Via Emerging Markets blog, a report on Iraq:

For most people, chances are that the mention of Iraq conjures up images of suicide bombs, sectarian strife, and widespread destruction. In the aftermath of the 2003 US-led invasion and Saddam Hussein’s deposition, a power vacuum and simmering Sunni-Shia tensions led to a bloody civil war that undermined prospects for reconstruction or stability. Ever since, international media has been keen to portray Iraq as an embattled state, and any headlines the country does garner are inevitably regarding conflict.

This article is an excerpt from Leopard Asia Frontier Fund’s February 2013 newsletter. You can subscribe to the newsletter here.

Unquestionably, Iraq’s political landscape has remained burdened by bureaucracy and corruption since the ousting of Saddam Hussein and the Ba’ath Party. And although the current Prime Minister, Nouri al-Maliki, is seen as a stable US ally who has cracked down on the insurgency, his rule has been criticized by Sunni leaders who argue that his Shiite-affiliated Islamic Dawa Party has become too cozy with Iran while neglecting Iraq’s Sunnis. Furthermore, continued attacks from former Ba’athists and al-Qaeda-linked Sunni extremists have not helped the fragile unity government, and progress towards cementing vital oil and foreign investment laws has been sidetracked by political disputes and infighting.

However, the tendency to categorize Iraq as another ‘doomed nation’ is specious. If you ignore newspaper scareheads and dig deeper, you will find encouraging indicators underpinning Iraq’s slow yet promising recovery. The security situation has improved dramatically in recent years – sectarian violence has fallen 90% from its peak 2006-07 levels, 24-hour street life has returned, and homicide rates have dropped below those of Chicago. On the economic front, Iraq was one of the world’s fastest growing economies last year, posting 10.2% GDP growth. Renewed foreign investment in the country’s petroleum industry and a recent IPO on the Iraq Stock Exchange are telltale signs of growing confidence in Iraq’s economic outlook and capital markets. Having gone through 3 wars and 13 years of economic sanctions over the past three decades, Iraq has been dubbed a basket case by most. But for savvy investors who can look beyond the country’s troubled past, Iraq’s uncelebrated progress makes it an alluring frontier market opportunity.

Post-war economic growth has been impressive in spite of the uncertainty surrounding Iraq’s tenuous political environment – the IMF projects Iraq to record 14.7% GDP growth for 2013, a remarkable feat given the country’s recent history. After Saddam Hussein’s invasion of Kuwait in 1990, the UN Security Council levied crippling economic sanctions against Iraq, which continued through 2003 until Saddam was deposed. Prior to the US-led invasion, Iraq had a state-owned economy in which foreign ownership was illegal and high tariffs were put in place to keep out imported goods. With the shaky peace that has held, Iraq has embarked on an aggressive privatization program, auctioning off formerly nationalized companies and encouraging foreign investment. China and South Korea have both become major trade partners – China’s Shanghai Electric is breaking ground on a US $1 billion project to build a power plant in Wasit Province and a Korean developer won a US $35 billion infrastructure deal to build 500,000 housing units in the country. Next year, Iraq may become Turkey’s 2nd largest export destination and will be able to piggyback on some of the growth that Turkey – a booming emerging market – is bound to achieve in the coming decades.

Improvements are also being made from a macroeconomic standpoint. Despite experiencing severe inflation of up to 70% in 2007, the Central Bank has been able to reduce the number to single digits in recent years, and it currently stands at 5%. Foreign reserves are expected to hit US $110 billion by the end of this year and the country has very little debt. Over the last eight years, Iraq’s GDP per capita has quadrupled and continued economic growth will be driven by its population of 33 million – 60% of whom are under the age of 20 – and its enormous oil reserves.

Iraq’s economic revival has been reflected in the growth of the country’s sole bourse, the Iraq Stock Exchange (ISX). The ISX began operations in 2004 and has remained open and functional throughout the country’s tumultuous history, despite being targeted by an attack in 2010. Although it is one of the youngest and smallest exchanges in the region, recent IPO activity and a new custody license have attracted the interest of foreign investors.

