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M’sia Strategy — Charging forward; bullish

posted 25 Jan 2011, 04:06 by Zam Mlk   [ updated 25 Jan 2011, 04:17 ]
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Written by A report from Deutsche Bank   
Tuesday, 25 January 2011 11:18

Rarely is Malaysia short of plans/programmes/corridors/various other projects with multiple acronyms to restructure the economy or the market. The problem is that implementation has been patchy. However, we have noticed a marked difference in the last three to four months — and this is what we are excited about.

For the first time since Tun Dr Mahathir Mohamad’s era, the current government, led by Prime Minister Datuk Seri Najib Razak, is making its mark and pushing ahead with the transformation plans. Sceptics are no doubt still aplenty and investors who have been bitten twice are still not convinced. So let us discuss five areas where we see material change for the better.

Acting now
i) Mega projects are under way and contractors are busy again. The RM36 billion mass rapid transit (MRT) project received Cabinet approval in late December. This was no small undertaking, we understand. The proposal, championed by Gamuda Bhd-MMC Corp Bhd, attracted protests from various parties including the Opposition, competitors and members of the public, all of whom questioned the merits and/or cost of the project. Finally, sensible heads prevailed given the desperate need to improve public transport in Greater Kuala Lumpur.

Phase 1 is expected to be completed by 2015 and should generate a positive knock-on economic impact for the entire construction chain, ranging from building materials to hiring skilled engineers. The construction sector has become vibrant. In 2010 alone, local projects almost doubled to RM11.2 billion, and this is just the amount of jobs secured by a select number of listed companies. Not surprisingly, with the global financial crisis hitting Middle Eastern economies, overseas contracts dwindled to just RM1.8 billion versus RM4.8 billion previously.

ii) Bravely cutting back on the huge subsidy bill. The introduction of the subsidy rationalisation plan came into effect in July 2010, much to the dismay of the general public. Since then, the government raised fuel/food prices in early December and again early this month. In the last two rounds, there were no public protests. Though a bitter pill to swallow, Malaysians are now finally more accustomed to volatile prices, we believe.

Malaysia’s subsidy bill for fuel, food etc has been colossal. According to Pemandu, the total subsidy bill in 2009 amounted to RM73 billion. This is equivalent to RM12,900/household or 10% of GDP. Furthermore, the subsidies have been “misdirected”, with the poor receiving only a fraction (2.2%) of the benefits. The cutback in subsidies is a positive and much needed move, we believe. This tells us that the government is increasingly (politically) brave enough to implement unpopular measures, especially at a time when Barisan Nasional (BN), the ruling coalition, desperately wants to win back the two-thirds majority in parliament. But really, the government has little choice. The country’s fiscal deficit is projected to stay above 5% for 2010 and 2011and the crude oil price has strengthened.

According to our chief economist, Michael Spencer, “Malaysia stands apart from most emerging market economies for having seen a larger increase in debt during the global financial crisis (from 41% of GDP in 2007 to 54% currently and not expected to see that debt/GDP ratio decline in the next year or two). Still, the debt seems easily financeable onshore.” Fiscal discipline is a topic Malaysia has to face, head on. And to start with, the government is considering the introduction of goods and services tax (GST).

iii) There were significant IPOs off the ground with companies such as Petronas Chemicals Holdings Bhd. Petronas Chemicals was the largest Asean IPO to date. Similarly, Malaysia Marine & Heavy Engineering Bhd (MMHE), also majority-owned by Petronas and a mid-cap, is the largest oil and gas fabricator in the country. These IPOs have certainly added depth and breadth to the market and, more importantly, have helped revive the interest of new foreign investors. They have also been timely, especially given the strengthening oil price.

