2003 – THE YEAR OF IRAN’S CAPITAL MARKETS

The race has just begun

By Albrecht Frischenschlager

May 2003

In the past three years the Tehran Stock Exchange (TSE) has made it at least once a year into international business papers – when the annual list of top performing stock markets worldwide was published. At times when blue chip stocks in developed countries where tumbling from one low to another, the TSE recorded annual total returns between 42 and 72%. Also in recent months this trend has continued: January to June 2003 the market is up by 50%. All this seems like a big bubble, ready to burst. So how can 2003 become the year of capital markets in Iran?

Historical Background

The Tehran Stock Exchange, the only formal capital market in Iran, was established in 1966. The exchange organization was structured through the work of two consultants from the Brussels Stock Exchange and was formalized in the Law on Establishment of the Stock Exchange, approved by the Majles in May 1966. Today, the TSE still operates under this original law.

During its first year of activity only six companies were listed. The number of companies increased to 43 by early 1974. After the first oil price boom and along with the increase in foreign exchange revenues of the country, the activities of the TSE expanded considerably. As a result, the number of firms listed at the TSE reached 102 by early 1978. Of these, 24 were commercial and specialized banks.

On the eve of the Islamic Revolution, in 1978/1979, trade slowed down. Only three new members were added in 1979, and in the following two years many companies were either confiscated or nationalized, which reduced the number of listed firms to only 55. Because all banks and insurance companies were nationalized in 1979 they stopped being traded on the stock market. Bond trading ended in 1983. It is notable, however, that despite being portrayed in the early days of the Revolution as a capital profiteering tool, the TSE was never closed down.

Finally after a decade of reduced activities the stock market picked up again in 1990 and today 335 companies are listed on the TSE.

Organizational and Regulatory Structure

The TSE operates subject to the influence and control of several government agencies. The TSE is under the formal management of the Tehran Stock Exchange Brokers’ Organization whose board appoints the Secretary General and his management team. The TSE is further subject to the powers of the Stock Exchange Council and the Securities Acceptance Committee (both of which are chaired by the Governor of the Central Bank) and the Stock Exchange Arbitration Board. Various other government organs, including the Ministry of Finance and Economic Affairs are also members of these supervisory bodies.

Trading System

The TSE is open for trading five days a week from Saturday to Wednesday, excluding public holidays. Trading takes place through the Automated Trade Execution System from 9am to 12:30am, which is integrated with a clearing, settlement, depository and registry system.

The TSE is solely an order-driven market and all transactions are executed in the manner and under the principles of open auction. There are no minimum trading lots.

The range of price movements is typically restricted to five per cent daily. This can be changed in specific situation by the General Secretary of the TSE in case of unusual price movements resulting in an extremely high or low P/E ratio. Short selling is not permitted. All purchase and sale orders are executed exclusively by authorized brokers on the floor of the TSE.

In 2002, the TSE authorities have split the TSE into two floors (A, B) and introduced a B1 and B2 board on the second floor. Different listing and delisting criteria apply on the various floors and boards. This has helped the TSE to improve the supervision of listed companies and to manage and to enforce punitive actions in case of violation of listing criteria.

In addition, the TSE authorities have introduced new listing and delisting criteria. Based on each floor’s prerequisite, applicants can apply for either the first or the second floor. However, none of the applicant companies can immediately be listed on the first floor. Initially, they have to pass a certain period of time performing well on the B1 or B2 board of the second floor. If companies, for any reason are not able to meet the requirements of their board or floor, they are degraded to a lower level.

Present Situation

After significant increases in the early nineties, share prices leveled off in 1998. In mid 1999 they started to rise again and in June 2003 market capitalization stood at US$ 17bn or approx. 15% of GDP. Average daily trading reached US$ 15m.

The companies listed at the TSE are divided into 24 sectors. Non-Metallic Mineral Products, Chemicals, Investment Companies, Motor Vehicles and Food & Beverage have the largest share in the market capitalization of the TSE.