In February, Asiacell, the Iraqi subsidiary of Qatar Telecom, successfully launched an IPO worth US $1.3 billion – the biggest initial public offering in the Middle East since 2008. The flotation was fully subscribed, and shares closed up 5.7% on the first day of trading. With Asiacell valued at roughly US $4.95 billion, the IPO doubled the market capitalization of the Iraq Stock Exchange to US $9.2 billion. The listing was also a testament to the growing confidence in Iraq’s capital markets from international investors, as 70% of the shares that were floated were bought by foreigners, particularly from the Persian Gulf.

Alongside Asiacell’s IPO, the ISX recently introduced a custody license to provide more security for foreign investors and to allow larger brokers to invest in Iraq. Most large institutional investors and emerging market mutual funds are required to have their shares held by custodians, and this development will encourage more foreign participation on the Iraq Stock Exchange.

Despite liquidity challenges, low market turnover, and a limited choice of sectors, the Iraq Stock Exchange remains attractive. It has very low valuations and is cheap in terms of price/earnings – many ISX stocks trade at a P/E ratio of around 4. In addition, there is a strong outlook for corporate earnings and a variety of industries are experiencing growth.

The dominant sector for Iraq’s economy remains oil, and production is up 40% from three years ago. In 2012, output rose 24% to reach 3.35 million barrels per day, the first time in over thirty years that production exceeded 3 million barrels. Iraq possesses the fourth largest oil reserves in the world and will produce 45% of the world’s marginal oil over the next twenty years. Just recently, the country surpassed Iran as the second largest oil exporter in OPEC, behind Saudi Arabia. In addition to ExxonMobil, Shell, and BP, a number of other petrochemical companies such as Gazprom, Petrofac, and China National Petroleum Corporation (CNPC) are now active in the country, both in southern Iraq and in oil-rich, autonomous Iraqi Kurdistan.

Iraq’s telecommunications sector, as highlighted by Asiacell’s recent listing, is another industry poised for growth. While many Middle Eastern countries have 90-130% mobile penetration, Iraq has one of the lowest rates in the region at 77%. Likewise, internet penetration stands at merely 10%. Just as Asiacell’s IPO was a precondition of the company being granted an operating license, Iraq’s two other major telecom players are also required to offer 25% of their shares to the public by listing on the ISX. Zain Iraq, a subsidiary of Kuwait’s Mobile Telecommunications Co. that is even bigger than Asiacell, plans to list in June. Korek Telecom, part-owned by France Telecom SA, must also list. These upcoming initial public offerings have the potential to increase the Iraq Stock Exchange’s market capitalization to over US $15 billion.

Another promising sector for Iraqi stocks is financial services. Prior to Asiacell going public, banks accounted for 83% of the ISX’s market capitalization. Iraq’s rising income levels are increasing demand for banking services, and both domestic banking institutions and foreign subsidiaries are listed on the bourse. Many banks on the Iraq Stock Exchange have exhibited stellar performance in recent years, with certain banks seeing their earnings quintuple from 2010 to 2012. Only about 15% of Iraqis have bank accounts, indicating huge potential for growth in upcoming years.

As Iraq continues to rebuild, rising income levels will lead to growth in the consumer goods sector across a variety of industries. Baghdad Soft Drinks, an Iraqi distributor with the exclusive rights to sell PepsiCo products in the country, saw earnings increase 500% last year, as demand for authentic Western goods has skyrocketed. General Motors (GM), the Detroit automaker, sold approximately 35,000 vehicles in Iraq in 2011, accounting for 30% of the new automobiles sold in the country and making Iraq the company’s second largest market in the region. GM believes that the market for new cars and trucks in Iraq may double within the next 2-3 years. Even luxury goods are on the rise in Iraq – high-end retailer Paris Gallery is planning to open five stores in the next three years and Sheraton is building two hotels in Iraqi Kurdistan.