Confident Malaysian companies and consumers
There has certainly been a flurry of deals in Malaysia over the last six months and more are under way, we understand. Malaysian corporates are confident, as evident by the greater number of property launches and increasing capex/working capital in sectors such as plantations, construction, oil and gas, education etc. Furthermore, industrial and manufacturing sales have recovered. Business credit growth has rebounded — all very encouraging.

i) Merger and acquisition (M&A) scene to stay busy. Over the next 6-12 months, we see three possible themes emerging in the M&A scene. First, strategic land sales by government-related entities. Second, a possible round of consolidation among the smaller banks, especially if the Hong Leong Bank Bhd-EON Capital Bhd deal concludes. Third, increasing “scale” in the property sector as developers “chase” acquisitions of smaller players to top up on landbank and, in some cases, brand names.

ii) Consumer confidence has recovered — this does not appear to be a low growth market. Consumers too are increasingly confident. The Nielsen Consumer Confidence Index is at its highest level since 1Q07. Private consumption growth has been relatively strong in comparison to other Asean markets and this is evident by robust retail consumption. Parkson Holdings Bhd, the largest department store chain in Malaysia, has recorded strong same store sales (SSS) growth of 8%-10% in the last two quarter, similar to levels seen in China. Mortgage growth has been robust too, but at manageable levels. Unlike in Singapore, we do not anticipate the government introducing draconian measures to cool down the property market. There are small pockets of residential areas in the Klang Valley and Penang where prices have risen a bit too quickly, but in general the Malaysian property market is far from reaching “bubble” levels. Only recently Bank Negara lowered the loan-to-value ratio of mortgages to 70% for third homes and beyond.

Net beneficiary of stronger commodity prices
Malaysia is a net exporter of crude oil, rubber and palm oil. Higher commodity prices should be positive for Malaysian companies, government revenue accretion (about 30%-40% of revenue was derived from the oil sector in the forms of taxes, royalties and so on) and the man on the street — especially in rural agricultural 
areas.

Commodities-related companies (e.g. crude palm oil producers, oil and gas fabricators or service providers) account for approximately 21% of the market. This is not a small number. More importantly, unlike Indonesian palm oil producers who are subject to a progressive export tax structure as prices go higher, Malaysian producers are not impacted. This means that Malaysian plantation companies are in a better position to benefit from higher palm oil prices.

After Thailand (PTT group concentrated) and Indonesia (coal and palm oil dominated), Malaysia’s commodity offering is about 21% of the market. This is a reasonable percentage in an Asean context. The 21% is made up of a variety of commodities, including oil palm, timber, oil and gas and, more recently, petrochemicals. As such, the Malaysian market offers a good hedge against rising inflation concerns in Asia.

‘Restructuring’ the stock market — growing up
The Malaysian market has gradually evolved for the better over the last five years. And the collective positive changes are increasingly being felt by the market. These collective changes have been crucial in slowly “enticing” foreign investors back into the market, we believe. The following “steps” have contributed significantly to these changes, in our view.

i) The extensive government-linked companies (GLC) restructuring under former prime minister Tun Abdullah Ahmad Badawi’s administration, with Khazanah Nasional Bhd driving positive changes (structure, board make up, value-add, returns, accountability, management and so on) across its key holdings.
ii) The rapid regional expansion of Malaysian companies, big and small. They include CIMB Group Holdings Bhd, Malayan Banking Bhd (Maybank), AirAsia Bhd, Berjaya Group, YTL Group, OSK Holdings Bhd and IOI Corp Bhd. In turn, Malaysia is now home to an increasing number of Asean champions.

iii) The liberalisation of equity shareholding “quotas” pre and post IPO in June 2009. This was crucial in regaining the confidence of non-government-related corporate and individual shareholders.

iv) The abolishment of the Foreign Investment Committee to expedite transactions made by foreigners in almost all sectors (e.g. property, construction). The big cap (re)listing of Maxis in November 2009 and Petronas Chemicals in November 2010.

We noticed three key trends from our Malaysia Strategy marketing trips to Hong Kong, Singapore, the US and Europe in 4Q 2010. First, foreign institutional investors were largely underweight Malaysia (and overwhelmingly overweight Indonesia). Second, many fund managers with Asian mandates have not looked at Malaysia for a while, with most hedge funds requiring a “refresher”. 

Third, most were being forced to look at Petronas Chemicals because of size (the largest IPO in Asean at US$4.1 billion) and its uniqueness given its cheap feedstock. As a result, many were “forced” to review Malaysia as an investable market. In addition, the offering came at a time when the petrochemical cycle was recovering and interest in emerging markets had picked up significantly.

