Will IR Iran realise its potential as one of the world’s largest frontier

economies?Erik L. van Dijk

Fund Forum Emerging MarketsLondon, March 4, 2009

Introduction 1

• Erik L. van Dijk– Implemented Consultant, specializing in GTAA,

Manager Selection– Markowitz – Van Dijk GTAA framework

• consists of 50+ countries; this has led to special interest in our Emerging Markets / Frontier Markets work

• See also:– Financial Analysts Journal, March/April 2003– http://www.cfawebcasts.org/cpe/what.cfm?test_id=748

» Webcast CFA by Seb Page (State Street)

– Advisor to AMIO

Introduction 2

• AMIO (http://www.amio.ir ; Farsi only)– Agricultural, Mining and Industry Organization of

IR Iran• Non-political• Goal is to develop/establish business and trade

relationships– Investment opportunities in Iran (for interested outsiders)– Investment opportunities abroad (for members)

• Representing some 1,000 Iranian firms ranging from small- and mid-cap (non-listed) to large, listed firms

Introduction 3

• IR Iran

– ‘’Neglected country’’ effect, similar to the well-known ‘’Neglected firm’’ effect

• Can you invest in an Islamic Republic?• Didn’t know they have a stock exchange• Isn’t it way too risky, because of the international situation?• Do they have an economy? Thought it was just oil and gas• Sorry! Embargo!

Introduction 4

• Neglected firm effect– http://www.investopedia.com/terms/n/neglectedfirm.asp

Investopedia:‘’The phenomenon of less-known firms producing abnormally high returns

on their stocks’’And:

‘’Neglected firms are usually the smaller firms that analysts tend to ignore. Information available on these smaller firms tends to be limited.’’

But also:‘’The abnormally high return exhibited by neglected stocks may also be due

to lower liquidity or higher risks associated with the stock.’’

Introduction 5

• But wasn’t neglect a US phenomenon?

– Can it be internationalized into an EM framework?• YES

– Compare V. Tripathi, ‘’Relationship between Institutional Neglect and Stock Returns in India’’, Business Analyst, Vol 1 No 1, pp. 85-92

– http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1134653

– Can we go from ‘firm’ to ‘country’ level?• WHY NOT? (but more research needed; EVD)

Frontier Market IR Iran

• These guys are big!SHOULDN'T IRAN AND SAUDI ARABIA BE IN?

COUNTRY GDP GDP PP GDP NORM Rank PER CAP Rank

  I II   Glob.   Glob.

Iran 382.3 859.7 621.0 19 9,427 50

Turkey 663.4 853.9 758.7 16 10,553 47

Egypt 127.9 405.4 266.7 35 3,263 79

Libya 57.1 74.7 65.9 68 10,673 46

Pakistan 143.8 411.9 277.9 33 1,608 91

Morocco 73.4 125.0 99.2 60 2,889 82

Saudi Arabia 376.0 546.0 461.0 22 16,378 36

Israel 161.9 185.8 173.9 52 24,443 28

Notes;in USD; GDP: USD billions; GDP NORM = 0.5*I + 0.5*II    

Sources; CIA Factbook, IMF, World Bank, Lodewijk Meijer    

Turqoise countries not in MSCI Emerging Markets      

Politics; General 1

• Different, but legal and political structure stable and ‘predictable’

GovernmentLed by M. Ahmedinejad

Supreme LeaderAli Khamenei

Majlis

GuardianCouncil

Assembly ofExperts

Elected; multi-party; factions

Elected

Candidates

Approved by GC

Led by A. Rafsanjani

12 member Supreme Court

6

6

Politics; General 2

• Guardian Council and/or Supreme Leader too powerful? – They have in the 30-years of the IR Iran treated their

responsibilities in a Shariah-related way, as it was supposed to be

• Direct involvement with day-to-day politics and economics has been marginal

• Shariah and other Islamic legal infrastructure components provide well-documented basis

• With respect to roles; system under development with IR Iran just 30-years young

Politics; Internal

• Currently (since 2005), conservatives dominating the Majlis and the government– Led by M. Ahmedinejad– Powerbase in the rural areas and among the poor– Political themes; Income distribution themes

• Indications that reformists will at least challenge conservatives in the coming elections (June 2009)– Led by M. Khatami and A. Rafsanjani– Powerbase in the cities– Economic themes

