No sooner had market index compiler MSCI announced that 19 regional stocks would be included in its Emerging Markets Index from 1 June, than the Qatar and UAE bourses experienced a heavy equities sell-off.

A year of positive expectation came to an abrupt end on 14 May, when exchanges in both countries posted weekly falls of between 3 per cent and 6 per cent as investors cashed in on gains achieved through the long build up to the announcement.

Coinciding with the seasonal summer slowdown in activity, interest from new investors, both foreign and domestic, will have to be significant if the markets are to recover their losses soon.

But with the markets having reached peaks at the beginning of May, the immediate inflows from foreign funds look unlikely to be as large as some had hoped.

The inclusion of stocks from Qatar and the UAE in the Emerging Markets Index have been forecast to attract between $500m and $1bn from international funds that passively track it. However, active fund managers are often already exposed to the region and unlikely to allocate more funds if they deem the stocks too expensive.

High valuations

The region’s stock markets have risen 44 per cent (Dubai), 13 per cent (Abu Dhabi) and 22 per cent (Qatar) since the start of the year. This suggests many prices may have gone beyond what company fundamentals justify, and already account for future for growth expectations that could take years to realise.

Dubai’s main stock market, the Dubai Financial Market (DFM), has a price-to-earnings (PE) ratio of 18.6, higher than the GCC’s largest and most liquid bourse, Saudi Arabia. Qatar’s stock market is slightly lower with a PE ratio of 16, though the exchange is largely illiquid.

The high valuations will deter foreign fund managers, who are typically cautious of riding a momentum wave and rather look to underlying values of companies.

BlackRock, the world’s largest asset manager, reportedly reduced its Frontiers Investment Trust’s exposure to UAE stocks in January “substantially” on concerns of excessive speculation. 

The predominance of speculative retail investors in Gulf’s stock markets increases the risk of volatility and the UAE in particular has been the target of much speculation.

While some stocks have simply caught up with their perceived real value, others have continued to climb on the back of rumours and announcements about future deals, or on assumption that they were be included in the Emerging Markets Index. The hope is that foreign investors entering the market will drive up prices even further.

The valuation of UAE developer Arabtec Holding, for instance, doubled between February and May on the back of news of a potential acquisition in Europe and an agreement to lead a $40bn housing programme in Egypt.

Another UAE developer, Emaar Properties, could also be benefiting from expectations of future performance, says a Dubai-based investment banker. “Emaar has doubled over the past three months. I would say that has gone beyond simply climbing up from a low valuation, which it already did by the end of 2013. It may have announced a lot of new projects, but unlike the stock price suggests, it hasn’t doubled its back log.”

Market correction

Given these high valuations, many analysts anticipate a market correction is imminent. “I think markets will drop when, following the MSCI upgrade [which officially takes effect on 1 June], retail investors realise institutional investors are not jumping on the opportunity to buy stocks,” says the banker.

A correction would not necessarily be a bad thing, however and is likely to signal a return to more sustainable growth, preventing a repeat of the 2009 crash, when prices more than halved.

Investors buying into highly valued stocks must also bear in mind they are likely to be taking on higher risk, says an analyst at a regional investment firm. “Not just in the short-term, but especially when we get to the stage where companies actually need to deliver,” he says. “If there are delays, we may see more volatility.”

More positively, however, some analysts say global investors may be willing to take on the Gulf risk as they look for a dollar-linked safe haven that could shield them from even greater volatility in other emerging markets such as Brazil and India.

“It’s very important to note that there is no precedent of markets being upgraded from frontier to emerging status,” says Rami Sidani, head of Middle East Investments at UK-headquartered asset management firm Schroders. “I expect Qatar and the UAE to be overweight in emerging markets portfolios, because of concerns in a lot of other countries in the index that struggle with current account deficits and currency volatility.”

Farouk Soussa, Middle East Economist at Citigroup, says in the long run there is potential for deeper markets in Qatar and the UAE.

“Coupled with strong domestic liquidity, the sharp rise in valuations is raising concerns regarding the sustainability of prices, particularly in the UAE,” he says. “That said, valuations are still far off the peaks reached in 2008, and the dynamics are also having a positive impact on the IPO [initial public offering] market, with more local corporates seeking to raise equity capital.’’

Any rapid growth in the market will drive a growing need for a larger pool of listings, as well as enhanced regulation and a more efficient institutional framework.

New listings will suck up some of the liquidity in overbought stocks and, if they meet MSCI’s criteria, may become candidates for emerging markets inclusion at the index compiler’s future semi-annual reviews.

Several IPOs are currently in the works in the UAE, including Emaar Properties’ malls and retail unit, which could possibly be followed by a DFM listing.

Rumours that it will receive regulatory approval to float 25 per cent instead of the standard 55 per cent could open the door to more exceptions ahead of an amendment in the Commercial Companies Law. The amendment sets the UAE’s free float minimum at 30 per cent for all companies.

The law does not mention the ability to sell-down existing shares, however, which may encourage local firms to float on markets overseas, such as on the London Stock Exchange, to avoid issuing new shares that would dilute their current share value.

But as the region’s markets undergo rapid development, some offerings will be trickier than others to explain. UAE retailer Marka surprised many with its oversubscription of 36 times, despite, as a “greenfield” company, not yet having a financial track record.

The take-up contradicts other risk management measures taking place in the region, such as the introduction of new regulations in the UAE in early 2014 requiring companies to set up an investor relations department. This will hopefully set the scene for stricter corporate governance enforcement.

Cross-market reform

Investors are also watching out for is the proposed merger of the Abu Dhabi Securities Exchange (ADX) and the DFM, which has been rumoured for many years and which is aimed at enhancing efficiency and investibility. No time frame has been set for the merger.

“There is currently a dichotomy between the UAE’s stock markets and regulators between the DIFC [Dubai International Financial Centre] and the wider UAE,” says Andrew Tarbuck, partner at the Dubai office of global law firm Latham & Watkins, who specialises in capital markets transactions. “This will continue to exist when the DFM and ADX merge, but it will be genuinely helpful to have consolidation in the stock exchange sector, given the relatively small size of the capital markets in the country. In Saudi Arabia, the market is larger and overseen by just one regulator.”

The sharp rise in valuations is raising concerns regarding the sustainability of prices, particularly in the UAE

Farouk Soussa, Citigroup

Qatar faces a similar need for market reform. Authorities have raised foreign ownership limits in some companies, and government-related entities are likely to launch a few more IPOs this year. However, the driver for this is Doha’s desire to deliver better wealth distribution for its local citizens rather than to improve stock market liquidity.

Despite all the uncertainty, however, the MSCI upgrades are a major milestone for the Qatar and UAE markets, although more progress is needed to attract a wider catchment of foreign investors.

The upgrades may not trigger an immediate boom, but it is a positive sign of sustainable growth rather than a build-up to a crash. It will engage a wider pool of more sophisticated investors who will be looking to engage with regulators to enhance the markets.