The recent IPOs have helped diversify sector offering across the top 10 stocks by market cap. Once heavily dominated by the banks, Tenaga Nasional Bhd and Telekom Malaysia Bhd, the top 10 stocks today now offer a better mix of sectors such as plantation, banks, petrochemical, power, gaming and telco stocks. This is particularly important as Malaysiacompetes for equity inflows against other Asean markets.

The recent listing of MMHE has also filled a crucial gap in the market. There was simply not enough scale in the fabrication sector to offer investors exposure to the fast-growing oil and gas services industry in Malaysia. Similarly, there is now a handful of mid-cap real estate investment trusts (REITs) after the listings of Sunway REIT and CapitaMalls Malaysia REIT last year. The press has carried articles on the potential listing of Magnum Corp Bhd, a numbers forecast operator once listed.

Attempts to increase the free float in Malaysia have begun. In October 2010, Khazanah placed out 2% of CIMB, and 6% of Malaysia Airports Holdings Bhd. More recently, the Employees Provident Fund (EPF) reduced its stake in RHB Capital Bhd from 54% to 48%. The government is committed to reducing its stakes over times, but patience is required.

Collectively, these measures are not going to shift Malaysia’s weighting in MSCI’s benchmark indices materially but they do at least help the Malaysian market to keep pace with the rest of Asean instead of lagging behind (as it has done over the last five years).

Increasingly a less defensive market
This is an important point to focus on. Often, Malaysia is viewed as a safe haven, low beta and/or defensive market. In short, dull. This view is increasingly redundant from several perspectives, in our opinion.

The EPF, which manages RM425.5 billion (US$140 billion) as of 3Q10, will soon be investing a greater proportion of its assets under management offshore. In Budget 2011, Najib announced the EPF would now be allowed to invest as much as 20% overseas. This compares with just 7% presently. This change has two key implications. First, “trapped” liquidity in Malaysia should ease as EPF’s share of total trades in the market (directly and indirectly) is as high as 40%, we estimate. Second, with greater non-Malaysia mandates managed out of Malaysia, driven by EPF’s change in policy and recent liberalisation measures in the asset management industry, the domestic fund management sector in Malaysia should be more vibrant.

Malaysian companies are deriving an increasing amount of their earnings from offshore entities. These early investments — which include banks and plantations in Indonesia and casino operations in Singapore — have started to pay off.

In 2005, on a market cap weighted basis, only 10% (7% excluding export receipts) of earnings from our universe of stocks were derived from offshore entities. This compares with 32% (26% excluding export receipts) in 2010 and 36% (29%) projected by 2012, based on our estimates. These are not small numbers. 

The big change since 2005 is due to a combination of three factors, we believe. First, GLCs expanding aggressively offshore, e.g. Axiata Group Bhd, Maybank and CIMB. Secondly, the listing of Parkson Holdings and Petronas Chemicals, offering exposure to China and other North Asian markets such as South Korea, and India. Third, the regional expansions of mid-cap companies such as Gamuda, IOI Corp, Hong Leong Bank and AirAsia.

The geographical exposure is mostly centred around Asean but larger companies are increasingly seeking growth elsewhere (e.g. Genting Malaysia in the US and UK). The increasing exposure to non-Malaysia profits means that local companies are more exposed to greater volatility but, in turn, greater growth. With the exception of Singapore, where the offshore component of earnings is largely China-focused, the other Asean markets offer limited exposure to the Asean footprint. This is where Malaysia truly stands out in an Asean context.

Positive flow trends
With liquidity returning to this market and improving EPS momentum, we see upside to the market in the near term. This comes at a time when a select number of investors are taking profits in Indonesia (market is down 5.2% year-to-date).

What is interesting is that in US dollars, Malaysia was one of the strongest markets in 2010, second to Thailand, and YTD it is outperforming the region and the rest of Asean. Not a bad start to the year. Average daily turnover too has risen significantly YTD, averaging around US$830 million/day (versus US$480 million/day in the 2H2010), and back to levels not seen since 2007.

