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iShares MSCI UAE ETF (NASDAQ:NASDAQ:UAE) is an exchange-traded fund enabling investors to get direct exposure to a broad range of companies in the United Arab Emirates. The fund’s benchmark index is the MSCI All UAE Capped Index, which is an index that is “capped”, or in other words rebalances to avoid over-concentration in a handful of single names. However, the index only had 26 constituents as of November 30, 2021, so in reality there is little protection here from concentration.
The UAE ETF had assets under management of just $31.4 million as of December 17, 2021. Fund flow data reveals one-year net inflows of about $10 million.
But UAE remains a small fund, and an unlikely beneficiary of significant direct inflows. Still, UAE’s small portfolio of holdings (32 positions as of December 17, 2021) could benefit domestically in the UAE, and also benefit from short-term repricings, without U.S. or other international investor flows. On a year-to-date basis, iShares reports a change of just under 52%, which means that the UAE ETF has easily beaten the S&P 500 U.S. equity index (which has risen by about 25% over the same time frame, on a price-only basis).
But the expense ratio of UAE is quite high at 0.59%, while the top 10 holdings represent almost 80% of the fund. So, without a strong valuation basis for buying into UAE, I would generally caution against the risk here. We will review the valuation shortly, but the table below illustrates the high level of fund concentration.
(Data from iShares)
Already from the above list you can see that UAE’s top sector exposures are in Communication Services, Financials, and Real Estate. While Communication businesses can be rather consistent, they are not typically high-return businesses, and banking stocks (even outside of the West) do not typically generate high returns on equity (excluding certain geographies such as Canada in which there are arguably oligopolistic profits).
UAE is an under-covered ETF, and as we have seen it is not especially popular. Data is scarce on forward projections, but Morningstar provides us with a forward price/earnings ratio of 14.94x as of December 16, 2021, and a price/book ratio of 1.47x. The MSCI UAE Index (a different index to UAE’s benchmark, but which contains some additional forward data, and is based on just 9 constituents that do feature in UAE’s index and portfolio) reveals similar numbers: 14.07x and 1.65x, respectively (but as of November 30, 2021). We will use the support of MSCI’s numbers to use Morningstar’s numbers.
Dividing the price/book of 1.47x into the forward price/earnings ratio of 14.94x, we find an underlying return on equity of 9.84%, which is on the low side, and confirms my doubt earlier regarding the lower returns of sectors like Financials (in our low-interest-rate world). This low ROE also concerns me in light of the strong performance of the UAE fund (year-to-date), of over 50%, because generally speaking a fund is not going to be able to grow faster than its underlying ROE on any long-term basis (except during bubble-like conditions where sentiment dictates all).
Professor Damodaran suggests a mature market equity risk premium of 4.77% for December 2021, and previously indicated a country risk premium of 0.42% for the United Arab Emirates. In terms of the UAE’s local interest rate, I cannot find a clear reference rate, although in September 2021 Abu Dhabi (the largest emirate of the UAE) priced its 10-year about 63 basis points over U.S. treasuries which was lower than a target of 90 basis points. To be conservative, I will add 1% to the current U.S. 10-year of 1.407% as a rough estimate of the risk-free rate for UAE investors, i.e. 2.407%.
So, our overall cost of equity comes to 6.96% together with the ERP, country risk premium, and risk-free rate. Morningstar consensus estimates place three- to five-year earnings growth rates at 8.07%, so we can also use that as inspiration following growth rates implied by trailing and (one-year) forward price/earnings ratios (for the trailing ratio, I am going to use the MSCI UAE Index’s ratio of 16.44x, but adjusted to 17.12x for December 16, 2021 to fall in line with our Morningstar-derived forward ratio of 14.94x).
Interestingly, my short-term valuation gauge indicates that UAE is undervalued, with upside potential of about 23%. I think, in light of fairly low U.S. investor flows (if we can use UAE, a fairly clean vehicle for investing in UAE equities), the upside potential here is based on still fairly moderate risk sentiment with respect to UAE stocks. If there were more interest, we could see this gap closing. Large regional exposures in the UAE to oil prices also matter, with UAE shares moving up alongside crude oil futures (the red line in the chart below).
However, crude oil prices tend to move higher on the back of positive risk sentiment to which equity prices are also (globally) generally positive correlated. So, the relationship here is probably not incredibly important, although we generally would want to avoid seeing an oil price crash if we are invested in UAE. Currently much higher and more stable oil prices should be constructive for UAE, but some modest under-valuation remains. I would hazard a guess that UAE will continue to see some modest out-performance, especially as the fund still remains well below its all-time highs since inception.
(UAE share price since fund inception.)
However, with a cost of equity of about 7%, and underlying return on equity of about 10%, the long-term return prospects of UAE are likely going to be in this region, of around 7-10%. I think what we have witnessed is a sharp reversal and repricing off of long-term lows (registered in 2020; years after fund inception on April 29, 2014); I am not convinced that any further short-term out-performance will continue for very long.
And not only do you have fairly meagre long-term growth prospects here, but you also have the uncertainty of investing in a region that is still very exposed to commodity prices. You are combining quite low returns in a positive scenario with the tail risk of large downside in a negative scenario; negative skewness, scenario-wise. Therefore, while I think the long-UAE trade might continue to work for a while, I would remain neutral from a long-term perspective at current prices.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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