Infrastructure development is another area that will draw investment. Most Iraqi businesses currently only get 8-10 hours of electricity per day from the grid and must supplement this shortage with private generators. With power plant projects underway, the recurring blackouts that plague Iraq’s industries should soon be a thing of the past. In addition to an electrical grid, the country’s schools, hospitals, sewage systems, municipal water facilities, and airports are all in deplorable condition after nearly three decades of war and will need rebuilding.

A final priority sector is housing and construction. Iraq faces an acute housing shortage and an estimated 3.5 million homes will be built over the next decade. Baghdad’s housing crisis is causing real estate prices to spiral upwards, and the Iraqi government is planning to spend US $30 billion on housing in the capital city in the next few years. The construction industry as a whole is expected to grow by over 6% a year through 2014.

The autonomous region of Iraqi Kurdistan in northeastern Iraq has shined as one of the country’s bright spots. Long oppressed by Baghdad, Kurdistan was formally recognized by the new Iraqi Constitution in 2005, which defines Kurdistan as a federal entity of Iraq but recognizes the region’s partial sovereignty and elected government. The Kurdistan Regional Government (KRG) was formed in 1992 and split into two administrations in 1994 after the outbreak of civil war. Kurdistan remained under two separate administrations (one located in Erbil and one in Sulaymaniyah) until 2005, when the two parties merged. Due to Kurdistan’s stability and substantial oil reserves, the region is more developed than the rest of Iraq and it has attracted more investment than anywhere else in the country.

Relations between Erbil and Baghdad have become increasingly tense, however, as many Kurds feel that the Baghdad government has diverted funds away from them. A number of major oil firms have been lured to Kurdistan by better contracts and operating conditions, and a dispute last year led to the deployment of troops from both sides on an internal border. While the KRG is trying to develop additional areas of its economy such as agriculture, tourism, and industry, Kurdistan’s oil reserves continue to be the backbone of the economy and a contentious issue with the federal government of Iraq. Baghdad was livid when ExxonMobil exited Iraq’s West Qurna 1 oilfield to focus on Kurdistan, signing an exploration agreement with the KRG without seeking preapproval from the Baghdad government. As the first major oil company to sign an agreement with the KRG, ExxonMobil exacerbated tensions between Baghdad and Erbil and reaffirmed the importance of petrodollars to both sides. For the economic benefit of both Iraq and Kurdistan, clear laws need to be finalized soon to safeguard foreign investment in the petrochemicals sector.

Another risk to Iraq’s recovery is perpetual sectarian conflict. Although violence is dramatically lower than its peak 2006-07 levels, bombings have continued to plague the country, with a February bombing in a Shiite neighborhood of Baghdad killing 22. Thousands of Iraq’s Sunni Muslims have protested against Prime Minister Nouri al-Maliki’s Shiite-led government due to what they feel is unfair treatment, and al-Qaeda-affiliated Sunni extremists have sought to exploit the tensions by targeting Shiites with bombings in an attempt to spark renewed civil war.

Iraq will also feel the consequences of ongoing unrest amongst its neighbors. As the war in Syria continues, the spillover of fighting and refugees threatens to destabilize Iraq – 40 Syrian soldiers were recently ambushed and killed in Iraq. Iraqi Prime Minister al-Maliki recently proclaimed that a victory for the Syrian rebels could reignite the flames of sectarian conflict in Iraq, Lebanon, and Jordan and lead to rising Sunni extremism in Syria. An escalation of conflict between Iran and Israel would also certainly have negative repercussions for Iraq.

Despite the challenges, Iraq is making steady strides on the road to recovery and is continuing to lure multinational firms and foreign investors with its improving security situation, massive oil reserves, and promising economic outlook. The governments in Baghdad and Erbil must ensure that all Iraqis share in the country’s economic growth, as unemployment and corruption remain far too prevalent. In spite its impressive economic indicators and wealth of petrochemicals, Iraq remains an oft-ignored, negatively-portrayed country. Seasoned frontier investors should see through these misconceptions and recognize that the first-mover advantage in Iraq could translate into sizeable returns. Starting in March 2013, the Leopard Asia Frontier Fund will begin making its first investments in Iraq.