Malaysia ended 2010 with foreign investors returning to the market. The listings of Petronas Chemicals and MMHE partly contributed to the inflows, we believe. Net inflows began in mid-2010 and have continued since. In 2010, there was clearly a persistent trend for higher-growth Asean markets such as Indonesia and Thailand, with Malaysia lagging slightly behind on demanding headline valuations and the perceived lack of execution on a myriad of government-led initiatives. This has changed.

Foreign shareholding has finally crept up, with November 2010 registering 22.1% after having hovered around 20%-21% since March 2009. We estimate that the bulk of liquidity into the equity market ended up in the financial sector and select names such as Genting Bhd and Kuala Lumpur Kepong Bhd. This trend is likely to trickle down to the mid caps given increasingly positive news flow, especially in the construction, oil and gas and property sectors.

We have also seen a similar trend in the fixed income market and combined, the inflows have contributed to the ringgit staying robust, ending 2010 as the second strongest major Asian currency after the yen.

Foreigners were big participants in the Government bond market in 2010 given strong inflows into emerging markets. 

Recently, FTSE upgraded Malaysia from secondary emerging to advanced emerging status, placing the market in the same category as Taiwan. The change will be effective June 2011. Victor Phua, from our derivative strategy team, tells us that the upgrade in status will likely induce an additional US$392 million of equity inflow into Malaysia from passive funds tracking the FTSE World index series (which covers developed and advanced emerging countries). He also believes that the positive investor sentiment generated from being recognised as an advanced emerging market can be a catalyst for the equity market. In the two previous country upgrades (Hungary and Poland), the domestic market outperformed the regional benchmark by as much as 27.1% in the three months going into the effective date in September 2008, and further extended the gains by an average of 13.4% in the month after.

(Do note, however, that the estimated inflow value is estimated based on our induction from abnormal volumes in prior FTSE rebalances. This historical measure may not account for recent movements in assets under management within respective FTSE index series, if any.)

Participation by retail investors has remained flat since late 2009. Retail investors still avoid the market, representing just 22% of turnover; in Thailand the number is >60%. We do not anticipate this trend changing dramatically in the near term but participation is likely to come in spurts as and when news flow or liquidity lifts.

A growth market in 2011. 2011 EPS growth of 26% ahead of the regional average and second in Asean

Based on our coverage universe, the Malaysian market is trading at 14.8 times and 13.6 times PER for 2011 and 2012 on EPS growth of 26.2% and 9.8% respectively. Malaysia’s EPS growth of 26% is second to Indonesia (26.7%) in an Asean context and the fourth highest in the region after Hong Kong (51.9%), India (29.2%) and Indonesia. This is strong proposition given that Malaysia’s headline valuations tend to be at a 10%-20% premium to the region.

The strong growth in 2011 reflects a combination of stronger palm oil prices, contribution from higher-growth markets (e.g. the increasing impact of Indonesian earnings on CIMB, Axiata and Maybank), full year contribution of Genting Singapore for Genting Bhd and the low base effect of selected companies such as Sime Darby Bhd. 

Malaysia’s regional diversification is increasingly paying off in the form of growth.

Similarly, Malaysia’s 3.4% net dividend yield is ahead of the regional average at 2.8%. This trend has been consistent in the last five years as Malaysia Inc continues to focus on shareholder returns. This also partially explains the 16%-17% return on equity trajectory for 2011 and 2012, in line with to slightly above the region.

Potential upside risk to earnings in 2011
The recent round of upgrades notwithstanding, we see further upside risk to our earnings given a combination of three factors. First, commodity prices are tracking above our current assumptions. For example, the palm oil spot price is now around RM3,640/tonne. This compares with our estimates of RM3,300 for 2011 and RM3,200 for 2012. Second, there could be further surprises from the property sector as margins recover strongly and new offshore acquisitions start to make an impact (e.g. Genting Malaysia’s racino operations in New York). Third, if G3 economies recover faster than expected, this should be positive for the economy given the country’s reliance on external trade. This should be positive for the small and medium enterprise sector and, in turn, the financial sector.