Politics; External

• Notwithstanding discussions about nuclear activities, new initiatives to stimulate dialogue– In Iran:

• Both conservatives and reformists indicate willingness • Partly economics-related; M*V = P*T and the impossibility to

control inflation when you earn too much (EVD)

– Abroad:• Obama Administration• Amidst financial crisis always re-evaluation of standpoints with

respect to others that have liquidity (EVD)

Economy; General

• Structure of the economy– Tilted towards Industry/Manufacturing (more than in the average EM)– Dependence on Oil & Gas still (too?) large

• But it helped the government to establish a budget surplus with revenues of $ 127.2 billion (2008) and expenditures of $ 98.5 billion (2008)

– Low public debt (25% of GDP)– Relatively high inflation (28%; see also later this chapter)– Unemployment of 12% (high, but normal in an economy that shifts from

Agriculture to Industry/Services)– In need of:

• New investments to increase efficiency• Knowledge transfer

Economy; General 1

Iran   % of GDP % of LaborF GDP per worker

  Agriculture 10,7% 25% 9260,9

  Industry 42,9% 31% 29943,7

  Services 46,4% 44% 22817,9

  GDP Norm 621,0    

  Labor Force 28,7    

Turkey   % of GDP % of LaborF GDP per worker

  Agriculture 8,9% 36% 7981,6

  Industry 28,3% 23% 39724,7

  Services 62,8% 41% 49451,3

  GDP Norm 758,7    

  Labor Force 23,5    

World VW % of GDP % of LaborF GDP per worker

  Agriculture 4,6% 13% 7275,1

  Industry 30,0% 32% 19275,1

  Services 65,4% 55% 24447,8

  GDP Norm 59531,8    

  Labor Force 2895,5    

World EW % of GDP % of LaborF GDP per worker

  Agriculture 9,2% 24% 7881,4

  Industry 33,8% 22% 31587,8

  Services 57,0% 54% 21702,3

  GDP Norm 59531,8    

  Labor Force 2895,5    

Notes; VW and EW denote World Value (GDP) weighted and equally

  weighted respectively    

GDP in billions of USD; Labor Force in millions of participants

Norm = equally-weighted average of GDP Official and GDP PPP

Economy; Real 1

• Growth economy; even amidst credit crisis and embargo

– Phases:• Phase 1: Pahlavi period• Phase 1ex: excluding 71/72-74/75 and 78/79• Phase 2: First ten years of IR Iran• Phase 3: Maturing IR Iran

Economy; Real 2

Real GDP Growth in Iran1960/61 - 2010/11f

-40,0%

-30,0%

-20,0%

-10,0%

0,0%

10,0%

20,0%

30,0%

40,0%

50,0%

60,0%

GDP Growth

Phase 1;Pahlavi period;

The Oil Story;Benefiting from the Oil Crisis, but distribution of wealth too unequal

Phase 2; Setting up a new country without support by others; ''equal distribution of poverty''

Phase 3; IR Iran grown-up;Frontier Market nr 1,

but will the world acknowledge it?

Economy; Real 3GDP growth (real) per period

10,9%

7,4%

-5,8%

6,8%

-8,0%

-6,0%

-4,0%

-2,0%

0,0%

2,0%

4,0%

6,0%

8,0%

10,0%

12,0%

Phase 1 Phase 1 ex Phase 2 Phase 3

Economy; Monetary 1

• Inflation (approx. 25-30%)– Fisher equation MV=PT explains the story

• Building new economy without support• PT growth mainly dependent on oil and gas• Relatively large net money inflow via:

– Current Account Surpluses– Iranians living abroad

• Insufficient (still) diversification of the economy• Problems in the savings/fixed income area under new

Islamic rule– Black Market for Foreign Exchange problem

Economy; Monetary 2

• Improvements expected– 2002; multiple exchange rate system abandoned– More realistic exchange rate policy by Central Bank

of Iran– Economic growth and diversification will help

improve things– Increase in international trade and two-way

investment activity will expand the monetary opportunity set

– Better functioning savings market

Economy; Potential 1

• Goldman’s Next-11

Economy; Potential 2

• Value of Oil and Gas Reserves– Oil (proved reserves; Jan 2008; CIA Factbook)

• 138.4 billion bbl– Value at $ 45 per barrel = $ 6228 billion = 16.3 years of Iranian

nominal GDP

– Natural gas (proved reserves; Jan 2008; CIA Factbook)

