Iraq could be the next Russia, says FMG
It's a rather unusual approach to pitching a fund, but then it's not your typical fund. Stockholm-based fund-of-funds manager FMG recommends that clients put 1-3% of their assets into its soon-to-launch Iraq Special Opportunity Fund, write it off as a loss on the first day, then "look again in three to five years", says the firm's principal Johan Kahm.
Given that the minimum investment is a mere $10,000, that may seem a tempting idea for some, especially when FMG is hoping for 1,000%-plus returns over a decade. But the proposal also highlights the challenges involved.
"This is one of the last emerging-frontier markets," Kahm told AsianInvestor on a trip to Hong Kong last week, adding that clients will clearly have to accept major volatility. The product targets private individuals, he adds, as "institutions won't go for this".
FMG, which specialises in emerging and frontier markets, will liquidate its existing Iraq Special Opportunities Fund and put all the money into the new vehicle, which will be run by two managers. The first client will be allowed in on June 1, when the fund will launch with $5 million, and it is likely to close at around $20 million. FMG will then invest that capital before opening again, says Kahm.
The fund broadly aims to benefit from Iraq's energy sector and economic recovery. FMG launched one of the first Russia-focused funds in 1995, and Kahm feels Iraq could be a similar, oil-based story. "Huge reconstruction and infrastructure efforts are required, and companies are all knocking on the door to be involved," says Kahm. "There's no shortage of money going into the country."
Iraq has the fourth largest proven base of oil reserves, with 115 billion barrels, after Saudi Arabia (267 billion bbls), Canada (179 billion bbls) and Iran (133 billion bbls). And yet Iran is only the 15th biggest producer, at 2.2 million bbls a day -- Saudi Arabia is top, with some 11 million bbls/day.
Moreover, oil companies such as BP and Royal Dutch Shell claim Iraq has the potential to produce 10 million bbls/day, thereby rivalling Saudi Arabia as the top oil producer. Shell chief executive Peter Vosser has said that $27 trillion of oil-industry investment would be needed to achieve this target.
While Kahm feels that is unlikely, he says that if the country could increase its output to two-thirds or half of that amount, it would clearly be hugely significant. For example, increased oil production could boost GDP by 50% in the next five years, according to IMF, Opec, Global Insight and Business Monitor estimates. And many expect the oil price is likely to rise significantly in the long term.
As regards the Iraqi stock market, total market capitalisation is just $2.5 billion, despite its oil reserves. That figure is on a par with Barbados, and just 1% of Russia's or 0.8% of Saudi Arabia's market cap. Moreover, the market is largely untouched by foreign investors, says Kahm.
Until April, calculations were still being done on blackboards in the exchange, but in that month, it bought the Nasdaq/OMX system. It now has close to 100 companies listed, says Kahm, although in reality one can only realistically deal in a quarter of these stocks due to low liquidity. And daily volume is between $0.5 million and $4 million.
Moreover, Dow Jones is to create a new index this year, and bank, media and telecoms IPOs are also expected in 2010, he adds, although there could well be unexpected delays. But, long term, there is a great deal of potential for growth in terms of the equity market, especially given that there are no restrictions on foreign ownership and no tax profits.
With regard to sector allocation, about 70% of the market cap is accounted for by banks, all of which have a very small capital base, says Kahm. Other than banks, there's little choice of stocks, he adds, and traded volumes are very low.
There's only one foreign bank in the market, HSBC, which has a majority stake in one of the local firms. In fact, HSBC is probably cheaper to buy than the local banks, for which you currently pay between 1.5 and 2 times book value, says Kahm.
The Iraqi government has decided that within the next three years banks must increase their capital reserves -- and that means either merging or selling out to foreign firms, says Kahm, which will be a good thing for the market.
"We see Iraq as a macro, top-down play," he adds. "If you looked at it bottom-up, you probably wouldn't go in."
Following the late-March election -- the result of which is still undecided -- uncertainty and a threat of violence hangs over the country. However, says Kahm, "what we know is that all the candidates are pro-foreign investment and pro-stock market", which is clearly good news for investors regardless of the political outcome.
As for the wider economy, the government has paid off much of the $100 billion-plus of debt it had in 2004, inflation has stabilised at around 6.5%, having exceeded 40% in 2006, GDP growth of 5-10% is forecast, and the Iraqi dinar has appreciated since 2007.
However, there are clear risks involved in investing in Iraq. The biggest worry is the political situation; the religious fighting between the various groups, says Kahm. Security remains a big issue, particularly with allied troops slated to withdraw next year.
In addition, the economy is very dependent on oil, being three times more sensitive to oil price changes than crude-rich Russia, corruption is a major problem, and there could be disagreements over the distribution of oil wealth.
Meanwhile, although the stock exchange is relatively transparent, notes Kahm, company and counterparty risk levels are high, and blow-ups can occur. Plus, if the country were to break down, the stock market would probably be closed down and the pricing mechanism would not work for a period.
Still, diversification should help mitigate potential blow-ups in individual stocks, and FMG plans to buy 20-30 companies that are likely to survive to this end.
Iraq is not an investment for the faint-hearted, then, but FMG is not short of frontier-market experience. With $200 million in assets under management, the manager runs funds focusing on Africa, China, India and Russia, among others.