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Iran: Last But Not Least
Economy, Domestic Economy

Iran: Last But Not Least

Iran is among the last markets that are still effectively closed to foreign investors. It is, however, by far the biggest and the most interesting one. The excitement around post-sanctions opening of the Iranian market reminds us of our early days in Russia in the late 1990s and in Turkey in the early 2000s when we found great long-term investment opportunities as pioneer investors, wrote Emre Akcakmak on the website of East Capital—a Stockholm-based asset manager specialized in frontier and emerging markets. Below is the full text of his article:
Since our first fact-finding visit about two years ago, we had a feeling that Iran has a lot in common with one of our largest markets, Turkey.
At the outset, the headline numbers on Iranian demographics look almost like a carbon copy of those of Turkey with nearly 80 million people at an average age of 28. The energy of the young population can be felt everywhere from a local bazaar to a modern art gallery and from hip cafes in northern Tehran to traditional restaurants in the mountains.
The echoes of Iran’s deep-rooted history and a strong sense of national pride can be felt in the air. Similar to Turkey, the gap between the rich and poor is wide. However, the strong culture of entrepreneurship and highly educated managers make a good foundation for overall economic growth and for strong job creation post-sanctions.
Iran’s capital, Tehran, also reminds us very much of its Turkish counterpart, Ankara. There are many old and nice looking buildings, but there are also many recently built and not very nice new ones. The city seems to be in desperate need of hotels, especially in case the recent influx of businessmen continues post-sanctions.
Much to our surprise, enormous infrastructure investments have already been undertaken all over the country, making a good base for further progress. Despite this, traffic often ground to a complete halt on the four-lane roads in Tehran, as the locally produced cars that dominate the chaotic traffic do not give any opportunity to move an inch.
Unlike Saudi Arabia that prohibits women from obtaining driver’s licenses, it is not uncommon to see women drivers on the streets. Young Iranians are everywhere and they certainly follow the latest fashion trends.
Places like the Pardis Technology Park (the self-proclaimed “Silicon Valley of Iran”), which hosts Iran’s young and ambitious minds, for instance, felt very much like we were visiting any startup office in Stockholm.
The Iranian economy is hit by the last and biggest wave of sanctions that came into effect in 2012 and disconnected the Iranian financial system from the rest of the world. Economic output, which recorded an average 4.5% growth during the five years prior to sanctions, contracted sharply by more than 8% during the two years following the sanctions.
The rial lost two-thirds of its value versus the US dollar, as Iranian exports fell and the country has not been able to access billions of dollars of oil revenues because of financial isolation. Inflation skyrocketed to 45% along with the currency depreciation.
Paradoxically, Tehran Stock Exchange almost quadrupled during the first two years of sanctions as locals rushed into real estate and stock market investments due to lack of good alternatives to park their cash.
The next thing on the agenda is the lifting of nuclear-related sanctions, which is expected to be implemented in early 2016 following the International Atomic Energy Agency’s final assessment report on 15 December 2015. Even though the road will be bumpy, Iran has a lot to gain from its return to global economy even during the early days.
First and foremost, oil exports are expected to increase by somewhere between 0.5 to 1 million barrels per day over 12 months following the sanction relief. Considering that Iran currently produces a little less than 3 mbd and exports about 1 mbd of oil, even the immediate effect of additional exports will be notable. However, it is not only about oil.
A re-inclusion of the Iranian banking system to global payment systems such as SWIFT should relax financial transactions and reduce trading costs, thus improve both volumes and diversity of Iran’s international trade. Second, there will be several sources of money flowing into the economy.
The most important short-term source is essentially Iran’s own assets that are frozen abroad. While there is a wide range of divergence among different estimates, we understand that Iran may have about $130 billion in foreign reserves, of which $30 billion, i.e. about 8% of GDP, could flow into the economy right after the lifting of sanctions.
Besides, as we can confirm by what we saw and heard in Tehran, there is a massive group of investors waiting to invest in the form of FDIs or on Tehran’s $92 billion large stock exchange soon after the doors reopen. Third, we think that the initial “feel-good factor” and improving sentiment will boost certain sectors that are exposed to domestic consumption, thus will further support economic growth due to strong pent-up demand.
A good example of this demand is the auto production that hit a peak of 1.6 million units in 2011 but halved by 2013. Looking at the age and lack of diversity of passenger car models on the streets, we can confidently say that Iran’s auto industry could, indeed, be up for a few great years post-sanctions. Besides, retail businesses from clothing to food may gain significant momentum when cash flow pressures on the locals ease and international players decide to come in.

Estimates of the IMF and World Bank on post-sanctions GDP growth hover around 5.5% for 2016 and 2017 before the growth slows down toward 3.5-4% in the following years. However, given current inefficiencies and future potential, we think that the economy may recover rather gradually but considerably exceed current expectations once the wheels start to turn.
Even though the open market suggests more than a 10% depreciation and locals agree with that, we believe that the rial may actually appreciate along with improving trade, access to foreign assets and portfolio investments.
Depending on the extent of rial appreciation and pent-up demand, inflation may go both ways from the current 10.8% but we reason that it could stay around these levels for a while before it possibly comes down to single digits as economy stabilizes.
Along with that, interest rates should decline; lowering the financing costs and giving further support the economic growth.
Tehran Stock Exchange, in the meantime, witnessed a continuous decline since it peaked in the beginning of 2014. Contrary to what one would expect from such a popular market that is about to open to foreigners, the TSE main index lost almost 30% during 2014 and 2015.
Locals attribute the poor performance to overall negative sentiment, declining earnings, lack of system liquidity and persistently high interest rates that kept investors away from the stock market.
Despite declining inflation, for instance, Iran’s first Islamic Treasury Bill issuance in September 2015 since the 1979 Islamic Revolution was priced to yield 24% per annum (i.e. about 14% real interest rate), signaling liquidity troubles and crowding out effect.
However, a likely decline both in inflation and interest rates may free up cash and lure the investors back to the stock market post-sanctions. The market is relatively well-diversified with chemicals making a quarter of the index, while financials, telecoms and holding companies all have close to 10% weight.
The total market capitalization of TSE is just over $90 billion with about 50 million of daily liquidity. Iranian stocks, on average, trade at 5x their current earnings, at a deep discount compared to 12.5x for emerging and 10.5x for frontier markets. Dividend yield for some companies is eye-catching at 15-20%.
Earnings growth at this stage is anyone’s guess, but we think that “non-sanctioned earnings” may grow remarkably, at least for consumer-driven industries. If the initial momentum is supported by an extensive reform process, Iran may replace Kuwait as the largest frontier market over the next decade, with a potential weighting of 25-30% in different indices.
Without a doubt, Iran is not only about opportunities. Considering the different layers of sanctions, a full opening of the market and Iran’s integration into global financial system may take years. Besides, the “snapback” mechanism for re-imposing sanctions in case Iran fails to deliver its obligations may be a big blow to early investors. Regulations and specific sanctions are complicated to different types of investors so many may want to stay on the sidelines until they understand how to proceed.
Furthermore, we found Iran a very specific market that may end some investors in tears as we think that understanding the culture and teaming up with right local partners will be essential, especially during the early years of the post-sanctions period.
As long-term equity investors, we try to combine clues to reach a conclusion for the markets we invest in. In the case of Iran, we are yet to fully evaluate risks and opportunities this special market offers. However, as an initial take, we can say that Iran reminds us of our early days in Russia in late 1990s and in Turkey in early 2000s when we found great long-term investment opportunities as pioneer investors.

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