1,790 index target suggests upside of 14%
Our one-year forward index target of 1,790 is based on 15.5 times PER 2012 or 1-standard deviation above post-2002 earnings. Sceptics might say this is too optimistic but we argue that earnings are strong within an Asean and regional context (as discussed above), the market has evolved to offer a greater variety of stocks and/or Asean champions, and we expect news flow to remain positive for the market. These factors are important.

So, where does Malaysia sit in Deutsche Bank’s Asean pecking order? In terms of upside to our respective country index targets, Malaysia’s upside of 14.1% is third after Indonesia (+26.1% upside) and the Philippines (14.3%).

Market catalysts — Valuation matters but news flow matters even more

Valuations alone rarely drive interest in the market. Government initiatives, project announcements, execution, political news flow and the anticipated direction of the ringgit tend to be the major catalysts. Below are potential events to watch out for, we believe:
i) Increasing progress from the Economic Transformation Programme (ETP) — so far, Pemandu has announced US$33 billion in investments from a variety of companies including ExxonMobil, Shell, Schlumberger and Cisco. Potential beneficiaries are oil service providers and owners of commercial office space.

ii) Potential call for a general election — this is may be unlikely in the near term as we believe Najib would prefer to deliver more results before trying to win over more voters, though we acknowledge that the opposition party is in disarray. Potential beneficiaries are GLCs.

iii) Potential news flow of more big-cap IPOs. Potential beneficiaries are banks with a strong investment banking arms, e.g. CIMB and AMMB Holdings Bhd.

iv) Large-scale land auctions anticipated around the Klang Valley. Potential beneficiaries are construction companies such as IJM and property developers like S P Setia Bhd.

v) FTSE upgrade from emerging to advance emerging, as discussed earlier. Potential beneficiaries would be the big caps offering liquidity. They tend to be the financials.

What we like…
We see four sectors outperforming in the 1H based on the themes highlighted earlier.

i) Financials — to benefit from sustainable credit growth and increasing investment banking opportunities. Our preferred picks in the sector are AMMB and CIMB.

ii) Plantations — we expect global agri-commodity inventory to stay tight as demand lifts and supply stays exceptionally tight this year. This is positive for upstream plantation companies such as KL Kepong but negative for companies such as Top Glove Corp Bhd in the rubber glove manufacturing sector.

iii) Property — low interest rates (we don’t think rates will move until mid-2011 at the earliest), increasing product offering, confident Malaysians and available liquidity should support an increasingly robust property market. With the ETP initiatives in full swing, this could also spill over to the commercial segment. For exposure to this sector, we prefer S P Setia and IJM Corp Bhd.

iv) Oil and gas — With the recovery in the oil price and increasing investments by oil majors into Malaysia, we have recently seen a proliferation of contracts awarded to local service providers.

…and stocks to avoid
The rubber glove industry is having a tough time managing an appreciating ringgit and high input costs (i.e. natural rubber). These companies, such as Top Glove, are not able to pass on 100% of the costs. We continue to like the longer-term positive dynamics of healthcare growth in the region and globally, but these near-term input cost challenges are going to crimp margins.

The telcos (though cash flow generative and resilient) are low-beta stocks and face increasing competition in the broadband space, which is likely to be disruptive. While we don’t believe the incumbents will be impacted materially, news flow on increasing product competition will put off most investors. The “fight” for the last mile is also going to drive capex numbers up.

Stocks: Confident consumers + Asean champs + inflation hedge
There are three overriding themes dictating our stock selection for 2011.
Confident consumers and corporates. For exposure to this encouraging trend, we like AMMB, CIMB, IJM Corp and S P Setia. These companies offer a combination of growth in the property sector (mortgages and property sales) and/or investment banking activity.

Asean Champs. Malaysia’s unique proposition of offering Asean growth exposure continues to be under appreciated. These names are CIMB and AirAsia.

Inflation “hedges”. Aside from property names, the commodities sector such as plantation and petrochemicals provide a hedge for those concerned with increasing inflationary pressures in the region. Names we like are KL Kepong and Petronas Chemicals. These names, ranging from US$2 billion to US$20 billion market capitalisation, offer an average 2-year EPS CAGR of 23%.

