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Middle EastMay 1 2006

Down but not out

A sharp correction in UAE stock markets is unlikely to deal a fatal blow to Dubai’s ambitions as a financial centre.
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Journalists cannot resist a cliché, so when the Dubai Financial Market (DFM) stock index fell 12% on March 14, the event was dubbed “Black Tuesday” before the sun had set over the city’s famous Creek waterway.

In truth, Black Tuesday was just one low point in a dark few months for the city’s stock market investors. The index peaked at 1267 points in November 2005, having almost tripled in value since the start of the year. But the rally quickly ran out of steam, and the benchmark closed at 612 points on March 14.

As always in the aftermath of a stock market boom and bust, the event prompted a lot of soul searching. What caused the bubble in the first place? When will it recover? And what are the wider implications for the local economy? The broad consensus is that it was a healthy and much-needed correction that, ultimately, should do more good than harm to Dubai’s ambitions to become a regional finance hub.

“Volumes are still healthy, investment banking mandates are still very strong throughout the region,” says Iyad Duwaji, chief executive of Dubai-based Shuaa Capital, one of the UAE’s leading investment banks. “I’m not surprised the market fell. We had given warnings to the market that valuation was getting ahead of itself and what we have seen is a volatile correction.

I do believe, however, that there is another leg to this market. If you look at the fundamentals they are still there.”

Birth of the bubble

The roots of the stock market boom/bubble can be traced back to September 11, 2001. At the time, Arab stock markets were peripheral figures: Middle East investors traditionally placed their money in the US, Europe and Japan. But increased scrutiny of Arab assets in the wake of the terrorist attacks in New York and Washington made many think again. While few sold out their portfolios in developed markets completely, they retained new wealth in the region. With oil prices beginning a steady climb towards $70 a barrel, that new wealth was significant.

By early 2005, though, a healthy increase in Arab markets, particularly Dubai, began to take on bubble-like characteristics. Retail investors, lured by the gains made by their friends over the previous two years, borrowed heavily to speculate on the market. That led to windfall gains while the index rose – but a series of margin calls meant those gains were quickly unwound once it turned.

Expensive valuations

Has the market bottomed out? Many analysts think not. The main DFM index closed at 625 points on April 18, having moved sideways since its dramatic dip in mid-March. Jonathan Garner, head of emerging equity markets strategy at Credit Suisse, says UAE stocks still look expensive compared with emerging market peers, such as South Korea, Brazil and Russia. “On that basis, it is a significant problem in terms of valuations. We use a number of different valuation metrics and on most levels the valuations look quite expensive.”

Bullish investors justify those high valuations by pointing out that the UAE is a high growth market. But Mr Garner urges caution when adopting such an approach. “You could argue that the Gulf markets have had above average earnings growth, which could justify price/earnings (P/E) ratios in the mid to high 30s. My question is: to what extent is that earnings growth repeatable?”

A research note published by Credit Suisse on March 31 showed UAE firms were trading at a trailing P/E ratio of 38.4. That was far higher than the emerging markets average of 15.8 or the US P/E ratio of 18.3. The average dividend yield in the UAE was 1.2%, again significantly worse than the emerging markets average of 2.4%.

By contrast, the UAE scored better than average on PEG ratios (P/E ratios divided by earnings growth). Credit Suisse calculated that earnings growth for UAE-listed companies was 91.4% for 2005, way ahead of the 5.1% seen in the MSCI emerging markets universe. However, Mr Garner urges caution in relying too heavily on PEG ratios to justify high current share prices: they rely on forecasts of future earnings growth that are open to serious question, particularly in the UAE.

Cautious note

“We are fairly sure about the source of earnings for the telecoms sector, from core telephony revenues. But we are concerned about the stability of banks’ earnings, and manufacturing earnings,” he says. “Some banks are heavily involved in the stock market, both trading their own account and lending to customers for trading. There are questions about the rapid growth in banks’ loan portfolios. And we know of at least one cement company that is involved in trading in the stock market.”

Philip Khoury, Dubai-based head of research at Egyptian investment bank EFG-Hermes, is also cautious. “If you look at the UAE, valuations are quite rich. To justify that, you should have good quality earnings and strong earnings growth. If you have problems with that, it becomes difficult to justify those valuations. We did see a healthy correction. But I don’t think all of those factors have worked themselves out today. I don’t think the elements are there to call the bottom,” he said in mid-April.

Quality of earnings is a theme that Mr Khoury returns to time and again. According to EFG research, the cement company to which Credit Suisse refers is not an isolated incident: for many industrial, food processing and insurance firms listed in the UAE, gains from stock market trading made up the bulk of 2005 profits, says Mr Khoury.

“A number of companies have made profits in 2005 related to their holdings of marketable securities,” says Mr Khoury. “For a lot of them, those profits will be significantly lower, if not negative [in Q1 2006]. We will be looking at the impact on the earnings of industrial companies, many of which have been dabbling in the stock market.”

Strong fundamentals

While many analysts are cautious about the prospects for UAE stocks, all stress that the economy is fundamentally strong. “One thing to emphasise is that in terms of economic fundamentals, these markets remain extremely strong. We are expecting strong hydrocarbon prices to remain. Hence, GDP growth is likely to remain with us.”

Douglas Dowie, CEO of National Bank of Dubai, says that the likely outcome is a more responsible approach to equity markets by investors, issuers and intermediaries, but that 2006 will remain essentially a strong year. “Before the correction of February and March, we were waiting for it to happen, which was a little uneasy. Now it has happened, we can move on,” he says.

“I still think you will see a fair bit of initial public offering activity, particularly when new laws come in that encourage family firms to list. We have had a correction but, ultimately, that is healthy.”

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Read more about:  Middle East , United Arab Emirates