Back on the high, what now?

Outperformer in weak markets
Malaysia appears to us to be a safe refuge for foreign investors for now given its strong domestic economic outlook (7.7% 2010E GDP growth, JPM forecast) and relatively defensive characteristics — low volatility and weak correlation with major indices — during this bout of increased volatility in regional markets.

In our view, short-term uncertainties surrounding the US bank bill, Chinese growth, EU bank stress tests, and European sovereign funding have caused the KLCI to get squeezed upwards alongside other Asean markets, with the index now standing above 1,350 (which is a 2010 as well as a 29-month high).
We see evidence of foreign monies trickling in based on foreign incremental buying and ownership levels.

Looking for the positives
We recap the Malaysia-specific positive drivers we see over the coming months:
1)    2Q10 reported results which are likely to remain relatively robust (current earnings growth of 23% in 2010 and 16% for 2011);
2)    Unveiling of Part 2 of the New Economic Model document (expected in August) which will provide greater granularity on the structural reform policies needed to put Malaysia on a higher growth trajectory;
3)    More evidence of greater Malaysia-Singapore cooperation especially in Iskandar, south Johor;
4)    More new IPOs to put Malaysia back on foreign investors’ radar screens; and
5)    Positive sound bites on the 2011 Budget (Oct 14) and proposed pump-priming agenda as the possibility of a snap general election may emerge in 2011 (although the election need only be held by March 2013).

The key risks
The pushbacks are 1) policy flip-flops by the administration as reforms prove difficult to implement and 2) relatively high valuations with market PE of 14.3 times and a 15.5% premium to MSCI APxJ which to some extent reflects the optionality of structural reform already.

Thus, despite the apparent low expectations of reform, the question is whether the market can further rerate without being accompanied by strong upward earnings revisions.
Our current end-2010 KLCI target of 1,400 based on a 14 times forward PE target stands unchanged. Tactically, we remain positioned in cyclical sectors with our top picks being AMMB, Public Bank, Tenaga, Genting and IJM.

Earnings growth for 2010 is 23.1% and for 2011 16.3% as we anticipate the economy to grow at 7.7% for 2010 and 4.8% for 2011 as confidence returns.

These earnings growth numbers have remained relatively stable for most of 2010 as the base assumption is still that the global economy remains in recovery mode whilst domestically, we await clear evidence that further structural reforms will take place.

A bit of a rollover in 2010E consensus earnings is seen as the outlook for 2H10 is unclear. In the last few weeks, foreigners have been incrementally net buyers of Malaysian equities, as per our order pad. We attribute the increased buying mainly to investors looking for safe refuge during this period of volatility.

On a cumulative basis, the selling appears to be over and we are starting to see a pick-up in net buying by foreigners.

Foreign ownership levels suggest that there has been a marginal increase from the lows of 20.3% in February 2010 to 20.6% as at end-June 2010.

We have also seen an increase in foreign holdings of the banks over the past quarter.

The cumulative foreign portfolio net flow data for equities provided by Bank Negara are until end-March 2010. We would not be surprised if there was an uptick from the low in 2Q10 when the data is released at the end of this month.

Suffice to say foreign investors do not seem convinced by the new administration’s structural reform story at this juncture. The big question is whether the flows can reverse if Prime Minister Datuk Seri Najib Razak surprises positively on this theme.

The biggest pushback from clients is that Malaysia remains a relatively expensive market. This is certainly true at present with the PE premium to the region standing close to 15.5%.

A re-rating of Malaysia needs to be backed by increased earnings growth trajectory which we think is currently dependent on:
1)    stronger-than-expected 2Q10 reported earnings trend (due next month);
2)    improved Singapore-Malaysia relationship which could boost land values in Johor and invigorate the economy;
3)    the unveiling of Part 2 of the New Economic Model policy document which hopefully provides granularity on reform implementation.

The counter argument for Malaysia being expensive is that other Asean markets like Indonesia and the Philippines are also on similar PE valuations.

Our regional strategists have Thailand and the Philippines as their top Asean country picks, with Indonesia as a neutral from an asset allocation standpoint.

At current valuations, Malaysia is unable to distinguish itself from the crowd. Thus we are neutral from a regional perspective. We currently have an end-2010 KLCI target of 1,400 points, based on a forward PE of 14 times, which offers 4% upside potential from current levels.

This article appeared in The Edge Financial Daily, July 29, 2010.