Finding the 'sweet spot'

A virtuous cycle looks to have begun in Malaysia, with a robust stock market, the government loosening controls and corporates consolidating - all with the potential return of domestic investors providing a positive backdrop.

Positive drivers for this year and next include fiscal stimuli from the Ninth Malaysia Plan (9MP). The government’s 9MP fiscal programme will revive the long-dormant construction sector and help create a “feel good” spark ahead of the next general election, which we expect to take place in the first quarter of 2008. The government has earmarked RM220bn for development spending between 2006 and 2010, an increase of 29% over the RM170bn allocation under the 8MP (2001-05). Meanwhile, moves are afoot to establish Malaysia as a new mecca for global Islamic finance.

Recent public spats between former prime minister Tun Mahathir and his successor Abdullah Badawi have cleared the air somewhat and actually provided further positive news to move the country forward. In addition to this, the independence anniversary will be celebrated with a global tourism push, which should cushion the economy against external vagaries.

This will also be the first full year of strong prices for Malaysia’s top non-oil commodities: crude palm oil, timber and rubber. This will facilitate the fiscal stimulus, boost rural areas and help create downstream industries, such as biodiesel. Besides concrete signs of economic liberalisation enabling growth, Malaysia is awash in liquidity with its loan-to-deposit ratio hitting new lows of late and corporate gearing continuously charting south. The theoretical cost of capital has hit medium-term lows with the prospect of further rate cuts this year, putting additional downward pressure on corporate funding costs. Meanwhile, corporate consolidation, mergers and acquisitions, and globalisation are taking shape rapidly. Significantly, the government-linked corporations (GLCs) are entering the third phase of their reform programme and we expect more tangible financial results from their restructuring. The market’s returns on capital are improving on better capital management. We expect returns on equity (ROEs) to chart north from 11% in 2000 and 13% in 2005 to 16% in 2007-08. Meanwhile, there are some encouraging signs for corporate governance. The latest World Bank report gave Malaysia good marks for ‘protecting investors’ (see IPA April).

Consensus-earnings upgrades are just beginning, a reflection the market has been a low priority for investors. With a rising value spread and appreciating currency, Malaysia is in a sweet spot (see figure 1).

However, the country is not without its challenges: it must find ways to tackle corruption and improve long-term competitiveness. The economy is also sensitive to the external environment. But we see opportunity in prolonging energy independence via hydropower, biofuels and new oil and gas initiatives. In the longer term, Malaysia will benefit from the rise of Chindia, its young population and Singapore’s strong economic prospects.

There is a big catch-up effect and expectations should continue to rise with potential for a virtuous cycle as the booming stock market drives consumer sentiment higher, off a depressed base. The valuation gap - the difference between return on capital and cost of capital - has expanded with further upside potential in ROEs as drivers create a potentially compelling cycle and boost consumer confidence. The impact of the strengthening stock market on consumers has yet to be felt.

 

This is coinciding with a long period of neglect, as evidenced by falling regional weightings, multi-year underperformance and a price-to earnings premium to the region that has collapsed. The Malaysian market is still at a discount to the 10-year PE average. The troubled Thai market and negative surprises in Indonesia related to Perusahaan Gas have given the relative investment case a big push. Finally, retail investors have yet to make a significant contribution.

We also like the fact that equity raising in Malaysia was limited in 2006, indicating there is no issue of digestion. This typically happens right before markets have a big move, like before the 1992-93 rally. Essentially, the ratio of available capital to the number of stocks has shrunk.

Past cycles have seen earnings expectations rise together with the bond yield. This time around, the bond yield may have bottomed out, but that is because the market expects increased economic activity. Hence, ROE upgrades will make up for a potentially higher bond yield. Therefore, it is likely that the valuation gap will persist for some time. A key indicator to watch is the earnings yield gap. Once this starts to contract towards the mean, one has to watch earnings-expectation momentum closely.

From 2003 to the end of 2004, the gap between earnings yield and the 10-year bond yield contracted from about 5%, all the way down to 1.2%. If the market yield gap goes to 1.2% again, it would have to drop another 1.4% (currently at 2.6%). This provides a dynamic environment because at this stage in the cycle, analyst estimates will chase bond yields because the latter means that the economy is improving. That, in turn, means PE can expand by 27%. What is likely, however, is a combination of both PE expansion and bond-yield increases, mitigating the impact. But in a virtuous cycle, all bets are off.

 

A key impediment since the Asian Crisis has been tight free floats and liquidity in Malaysia. While Malaysia had plenty of big stocks, as of early 4Q06, few had the liquidity to attract big global funds. This set in motion a vicious cycle as less liquidity meant less attention, and so forth.

This is now changing. With interest in fundamentals picking up, volume is on the rise. Plus, with short selling having been implemented in January, coupled with economic liberalisation moves in general, the market’s structure is improving. Rationalisation of the government’s GLC holdings over the next two years should add to trading volumes. There is also potential for the return of the retail investor.

However, there is one negative trend - that is, companies’ increasing interest to list overseas amid corporate restructurings, which effectively means listings get transferred (Wilmar - PPB Oil Palm is a case in point). However, Bursa Malaysia is well aware of this and efforts will be made to make the market more attractive. With rising attention to the Malaysian market from overseas, this trend is likely to be mitigated. So far, we have seen little to no impact on investor sentiment.

