Why are some asset managers not yet convinced Saudi is the world’s most compelling economic story? We sat down with our friend EFG Hermes Head of Research Ahmed Shams El Din to discuss why foreign investors in public markets are still shy on Saudi, the outlook for the banking sector, and overlooked pockets of opportunity. Shams splits his time between Riyadh and Cairo, where EFG Hermes is headquartered.

Foreign institutional investors are overlooking Saudi public equities: From a public equity perspective, foreign institutional investors are underweight on Saudi, Shams El Din said. Valuation has always been a concern for countries on the cup between smaller-sized emerging markets and larger-sized frontier markets, Shams El Din explained.

Investors that are underweighting Saudi Arabia have been proven wrong for three years in a row, Shams El Din said. “Foreign institutional investors — particularly when they’re looking at emerging markets — buy into banks at 1x book [value], consumer stocks at 15x, petrochemicals at 10-12x on average. They find it very hard to pay 25x for a company that has similar fundamentals.” Saudi Arabia offers a stronger growth outlook and lower risk, and investors have struggled to translate this into a valuation that makes them comfortable.

Part of the problem: The Saudi model has yet to be digested, Shams El Din explained. Investors don’t fully understand the Saudi transformation story the same way they understand markets like Vietnam, which is heavily export-driven. Saudi Arabia is diversifying its economy away from the oil sector, but the country is investing in areas where oil liquidity is needed, he said.

The socioeconomic changes — all of which are positive — that have been happening on the ground over the past several years took many investors by surprise, Shams El Din said. The domestic story in Saudi Arabia right now is all about focusing on shifts such as women’s empowerment and a first-ever focus on tourism. “It’s taking time for the investment community to start pricing the socioeconomic changes that are happening on the ground. But it’s about time — they can’t keep underpricing Saudi,” he said.

It’s about investing in the Saudi story, rather than focusing on just investing in large caps: Foreign institutional investors have zeroed in on large caps such as Saudi Aramco, SNB, and Sabic, according to Shams El Din. “All the companies that have had really strong stories over the past couple of years are technically small caps, but that’s because large caps constitute 60-70% of the market weight,” Shams El Din said. “You don’t play the Saudi story — the domestic demand story — with large caps, which are all petroleum, exports, and banks.”

Mid-caps have been outperforming: “If you remove the five biggest large caps from your calculations, the dynamics change completely and the market re-segments,” he said. The vast majority of names that have made “phenomenal” returns over the past five years are small caps in the Saudi market.

Still, a growing number of asset managers have appetite for the Saudi story: Retail investors now account for around 55% of the market, compared to c.95% five years ago. And even within the 55%, a growing number of retail investors are investing for yield, rather than just hit-and-run plays on momentum and gossip.

Meanwhile, liquidity in Saudi Arabia’s banking sector is an area on which to keep your eyes, Shams El Din said. We’re not talking about systemic risk here, Shams El Din says, but “if you’re diversifying [the economy] and you want private sector competitiveness to grow, you need to decentralize the funding options. The funding options right now are Saudi banks, but their loans-to-deposits ratios are stretched to the maximum,” he said.

Deposit growth is lagging behind credit and loan growth because of the massive investment in infrastructure. Credit penetration remains low, although borrowing capacity is huge, Shams El Din said. In the past two years, SAMA has intervened twice by injecting liquidity into the market, but that model doesn’t go hand-in-hand with the new Saudi policies, he added.

The solution? A “very active capital market,” Shams El Din suggests. “The dark horse in Saudi Arabia is debt capital markets (DCM), not equity capital markets (ECM),” he said. Private issuances in debt capital markets have been picking up over the past few months, but they’re still lagging behind most emerging markets: Where the average emerging market has DCM issuances that are around 25% of GDP, Saudi Arabia’s currently stands at 3% of GDP, Shams El Din said.

A growing debt market will be key to sustain valuations we’re seeing in public equities, which have seen “an impressive turnaround,” Shams El Din stressed. “Without DCM, however, the hype that we’re seeing on ECM is not going to be sustainable.”

Key to sustaining international interest: continued improvement in the regulatory and policy environments, including recent changes on zakat: “You can’t pay 2.5% zakat on fixed income because the yield is only 4%,” Shams El Din said. These types of regulatory changes would go a long way towards helping investors better understand and price the market, which will spur more investments.

Another area where regulatory overhaul will go a long way: The country’s real estate sector, which Shams El Din also identified as one of the undiscovered gems of the Saudi story. Regulatory changes on real estate ownership would be very positive for driving foreign investors into the economy, particularly as “there’s still a lot of uncertainty on how foreigners would buy real estate,” he said. “Real estate is a very decent sector itself — it’s huge in terms of liquidity, but it’s dominated by private builders. The Saudi market needs a national champion in the real estate sector — the market currently has a handful of very small players, which are all very well managed but can’t be considered national champions, Shams El Din said. “There has to be consolidation and legislative or regulatory reforms for foreign ownership.”

Petrochemicals also remains an interesting sector, but is over-penalized largely due to cyclical and structural factors, Shams El Din said. It’s “significantly outperformed the market,” he said.