Yousif says the plan for an Islamic stock market is a logical extension of the widespread growth of sharia-compliant products.

"We believe this is the time when we should launch these kinds of products in the market," says Yousif. "In the past, there were too few around and there was only narrow knowledge of Islamic finance."

The Islamic equity market would start with accepted Islamic products and expand over time to include companies that operate according to sharia principles, says Yousif. "Bahrain is the natural base for such a market as the country is the region's Islamic finance hub," he says.

The project is the idea of Sheikh Saleh Abdullah Kamel, chairman of the General Council of Islamic Banks.

Other institutions that have expressed an interest in the investment bank include Saudi Arabia's Islamic Development Bank and Saudi Investment Bank.

The new investment bank would raise capital through the issuance of sukuk, which would be traded on the new stock exchange in compliance with Islamic law. The BSE already lists several sukuk, most recently a BD95m Islamic leasing (Ijara) sukuk issued by the CBB in late 2007.

Increasing competition

Yousif and the other key bankers are concentrating first on setting up a new Islamic 'mega-bank'. "Once we have finished that we will finalise the Islamic equity market as they are linked," says Yousif.

However, plans for a Bahrain-based Islamic equity market face competition.

Late last year, Investment Dar, a Kuwaiti Islamic investment bank, applied for permission to open a stock market that would comply with Islamic principles. The exchange would be open to Kuwaiti and foreign companies.

Bahrainis may feel their leading edge in sharia-compliant issuance will give them the advantage if rival Islamic equity markets are bidding for investors.

The local bourse's solid performance will provide further reassurance that the smallest of the GCC states is ready to think big to retain its reputation as the Gulf's financial centre of choice.

Bahrain all-share index - top five firms by market cap

1. Ahli United Bank - $5.6bn

2. Gulf Finance House - $3.2bn

3. Batelco - $3.2bn

4. Investcorp - $2.2bn

5. United Gulf Bank - $1.8bn