The top ten companies quoted on the TSE consist of three cement companies (Fars & Khuzestan Cement, Tehran Cement, Sepahan Cement), two investment companies (Bank Melli Inv. Co., Ghadir Inv. Co.), Iran’s largest carmaker (Iran Khodro), Khark Petrochemical, Iran Chemical, Iran Ship Building and one pharmaceutical company (Darupakhsh).

In 2002/03 the TSE recorded a total return on investment (TEDPIX) of 51.2 per cent, consisting of an average weighted price increase (TEPIX) of 34.7% and an average weighted increase in dividend payments (TEDIX) by 12.3%. In March 2003 the average weighted P/E stood at 9.5x March 2003 earnings, whereas the average weighted dividend yield reached 15.4% (after tax: 12%).

The Year of Capital Markets – Part 1

So why could 2003 turn into the Year of Capital Markets in Iran?

The answer lies in a very ambitious reform program, combined with company valuations still well below other emerging markets and the expected entry of foreign investors into the stock exchange.

Entering a New Age

The TSE has started a modernization program aimed at preparing the market for the 21st century. The most important elements are:

New Capital Market Law: The TSE is presently in the process of drafting a new comprehensive capital market law to replace the Law on Establishment of the Stock Exchange of 1966. Drafts have been circulating already for many months, and it is expected that in the second half of 2003 a final version will be submitted to the Majles.
New Trading System: The TSE is presently conducting a tender for introducing a completely new trading system. It is expected that the winner is announced in summer 2003 and that the new hard- and software will be installed by the end of 2003.Foreign Portfolio Investment By-laws: The TSE is presently in the process of preparing by-laws allowing direct foreign investment in the TSE. The responsible commission has already completed its work and the final draft has been submitted for approval to the Stock Exchange Council. The main provisions of the draft are:

foreign based investment funds and individuals/corporates can invest in listed companies, subject to getting an approval from the Foreign Investment Board adjunct to the Ministry of Finance and Economic Affairs (under the Foreign Investment Promotion and Protection Act) or from the Stock Exchange Council;
they can invest directly or via a special purpose vehicle in one of Iran’s Free Trade Zones;
foreign investment funds need to be listed at a reputable foreign stock exchange, have an Iranian custodian and a qualified investment manager; governmental organization cannot be shareholders in such investment funds;
the maximum investment of each investment fund in the TSE must not exceed 1% (presently US$ 150m) of the total market capitalization; the maximum investment of each individual/corporate must not exceed 0.1% (presently US$ 15m) of the total market capitalization;
investment funds cannot take out their capital during the first 2 years; thereafter they can redeem every 3 months up to 20% of the capital;
individual/corporate investors require a permit from the Stock Exchange Council to purchase more than 5% of the shares of a listed company; for investment funds this limit has been set at 10%;
no foreign investor can hold more than 49% of a single company listed at the TSE.

Commodity Exchange: The TSE has entered into co-operation with the Ministry of Mines & Metals for establishment of a commodity exchange for ferrous and non-ferrous metals. Planning for this venture has been finalized and concrete preparatory measures have already started. In addition to the metal exchange a commodity exchange for agricultural products is currently under preparation. So far no starting date has been set.
New Financial Tools: The TSE is presently studying the possibility to introduce new financial tools such as certificates of deposit, preferred shares, future contracts, convertible participation certificates (convertible bonds) and options.

The Market Who Beats Itself

Despite a substantial increase in share prices in recent years, the TSE with an average P/E ratio of 9.5 and an after tax dividend yield of 12% still compares well with other exchanges. The average P/E of emerging market is 13.4 while the dividend yield stands at 2.5%

What makes the TSE even more interesting for portfolio investors is the fact that there is no correlation with other emerging stock markets and not even with the oil price, as evidenced by below chart.