• 26.85 trillion cu m– Value at $ 185 per 1000 cu m = $ 4967 billion = 13.0 years of

Iranian nominal GDP

Economy; Potential 3

• Large pool of labour– Population of approximately 70 million– Relatively young:

• Median age 26.4 years

– Population growth 0.8% per annum– Education improving, with education expenditures

equal to 5.1% of GDP (2006)

Economy; Potential 4

• Importance of IR Iran’s SWF structure– Internally

• Pension plan structure that they contemplate building• Similar to the Dutch experience in the 1950s

– Externally to help improve relationships• When wealth is based on/ helped by (illiquid) oil and gas

reserves:– Relatively aggressive investment policy in financial assets

possible, but diversification essential *– Benefits receivers abroad and domestically

• B. Scherer PhD (Morgan Stanley), Portfolio choices for Oil-based Sovereign Wealth Funds, • Jan 2009

TSE; General 1

• Stock exchange well functioning according to EM standards http://www.iranbourse.com/en/– Legal (started in the 60s, based on plans already laid down by Belgian

specialists in the 30s); 35% government-owned– Full-member of World Federation of Exchanges– Price formation (automated, order-driven; 2007 AEMS acquired from

Atos Euronext)– Short-selling prohibited– Day-trading allowed– Data availability– Foreign ownership of firms limited to 49%– Foreign funds allowed, but approval of Min of Finance required

TSE; General 2

• Exchange still small with an equity focus – (400 firms; USD 70 bn as of Mid-2008; USD 50 bn

as of Feb 21, 2009)– Also: Islamic-style corporate bonds– And: Project-based participation certificates with

fixed income like component during time till completion and profit component at maturity

TSE; General 2

Firms on TSE

0

50

100

150

200

250

300

350

400

450

1967 1974 1978 1979 1981 1990 2009

Year

# of firms listed

TSE; Analysis 1

• TSE is not an oil exchange

• Manufacturing and (since its privatization round in 2008) Telecom Iran (TCI) dominate

• Financials are important, but the two main banks Melli and Saderat are state-owned

TSE; Analysis 2

Industry MCAP %

Post and Telecommunications 7078.3 14.1%

Basic Metals 7001.4 14.0%

Financial Intermediaries 4363.5 8.7%

Cement Lime and Gypsum 4235.6 8.4%

Motor Vehicles and Auto Parts 4159.5 8.3%

Diversified Industrials 3320.6 6.6%

Metal Ores Mining 2915.3 5.8%

Banks Credit and Other Financial Institutions 2719.6 5.4%

Chemicals and Byproducts 2416.8 4.8%

Refined petroleum products and nuclear fuel 2126.2 4.2%

Transportation 1617.4 3.2%

Pharmaceuticals 1465.8 2.9%

Investment Companies 1422.5 2.8%

Real Estate and Construction 1219.9 2.4%

Technical and engineering services 1028.2 2.1%

  47090.6 93.9%

Source; TSE Feb 21, 2009

TSE; Analysis 3Firm Industry   MCAP of Total

Telecommunications Iran Post and Telecommunications   7078.3 14.1%

Esfahan's Mobarakeh Steel Cy Basic Metals   2799.3 6.1%

Iran National Copper Industries Cy Basic Metals   1652.1 3.6%

Saipa Cy Motor Vehicles and Auto Parts   1557.7 3.4%

Islamic Republic of Iran Shipping Lines Transportation   1293.1 2.8%

Parsian Bank Banks Credit and Other Financial Institutions   1173.2 2.5%

Chadormalu Mineral and Industrial Cy Metal Ores Mining   1163.0 2.5%

Omid Investment Cy Diversified Industrials   991.7 2.1%

Iran Power Plant Project Management (MAPNA) Technical and engineering services   940.0 2.0%