Risks — tightening in Asia; politics. With rising inflation (led by food prices and oil) across Asia, monetary tightening in Asean is a risk to Malaysian earnings, particularly for those names with a heavy regional footprint. The threat of tightening/inflation appears highest in Indonesia, Philippines and Thailand, while the outlook for Malaysia and Singapore is more benign. Furthermore, China’s monetary policy also poses a risk given 21% of Malaysia’s market cap is commodity-linked and China (along with Singapore) is Malaysia’s major trading partner, accounting for around 12% of exports.

A later-than-expected general election could slightly damage market performance, as expectations seem to be set for mid-2011. Because Malaysia is a market that re-rates on news flow momentum rather than its valuation proposition, perhaps the biggest risk for the market remains the inability of the Government to implement the ETP. However, we remain impressed with the 
progress made.

The ringgit: A fundamentally bullish view is still warranted
The ringgit appreciated close to 12% in 2010, making it the second best performing currency in Asia (behind the yen), thanks to a strong current account surplus, a surge in portfolio inflows, and an accommodative central bank. Our economics team forecasts the ringgit will appreciate a further 2.1% in 2011 from current levels. This is slightly below the Asean average of 3.8%.

Our economics/FX teams believe its fundamentally positive view on the ringgit in 2011 is justified for four main reasons:
i) Momentum in equity flows should extend in 2011. Malaysia saw some US$43 billion of foreign equity inflows in Q1-Q3 2010, compared with about US$50 billion for the whole of 2009. Partly attributed to the government’s reform initiatives, the local stock market scene livened up with record issuances in 2010.

ii) Corporate bond inflows should improve. The domestic fixed income market received strong inflows from EM real money investors in 2010. However, these investors mostly bought into government/central bank papers, while holdings in corporate bonds remained quite stable (Figure 40). With positioning in government bonds getting crowded and yields no longer that attractive, a key investment theme could be for investors to rebalance their portfolios away from government bonds to local currency corporate bonds.

iii) Trade balance will be supported by commodity exports. Malaysia has continued to run a huge current account surplus (12.7% of GDP in H1), although it has fallen quite sharply after peaking in Q1. Demand for Malaysia’s key commodities exports — particularly oil and palm oil, have continued to be quite robust. Higher commodity prices in 2011 could help to lift commodity-related exports.

iv) Bank Negara unlikely to impose capital controls. BNM would be very reluctant (and probably the last in the region) to impose strict capital controls. With the government needing to fund its fiscal deficit and with foreigners typically being quite active in the local bond market, the negative impact of capital controls (on government bonds) would be much greater than the benefit of simply defending a level on US dollar/ringgit. Moreover, capital controls would detract from the government’s broader goal of revitalising capital markets and boosting FDI.

Risks to the positive ringgit view: outflows by EPF and forex intervention by BNM
The positive view on the ringgit could be partially offset by domestic outflows from the EPF. The EPF currently holds about 7% of its US$125 billion assets overseas, and won approval earlier in the year to raise that proportion to 10%. Furthermore, the government has proposed to raise that limit to 20%. If the 20% limit proposal gets approved, this represents a potential US$16 billion of portfolio outflows by the EPF, although the timeframe over which the new allocations get deployed is unknown.

Continued forex intervention by BNM is another risk that could constraint the ringgit’s appreciation. BNM was highly accommodative of currency strength throughout much of 2010, although towards the end of the year it started to defend the 3.08 level more aggressively. The constraints to FX intervention are not exceptionally high for Malaysia, so we do not see much difficulty for BNM in continuing its intervention and guarding the 3.08 level in US dollar/ringgit in the near term. Nevertheless, if commodity prices start to rise more sharply and threaten the inflation outlook, BNM could soon relent.

Economics
Recent declines in export volumes are unlikely to be sustained, so we expect a near-term rebound from a decline in GDP in Q3. Growth of 4% in 2011 is below our 2010 forecast of 6.8% but stands at about the economy’s trend growth rate. We should see a period of slightly stronger growth in 2012. The government has used fiscal stimulus over the past couple of years to stabilise the economy in the face of extreme fluctuations in exports. But it now has a large deficit and rising debt, which may at some point worry investors.


This article appeared in The Edge Financial Daily, January 25, 2011.

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