Passport Capital Takes a Road Less Traveled in Saudi Stocks

John Burbank believes the oil-rich kingdom has the makings of a global winner — fueled by undervalued stocks in an inefficient market.


At a time when most emerging markets have seen growth slow, Saudi Arabia and its neighbors are a notable exception. All six Gulf Cooperation Council states — Saudi Arabia, Bahrain, Kuwait, Qatar, Oman and the United Arab Emirates — have been able to stimulate their economies through domestic investment and build their consumer sectors. To John Burbank III, chief investment officer and founder of San Francisco–based hedge fund Passport Capital, Saudi Arabia, the largest GCC economy by far, looks to be the most promising market as a global macroplay (see also “Hedge Fund Manager John Burbank’s Investment Alchemy”).

Burbank’s colleagues share that view . The fact that 10 percent of Passport’s total assets are now invested in Saudi Arabian equities came about as the result of a consensus among Passport’s three investment disciplines: macro, fundamental and quantitative.

Saudi Arabia fits into Burbank’s belief that current winners in the global economy are countries and industries able to flourish without being dependent on global GDP growth. Tim Garry, head of Passport’s quantitative unit and risk committee, argues that many equities on the Tadawul, the Saudi stock exchange, are significantly mispriced and have little correlation to other markets. Even better, in recent months he has found that Passport’s Saudi stocks have diverged from prices of domestic indexes by as much as 80 percent, evidence of inefficiencies that should pay off for those who do their research.

The man who actually picks those stocks is Arshad Ashraf, who manages the Middle East, Africa and South Asia portfolios for Passport.

Ashraf spends four months each year traveling in the Middle East. “Saudi Arabia is one of the least-understood markets in the world,” he says. Most foreign investors are probably not aware of the advantages of its highly liquid capital market, he adds, and its young, well-educated population, some 60 percent of whom are under 30. The Tadawul now has a market capitalization of $455 billion, not too far below the $516 billion market cap of the MSCI Frontier Index. Ashraf is also impressed by Saudi Arabia’s $718 billion in foreign exchange reserves, which beats the combined reserves of emerging powers Brazil and India, now around $667 billion.

Ashraf and Burbank first met in early 2007 when Ashraf, then a student at Stanford Graduate School of Business, was working with classmates on a project about investing in the Middle East.

“One of our professors said, ‘You should meet this guy who’s an alum and thinks about the world differently,’” Ashraf recalls. He and his classmates, he says, were “blown away” by Burbank’s willingness to spend time with them and the way he viewed the investment world. “It was like a Socrates engaging with his young disciples,” he says. “Like him, I had taken my time to find my career path, and he was willing to give me time to learn and make mistakes.”

Ashraf, who grew up in Pakistan and moved to the U.S. to attend Boston University, is one of a number of Burbank hires who took a roundabout path to an investment career. He has undergraduate degrees from BU in both engineering and religion; he believes the latter prepared him for investing. “Investing is all about conviction, and it is not built overnight,” he says. “You’re bound to be disappointed if you follow others’ beliefs without question. You’ll never have perfect information. There always comes a point when you have to take a leap of faith.”

He joined Passport Capital as an intern in June 2007, the day after he graduated from Stanford. Within four months he had worked his way up to an analyst position, then to portfolio manager.

He started thinking about Saudi Arabia as an investment possibility after visiting in May 2008. At that time, the market wasn’t open to foreign investors, but he was sure that would soon change. He saw that the Saudi government viewed the local capital market as a way of addressing some of the nation’s biggest problems. Unemployment is high among the younger population and a major concern, especially given the unrest that has shaken the Middle East. The GCC has been largely spared, with the exception of demonstrations, riots and martial law that have beset Bahrain since spring 2011. In a drive to bridge some of the gap between haves and have-nots, the Bahrain government under King Abdullah has devoted a substantial part of the budget to improving education and using the stock market to build a private sector separate from the oil industry.

Well before the Arab Spring, the Saudis in 2003 created a local regulatory agency, the Capital Market Authority, and soon began a campaign to list more companies on the Tadawul, distributing shares to the public. As a result, initial public offering prices skyrocketed, only to tumble by 20 percent in one week in March 2006. That was an eye-opener to authorities, who recognized that with 95 percent of the market driven by local retail investors who had few other outlets for their money, boom-and-bust cycles were inevitable; the exchange needed the presence of foreign institutions to temper prices.

The CMA did open the door a crack in October 2008. Since then foreign funds have been able to buy Saudi shares, though only through swaps and promissory notes issued by locally licensed brokers.

Ashraf and Burbank started looking for stocks to buy soon after. Researching individual companies was a challenge, however. They requested meetings with senior management, who, at least initially, weren’t sure what to make of their foreign visitors when Ashraf came to call, sometimes with Burbank. “Most foreign fund managers go to Saudi Arabia to raise capital to invest elsewhere around the world,” says Ashraf. “We were doing the opposite.” He got the impression that even locals had little faith in the value of their domestic market. Disclosure practices have improved significantly since 2008, especially among the best-run private sector companies.

Ashraf has kept an eye out for companies that tap into the domestic consumer market. “They [the Saudis] have one of the highest usage rates of Twitter in the world,” he says. That is largely thanks to young people — 50 percent of Saudis are under 25 — who who are also heavy users of high-end smartphones. One of Passport’s top portfolio holdings is Etihad Etisalat Co., Saudi Arabia’s second-largest mobile phone operator, which sells almost exclusively to the domestic market. Another large Saudi holding for Passport is al-Tayyar Travel Group, which provides travel services for students studying abroad.

The heads of the CMA have talked about opening the market further so that foreign institutions can buy stocks directly through the exchange. Even under the current system, however, foreign capital is increasing. Net inflows of foreign capital to the Saudi stock exchange amounted to $93 million at the end of the first quarter of 2012 but rose tenfold, to $990 million, by June of this year. While some analysts have said that reforms could occur some time in 2014, Ashraf believes that’s pure speculation. Reform isn’t an easy call for Saudi authorities. They have seen other emerging markets get crushed when foreign investors suddenly decided to exit. The major incentive for the Saudis is that reform would make the stock market more efficient.

Hedge funds like Passport, however, find the inefficiency a major attraction. “I’d personally be okay if Saudi Arabia never opened,” says Garry. “When the country opens, money will flood in from outside, and it will become a beta trade.” That’s when Passport’s portfolio managers presumably will sell their holdings. Of course, no one knows when that will happen, meaning Passport has to be always ready to move on to its next investment theme.