Civil Pension Fund Investment Cy Diversified Industrials   932.3 2.0%

Gol-e-Gohar Iron Ore Cy Metal Ores Mining   864.1 1.9%

Ghadir Investment Cy Diversified Industrials   844.9 1.8%

Khouzestan Steel Cy Basic Metals   828.7 1.8%

Khark Petrochemical Cy Chemicals and Byproducts   785.9 1.7%

Iran Khodro Industrial Group Motor Vehicles and Auto Parts   765.2 1.7%

Eb Bank Banks Credit and Other Financial Institutions   638.9 1.4%

Fars and Khuzestan Cement Cy Cement Lime and Gypsum   633.6 1.4%

Karafarin Bank Banks Credit and Other Financial Institutions   496.2 1.1%

Butane Industrial Group Machinery and Equipment   495.5 1.1%

19 Firms > 1% of total market cap     25933.7 56.1%

TSE; Analysis 4

• Return analysis– Not totally insensitive to the credit crisis, but interesting

returns when considering that they have been achieved during a period in which the rest of the world ignored opportunities in Iran. And it wasn’t only the crisis, but also the IPO of TCI

– Currency outlook has improved substantially since the multiple exchange rate framework has been abandoned in 2002

– Attractive risk profile (see also below)

TSE; Analysis 5TEPIX in Rials 1998-2009

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

Nov

30

1998

Mar

31

1999

Jul 3

1 19

99

Nov

30

1999

Mar

29

2000

Jul 3

1 20

00

Nov

29

2000

Mar

31

2001

Jul 3

1 20

01

Nov

28

2001

Mar

31

2002

Jul 3

1 20

02

Nov

30

2002

Mar

31

2003

Jul 3

0 20

03

Nov

30

2003

Mar

30

2004

Jul 3

1 20

04

Nov

30

2004

Mar

30

2005

Jul 3

1 20

05

Nov

30

2005

Mar

28

2006

Jul 3

1 20

06

Nov

29

2006

Mar

31

2007

Jul 3

1 20

07

Nov

28

2007

Mar

30

2008

Jul 2

9 20

08

Nov

30

2008

TSE; Analysis 6

• Interesting risk profile– EM-like returns after correcting for Rial depreciation– Normal volatility for frontier / EM market– Low (and relatively stable; see appendix) correlation and

beta with rest of world

1998 (12) - 2009 (01); Monthly data

Factor TEPIX$ MSCI WORLD$ MSCI EM $

RET 0.60% -0.06% 0.64%

VOLA 8.82% 4.79% 7.77%

BETA 0.145 1.000 1.373

TSE; Analysis 7

• Embargo analysis– Incredibly low impact, because of financial power

Iran has– Impact mitigated due to large, strong trading

partners stepping in (CHI, RUS, JAP, TUR) and even in the West you see signs of the embargo breaking down due to the credit crisis and the expected change in US policy

TSE; Analysis 8

• How to invest in Iran?– (Still) limited opportunities for foreigners in indirect investments via

funds• First Persian Fund (with Melli Bank) just started• New initiatives (e.g. AMIO-LM)

– Direct investments by foreigners in TSE• Possible, but is this the market where you want to be in directly as

outsider?• Better to exploit inefficiencies via specialist

– Foreign Direct Investments• Big projects• Interesting opportunities to co-invest

Conclusions 1

• Goldman is right; it is a Next-11 market, if we want or not

• International investments (both direct and indirect) will grow– By Iran abroad– In Iran (market attractive when looking at the return-risk

profile)

• Embargo in its current form will evaporate– And this will make increased performance of the TSE more likely than

some kind of additional correction

Conclusions 2

• How?– FDI (project financing; e.g. infrastructure or oil /

gas projects)– Fund

• Still limited opportunities– First Persian; closed-end equities fund, closed August 2008

» USD 100 mn (approx.)– Under construction; AMIO-LM

» Euro 500 mn» Mixed; equities and ‘other’

Contact

• Erik L. van Dijk– Tel. + 31 6 155 86 109– Email: erik_dijk@hotmail.com (temporary)– Website LM under construction (April 1 expected)– http://www.linkedin.com/in/evd101

Appendix; 36-months volatility

0.000

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0.040

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0.080

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0.160

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TEPIX$ MSCI WRLD$ MSCI EM$

Adjustment to the new exchange rate regime 2002-2005

Appendix 2;36-months correlation

-0.400

-0.200

0.000

0.200

0.400

0.600

0.800

1.000

1.200

Nov

28

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TEPIX$ MSCI WRLD$ MSCI EM$

Appendix 3;36-months beta

-1.000

-0.500

0.000

0.500

1.000

1.500

2.000

2.500

Nov

28

2001

Feb

27

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TEPIX$ MSCI WRLD$ MSCI EM$