While share prices have been going up considerably in recent years also profitability of most listed companies increased due to a rise in domestic sales prices and an increase in productivity. Many sectors could also capitalize on the opening of the Afghan market. The same is expected to happen in the coming months with Iraq. Although the US administration in Iraq is not expected to encourage purchase of Iranian products, foreign construction companies will for sure not bring cement from Europe, but source it in neighboring countries; and Iran has not only a geographical but also a substantial price advantage. The same applies for various other product groups.

Foreigners at the Door

The final OK to the foreign investment by-law has not been given. Nevertheless, the race for introducing the first foreign country fund already started months ago. The winner is a consortium with Cairo based EFG Hermes - the largest investment bank in the Middle East – as fund manager, and Iran Foreign Investment Company – managing more than US$ 2bn in Iran’s foreign assets – as sponsor. They have established a unit trust under the name First Iran Fund in Bahrain with an initial capitalization of up to US$ 50m and with Bank Saderat as custodian. Until registration under the new foreign investment by-law the fund will invest in Iran through a special purpose vehicle established in Kish Free Trade Zone.

Other funds, including a project spearheaded by Bank Melli are expected to follow suit.

New Faces

Last but not least also changes in the management of the TSE and in the Privatization Organization are expected to have a positive influence on Iran’s capital markets:

The former top management of the Tehran Stock Exchange has moved to the Privatization Organization. Mr. Mir Motahari has been appointed Head of the Privatization Organization and Deputy Minister of Finance & Economic Affairs.

Mr. Hossein Abed Tabrizi, former member of the Stock Exchange Council and Chairman of Bank Eqtesade Novin (one of the newly established private banks) has been appointed new Secretary General of the TSE.

The move, initiated by Dr. Mazaheri, Minister of Finance and Economic Affairs can be interpreted as follows:

First, it is expected that the frictions between the major policy makers regarding Iran’s capital markets (i.e. Central Bank, Ministry of Finance and Economic Affairs and TSE) will reduce. Dr. Tabrizi is seen as a close ally of the minister. Also the new Central Bank Governor, Dr. Sheybani, seems to have a better working relationship to the minister than the late Dr. Nourbakhsh. This will guarantee that the various capital market reforms are implemented in a timely manner.

Second, the change indicates that the TSE will play an even bigger role in the privatization process (as the new PO management are all TSE veterans). Already in past two years the Privatization Organization has been ceding shares in listed companies to the public almost on a daily basis. It is expected that this process will continue. In addition, the Privatization Organization might use the TSE for privatization of large and presently unlisted governmental organizations, including banks.

Usually, financial institutions are the biggest listed companies in emerging stock markets and also the first to attract foreign investment. In Iran banks have been eliminated from the stock exchange in the aftermath of the Revolution. However, in 2002 the Stock Exchange Council has passed a by-law for the admission of banks. Already Karafarin, one of the newly created private banks, has successfully applied and is expected to be listed in the near future. Also government-owned banks Refah Kargaran, Saderat, Sepah and private banks Eqtesade Novin and Parsian have shown interest in entering the TSE.

The Year of Capital Markets – Part 2

All these changes and promising prospects have increased in recent months despite political tensions in the Middle East interest among domestic investors, Iranian expatriates and foreign investors.

Interest has been leveraged by economic reforms in Iran, including a unified and predictable exchange rate, the good financial standing of Iran and a successful Eurobond debut.

In this context it is worth mentioning that Iran has also products on offer for emerging market fixed income investors. Whereas the second sovereign Eurobond offers a coupon of 7.75% and trades at a premium, domestic sovereign bonds (always traded at face value and as liquid as cash) offer a quarterly coupon of 4.25% resulting in an annual return of 18.1%. Whoever thinks that the Rial will devalue less than 10% a year against the US$ (and I personally do) has an interesting investment alternative.

History has shown that every bullish market gets one day overheated and the bubble bursts. But the Iranian market has still a long way until reaching such stage and whoever starts investing in Iran in 2003 is unlikely to be disappointed.