A return of the retail investor represents a significant source of liquidity for the market with focus on the cheaper stocks in absolute value terms. Higher retail interest will spur more corporate activity and raise overall liquidity in the market, putting the market on global radar screens.

With the above boosters in place, we see potential for a good cycle to develop with banks standing ready with unprecedented liquidity to help fuel another consumption and investment cycle. Consumer sentiment, we believe, is bottoming given peaking inflation and interest rates. The ringgit is also strengthening, potentially triggering asset reflation. In our discussion about Malaysia’s long-term competitive advantages in manufacturing, we stress the pickup in investment approvals and some interesting announcements, which could surprise the market in 2007-08.

A key resistance to sentiment is now valuations of specific, high-performing counters. However, the focus in Malaysia should be on the earnings story and there is plenty to surprise over the next year as companies capitalise on expanding opportunity pools.

 

The market PE of 15 times (2007 forecast) is not demanding given the growth momentum and potential for more liberalisation moves by the government, in addition to other “pre-election” goodies. Salaries for government employees have been raised by 7.5-42%, something that is certain to boost consumer confidence. The ringgit continues to appreciate with bond yields setting new lows. The latter is foreshadowing a rate cut going into the second half, another boost for consumers and the property sector. With this liquidity environment, mega projects will be given a boost.

Foreigners have been instrumental in pushing up the index in the past six to nine months.

Bursa Malaysia’s numbers show that foreign shareholding in the market hit 27.5% as of March 2007, up from 22.5% in December 2005. Increased interest from local funds could now be necessary to push the market much further. According to Bursa numbers, their activity has declined from 34% of the total in 2005 to 27% year to date. We believe that this is likely with rising consumer confidence. Positively, retail interest is picking up in Malaysia, off a relatively low base.

 

Sowing seeds of diversification

Over the past four decades, the Malaysian economy has successfully diversified from dependence on tin and rubber to manufatured exports, which now account for 82% of exports. Electrical goods and electronics make up half that figure. However, the importance of the commodities sector within broader capital markets is greater than meets the eye. For example, there are significant non-listed plantation assets in Malaysia (including several government-related ones, eg, Felda), not to mention the big share of those in Indonesia. And hypothetically, listing Petronas at a forward PE of 15x and assuming 15% earnings growth would create an entity with a market cap of $207bn (RM754bn).

That would almost double the size of the Malaysian market (around RM890bn). There are several positives that would emerge, including immediate inflows of funds to the government and a catapulting of Malaysia’s market standing in the region. However, political considerations are a significant stumbling block to this scenario and there is no real incentive because Petronas does not need the cash. The outlook for palm oil prices has never been better, with an expected surge in biodiesel demand around the world and particularly in China and India. Malaysia is still the world’s largest palm-oil exporter and its importance is magnified when you consider that Malaysian plantation companies control an estimated 25% of Indonesia’s industry.

Malaysia has significant overseas holdings of oil and gas reserves via Petronas, effectively almost doubling the country’s net oil exports. The oil factor is augmented by the string links with the Middle East and the increasing flows of capital from the region. Malaysian companies such as MMC and Malakoff have won contracts in Saudi Arabia. In turn, Saudi and Kuwaiti banks are expanding their presence in the Malaysian market.

If oil remains in the $50-70 a barrel range, the initial flow of Middle Eastern money into Malaysia could turn into a big wave as the market gains recognition and other property markets in the region get too expensive. Other investments for big ticket investors could be infrastructure and big-scale developments like UEM World’s Nusajaya South Johor Economic Region.

 

Government focuses on results

One of Malaysia’s oft-stated strengths is political stability. But the undercurrents and cast of players in Malaysian politics are often not easy to read and follow, especially for foreign investors. This was particularly true late in 2006, as newspaper headlines described an unprecedented public spat between former prime minister Tun Dr Mahathir Mohamad and his handpicked successor, Datuk Seri Abdullah Badawi. These public criticisms by Tun Mahathir on Badawi’s leadership raised fears about unity within UMNO, the leading political power and agenda setter in Malaysia.

For global investors, the immediate reaction was one of caution towards the market. This is an ironic shame, for much of the press coverage we have seen is due to exactly the types of change and political growth that many foreign observers have been calling for. Newspaper articles of current and former leaders going head-to-head are unprecedented in Malaysia, but would barely raise an eyebrow in most larger markets.

CLSA’s view is that these developments are a noisy but necessary part of Malaysia’s continuing growth as a strong and functioning democracy, and that concern over political issues will only lead to greater opportunities for those investors willing to look past the headlines and understand the real issues.

The next general election must be held before May 2009, which would be five years after the government’s massive victory in 2004. Political changes abound; first the fundamentally Islamic PAS will try to capture as much of the vote from the more conservative elements of the Malay population. Second, former deputy prime minister Anwar Ibrahim has signalled he wants to return to politics and parliament in 2008, on a reformist ‘new economic agenda’. Because of his earlier conviction, he cannot contest an election until April 2008. There are suggestions that Abdullah Badawi will call for an earlier than anticipated election to foil Anwar and capture the feelgood factor in the country at the moment.