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Saudi Arabia Strategy: Everything to change on 28 March, reiterate OW

First part of market-changing index events….

On 28 March, we expect FTSE to announce (after US markets close) that Saudi Arabia will be upgraded to EM (in at least two tranches from March 2019). We also believe MSCI will follow suit in June (date TBC) – this, as we have said in the past, will be a game-changing event for the Tadawul and Saudi stocks, in general. The upgrade cycle (see timeline on RHS) could therefore start from 28 Mar 2018 and end in Sept 2019 justifying our OW call on Saudi Arabia (+30% TR expected, up 5% since our note, 9% YTD). A ‘no upgrade’ decision from FTSE would be a major shock/ risk to our call.
…to lead to cUSD5bn inflows (2.4% of EM)…

Saudi Arabia could account for 2.4% of FTSE EM (fig.1) & 2.3% of MSCI EM (fig.2) leading to cUSD5bn and cUSD10bn inflows, respectively. Aramco would add c20bps to the EM weight and cUSD1.1bn passive inflows from FTSE and MSCI Trackers for every USD10bn of float market cap. We do not expect major surprises in terms of large caps not making the cut as i) a two-tranche inclusion would allow less liquid names to pass; and ii) we expect the MSCI Standalone index to converge into MSCI Saudi Arabia Index using requirements for existing constituents. We would avoid BUPA, ARNB, SABB, and PETROR as plays on passive flows on eventual foreign room issues. 
…banks are best-placed for this trade…

Tadawul is trading at 13.9x fwd P/E and historical expansion stretched up to 16.2x (post-2009 peak). Key concerns for the Saudi inclusion trade are: i) oil price drop; ii) geopolitics; and iii) local supply of shares. Positioning purely for the index inclusion story means looking at heavyweights with relatively sound fundamentals and thus we favour banks (RJHI, SAMBA). We also flag TAWUNIYA as the only insurer in MSCI Saudi Index (BUPA will be removed as early as May 2018); stock is -25% YTD. We note that the UAE’s and Qatar’s (fig.3) experiences suggest flows/ADVT ratio is not the best guide to expected performance, factors such as actual supply on the day and active demand over the cycle will be important as well.  
…& this is just the tip of the iceberg; cUSD30-45bn inflows ahead  

Saudi has attracted cUSD1.65bn net foreign inflows YTD. However, foreign institutional ownership remains low at c1.8% for Saudi benchmark names vs. c8.8% for Qatar and c11.7% for UAE benchmark names. If Saudi Arabia reaches the UAE’s and Qatar’s level that would imply cUSD30-45bn of total inflows (passive & active) over the next two years. Getting to levels in line with EM peers of a similar size (Mexico and Russia) would imply much higher flows, roughly cUSD90bn of inflows.

Mohamad Al Hajj