Confidence among investors on the Saudi stock exchange (Tadawul) appears to have been bolstered by the introduction in April of a new market structure that brings increased transparency, by subdividing indices into 15 different business sectors, and calculating performance based on free-float shares.

Such technical improvements are not groundbreaking, but they are examples of the way the kingdom's Capital Market Authority (CMA) is steadily working to bolster the credibility and solidity of the Tadawul.

These measures are intended to enhance the long-term attractiveness of the exchange for foreign investors, who only accounted for 3.1 per cent of trading volume in 2007 because of the restriction on foreign share ownership, which is allowed only through investment funds. It is also intended to provide reassurance for the Saudi private individuals who account for the vast bulk of activity on the bourse.

Providing reassurance is crucial. The CMA cannot afford any repeat of the boom-bust cycle experienced in 2006, when the country's first bubble of public enthusiasm for equity investment, fuelled by a large number of attractively priced initial public offerings (IPOs), was brought to a halt as confidence declined and the market plunged spectacularly (see chart below).

Prior to the crash, ordinary Saudis had invested in IPOs as they offered financial returns that would otherwise have been beyond their reach. The February 2006 crash shattered these illusions and left many in financial ruin. In the wake of the crash, the total value of registered personal loan defaults in the kingdom reached SR5bn ($1.3bn) in 2006. In 2007, the total climbed to SR7bn.

In contrast to Western economies, where private share investment is largely managed by professionals, Saudi individuals account for 93.8 per cent of all share purchase trades on the Tadawul. Only 2.2 per cent of purchases are made by corporate buyers, and 0.5 per cent by mutual funds.

Confidence has slowly recovered since the crash in 2006 and by December 2007, Saudi investment bank Jadwa Investment was warning that the market had "overshot" once more, pushing share prices to levels that were not justified by the fundamentals of the economy or the performance of the companies concerned. Jadwa said the Tadawul All-Share index (Tasi) was overvalued by one-fifth.

Jadwa forecast a correction in share prices, perhaps triggered by a drop in oil prices, a slow_down in other emerging markets, or a realisation that shares were overpriced. It was feared that a new collapse would undermine confidence in the Tadawul, depleting the strong local support that has made such a powerful contribution to the market's development.

To date, no such correction has occurred and Saudi Arabia's economic boom has provided a measure of protection from the slowdown in global confidence. But the threat of the correction has spurred the CMA and the kingdom's major investment houses to take full advantage of this interlude of good fortune to consolidate the strength of the Tadawul.

Stabilising the bourse has been one of the key objectives of the CMA. It is therefore taking steps to attract more international players and domestic corporates to broaden the investor base. The decision to allow mutual funds to be established has been critical in shoring up the stability of the Tadawul. However, progress has been slow as many Saudi investment houses are relatively young spin-offs from banks and are yet to develop a full product range.

Increasing the involvement of corporate Saudi and foreign investors should make a significant contribution to stability as their professional fund managers are likely to take decisions based on a long-term view of company performance, as opposed to the actions of personal investors who are driven by the quick profits traditionally acquired through IPOs.

Reducing volatility

However, the authorities are keen to maintain the flow of IPOs, as they broaden the range of shares on offer and help to reduce the chances of a return to the large-scale volatility of two years ago.

Tawfik al-Wan, senior analyst at Jeddah-based BMG Financial Advisors believes the Saudi stock market will gradually mature, developing a culture in which investors seek returns not from short-term sales of newly launched shares, but from the steady flow of dividend payments on shares that they hold over the long term.

He therefore expects to see Saudis paying more attention to solid business performers. "As investors get more educated, I think they will be going towards less speculative sectors inside the market, and less speculative shares," he says.

This trend towards a market that is broader and more solid is already under way. "We have been able to see, since the start of 2008, some of the signs of the market stabilising," says one senior analyst at Saudi investment broker Al-Istithmar Capital. "The new company IPOs are giving the market more depth."

To some extent, this has been driven by the steps taken by the CMA to improve the functioning and transparency of the Tadawul, while taking a tougher regulatory stance towards listed firms.

To encourage more activity, the authority has opened the market to foreigners resident in the kingdom, approved rights issues for companies that could show a need for fresh capital, accelerated the approval of listings, permitted book building to price new offerings, allowed new IPOs to allocate shares to funds and financial institutions, and permitted investment banks to offer investors several IPOs simultaneously.

But at the same time, the CMA has been prepared to act tough, strengthening corporate governance rules, threatening suspension or delisting of companies that fail to perform or are on the verge of insolvency, investigating unusual trades and pressuring companies to meet the deadlines for quarterly disclosure of key financial data.

On 22 April 2008, for example, it refused to approve a planned capital increase by Saudi Industrial Development Company (SIDC), which needed to raise funds for a planned acquisition.

"The CMA is one of the most effective and efficient Saudi regulatory bodies that is related to the capital market and the financial sector," says Al-Wan. "It is respected. It is hands-on in the market, protecting small investors, and I believe it is doing quite a good job. It is not a typical bureaucracy at all."

As the Tadawul consolidates, there is broad agreement among analysts and brokers over the sectors on which investors should focus. "Banking, property, telecommunications and petrochemicals are the stronger sectors," says the Al-Istithmar analyst.

Al-Wan cites industry, real estate and banking as the less speculative areas that should be attracting investors. He says the restructuring in April 2008, which broke the old services category down into its key components, is helpful as it is now possible for investors to easily track sub-sectors such as insurance, where they should be cautious as many of the companies are newly established and will struggle to make profits for some time.

Depleting resources

Once the insurance industry has become more established, it should become a more attractive proposition, whereas the problems facing agriculture, for example, are more fundamental because of the government's decision to prioritise the use of Saudi Arabia's precious and steadily depleting water resources.

By contrast, there is no doubt about the positive outlook for some other sectors. "Petrochemicals is hot at the moment," says Ahmed Bakhashab, a senior equity trader on the Tadawul.

Major developments such as the Petro-Rabigh IPO have raised the industry's profile among investors. Moreover, this popularity is founded on solid fundamentals: the competitiveness of the Saudi industry and the strong international demand for the fertilisers it can produce at a time of world food shortages.

Bakhashab also expects strong growth in the property market, where developers are already finding huge demand for off-plan sales in King Abdullah Economic City and other major projects. "According to our research, in the petrochemicals and real estate sectors we are looking at 60-70 per cent growth over the next two years," says Bakhashab.

Telecommunications is another sector that appears set for continued growth. Kuwaiti operator Zain paid SR24bn for the kingdom's third mobile phone licence in 2007 - double what the UAE's Etisalat paid for the second licence. At 183 per cent, its IPO in February did not achieve the spectacular levels of over-subscription seen on some earlier issues on the Tadawul, but that in itself may be a sign of the market's growing maturity.

This exemplifies the direction in which the Tadawul needs to move: away from speculative bubbles fuelled by IPOs towards investment in stocks that retain long-term growth potential because of their underlying business strengths.

Tadawul all-share index - top five gainers

1. Arabian Insurance Co-operative Company - Up 245 per cent to SR34.50

2. Sagr Insurance - Up 235 per cent to SR33.50

3. Trade Union - Up 220 per cent to SR32.0

4. Anaam Holding - Up 215.5 per cent to SR52.0

5. Petro-Rabigh - Up 134.5 per cent to SR49.25

Source: Tadawul