Will UAE’s next IPO provide protection against inflation?

Money has many functions, but perhaps the most important function is to store value.

However, when the money supply increases, we have too much money and too little goods (Milton Friedman’s inflation axiom is always and everywhere an explanation for the phenomenon of money).

If we look at the narrow definition of the money supply (M1), it has effectively doubled during Covid and, as expected, the effect has been inflationary. On a side note, it’s surprising that in our age of believing that “cash” doesn’t matter, we seem to have more and more cash.

In the UAE, M1 was largely stable at around AED450 billion by the end of 2017 and increased to AED738 billion by the end of 2022, driven mainly by the Fed’s quantitative easing program. In a complex system, we can introduce other variables, such as supply disruptions and hoarding, but these issues obscure the underlying drivers of monetary growth.

With this increase in the monetary base, there is no doubt that inflation rears its ugly head and erodes real income. History shows it takes a while to get cut.

At the same time, asset valuation distortions prevailing in the US capital and real estate markets have begun to compress. Chewy, a pet food supply company in the US that trades at more than 300 times earnings, is just one example that is too big to list.

In this environment, the obvious question is whether UAE stocks will be affected. In an inflationary environment, corporations — like toll bridges — act as a natural hedge against inflation. Infrastructure is built with “old money” that does not require constant replenishment of capital expenditures and is therefore more resilient to inflationary pressures.

The same goes for power generation companies, although population growth requires some capital expenditures. So it’s no surprise that a company like Salik is up 45% since its IPO, excluding dividends.

Empower has grown by nearly 20%, and even DEWA has returned 8% to shareholders in the form of cash dividends since listing). In FMCG, Americana, up 40% since listing, is again operating efficiently in an environment where same-store sales benefit from higher prices (net of rising input costs).

These types of companies don’t suffer from valuation multiple compression because investors gravitate toward legacy assets with high cash-generating capabilities. Legacy assets also extend to goodwill, as the recent success of Al Ansari’s IPO demonstrated.

A multigenerational family business whose name is synonymous with Cornerstone Security, you won’t even find it at a bank among its loyal customer base.

When we expand this line of thinking, natural resource companies also benefit because the underlying price of the commodity remains high and the marginal cost of extraction is low. That’s not to underestimate the market signals that continue to support technology — such as the outperformers Bayanat and Presight.

Instead, it’s saying that the valuations of companies that depend on growth don’t inflate as much during long periods of inflation. How long this bout of inflation lasts remains to be seen. In order to get under control, the core problem of the money supply must be addressed. By definition, any reduction in such numbers would require a period of valuation contraction for underhedged companies (lower ability to generate high levels of cash).

The interest in the UAE and regional capital markets has coincided with a period of high inflation and companies offering protection from this corrosive force, leading to increased interest from retail and institutional investors. Not all IPOs are doing well, and there are likely to be many more to come.

Overall, valuations and inflation hedges have both played a key role in driving the level of investor demand for well-run businesses that benefit from higher inflation. It is imperative that inflation does not become entrenched, as its harmful effects far outweigh any benefits.

However, we know that it will take extraordinary perseverance to keep inflation expectations in check. The longer it goes on, the more vulnerable investors are to its corrosive effects.

The refuge offered by the current wave of IPOs provides a natural hiding place and cornerstone for investors long accustomed to not worrying about higher debt-servicing costs. More are on the way.