Lead Story: Look for gems in small and mid-cap space

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MALAYSIA’s fuel price hike from a subsidy cut effective Oct 2 — just a week ahead of Friday Oct 10’s tabling of Budget 2015 — was generally expected by economists and stock market experts. While there are those who think the move could have been better timed, the experts say subsidy rationalisation is inevitable for the government to achieve its 3.5% of GDP budget deficit target for 2014.

Simply put, without a subsidy cut, the Malaysian government is likely to overshoot its projection on expenses for 2014 based on its spending in the first half of this year.

In a note following the 20 sen/litre subsidy cut that raised RON95 prices to RM2.30 per litre and diesel to RM2.20 per litre, Citi Investment Research’s Wei Zheng Kit estimates that the fiscal savings from the government’s move could be between RM1.8 billion and RM2 billion for 4Q2014, higher than his initial estimate of RM0.8 billion. This is given that market prices for RON95 and diesel have fallen from the RM2.73 per litre and RM2.80 per litre assumed when the earlier 20 sen per litre fuel price hike happened on Sept 3, 2013.

The Malaysian government, which is believed to be on track to achieve its Budget 2014 deficit target, following the week prior to Oct 6’s subsidy cut, still needs to spend over RM21 billion to subsidise RON95, diesel and liquefied petroleum gas (LPG) for 2014 — a sizeable amount that will better aid the intended recipients in the lower income groups, through a target subsidy scheme. The current unsubsidised market price is RM2.58 per litre for RON95 and RM2.52 per litre for diesel, the Domestic Trade, Cooperatives and Consumerism Ministry reportedly said.

Subsidy rationalisation and the implementation of the Goods and Services Tax (GST) from April 1, 2015 are two main reasons economists expect higher inflation next year and why stock market experts have been looking for winners in a rising inflationary environment for more than a year now.

“Basically, you see rising business costs in a rising inflationary environment,” says RHB Research Institute Sdn Bhd Executive Chairman Lim Chee Sing, who is a well-respected economist.

In a subdued growth environment — where major world economies are unable to transition from a recovery to an economic boom — corporations, Lim says, do not have much pricing power because demand growth is not strong. “As a result, margins are being squeezed everywhere, particularly for Corporate Malaysia. There is a general lack of earnings growth to create new shareholder value for investors,” he explains.

“The key for investment, therefore, is to identify growth stocks that will create value for investors. These are found mainly in mid- to smaller-cap stocks and that is why the FBM Small Cap index has gone up by 19.3% year-to-date versus -1.3% for the FBM KLCI benchmark,” Lim says, adding that earnings growth for these so-called growth stocks can come from the execution of new contracts, capacity expansion or M&As in spite of lower margins.

Berjaya Auto Bhd, Tambun Indah Land Bhd, Matrix Concepts Holdings Bhd, Scientex Bhd, Press Metal Bhd, Eastern & Oriental Bhd (E&O) and Tune Ins Holdings Bhd are a few examples of the kind of stocks Lim is referring to.

Among the bigger-cap stocks, Lim says investors should look out for buying opportunities on market weakness. The latter may arise when a particular stock has been oversold for rich valuations that value emerges.

Lim points out that SapuraKencana Petroleum Bhd’s stock price has retracted 15.7% year-to-date, Bumi Armada Bhd shares have tumbled 21.4% year-to-date, Malaysia Airports Holdings Bhd (MAHB) has shed 16.4% year-to-date while Guinness Anchor Bhd is down 18.9% this year.

Vincent Khoo, who heads UOB KayHian Research in Kuala Lumpur, also likes Bumi Armada, which he describes as among the laggards with defensive businesses that investors should look out for.

“Inflation will be an issue to contend with for a period of time [in Malaysia] … However, we are going counter against the rest of the world, which is experiencing some deflation,” says Khoo, who expects details on the implementation of GST and further subsidy rationalisation to hog the limelight at the tabling of Budget 2015.

Expectations are that a targeted subsidy programme, particularly for fuel, will feature in the unveiling this Friday (Oct 10) of Budget 2015, themed “Accelerating Growth, Ensuring Fiscal Sustainability and Prospering the Rakyat”. The new mechanism is likely to segregate the subsidy on RON95 and diesel based on the user’s individual income versus the current blanket subsidies regime that also subsidises the higher-income group.

“In light of the rising cost of living and inflationary pressures, particularly on the vulnerable groups, we expect [subsidy rationalisation] to be accompanied by continued and possibly higher cash transfers, a continuation of people-friendly measures such as the affordable housing scheme,” Khoo tells clients in an Oct 1 note.

“We maintain our view that ample domestic liquidity will continue to support a stretched end-2014 FBMKLCI target at 1,930 points, which pegs the index at 16.1 times forward earnings, despite peakish valuations and softening economic fundamentals.

“We also still expect modest outperformance by small/mid-caps, amid the pullback of speculative stocks since the trading volume exceeded seven billion shares on Aug 14, and continue to advocate fundamentally-sound small-mid caps with near-term event catalysts,” Khoo adds.

UOB KayHian’s top picks are Malaysian Resources Corp Bhd (MRCB), Deleum Bhd, Barakah Offshore Petroleum Bhd, Uzma Bhd, and SKP Resources Bhd, which it reckons has the potential of capturing new contracts with its potential synergistic merger with sister company Tecnic Group Bhd. The research house’s large-cap picks are Gamuda Bhd, SapuraKencana, Bumi Armada and Tenaga Nasional Bhd.

Chan Ken Yew, who heads Kenanga Research, also cites strong domestic liquidity as among the “saving graces” for the local equities market following the recent conclusion of an uninspiring 2Q2014 corporate earnings reporting season, in which 37.4% of companies under coverage turned in below-par results. This is worse than the 32% in the first quarter of 2014 and 34.4% in 4Q2013.

While rich market valuations and unexciting earnings growth would cap upside potential for the Malaysian market, Chan — who has a 1,910 points KLCI target for 2014 and 1,980 points for end-2015 — also reckons downside could be limited and advocates a “buy-on-weakness strategy”.

“The easiest way to capitalise on the favourable 4Q performance is to identify the year-to-date underperformers for a potential brief rebound due to window dressing activities,” Chan says, citing SapuraKencana and Petronas Chemicals as examples.

While most domestic sectors, especially direct consumer spending driven companies, will be affected by rising inflationary pressures, Chan recommends GST beneficiaries and export-driven companies such as Malaysian Pacific Industries and VS Industry Bhd that could also benefit from a weaker ringgit. He also likes stocks and sectors buoyed by corporate exercise newsflow such as Malaysia Building Society Bhd, RHB Capital Bhd and Sime Darby Bhd that may spin off some units.

Whether or not these stock picks will turn out to be prescient, what’s certain is inflation is set to accelerate in 2015 when the 6% GST is implemented on April 1, 2015. And given that the government is targeting to bring down its budget deficit to 3% in 2015 and work towards a balanced budget by 2020 while bringing down its debt levels that are near its self-imposed levels of 55% of GDP, experts say the government would likely find it easier to bring down its subsidy bill than its emolument bill that makes up an even larger slice of its operating expenditure.

Economists at RHB Research reckon that the government “may even have to look into rationalising other subsidies as well on a gradual pace in order to reduce its operating expenditure”.

“Although this may translate to higher inflationary pressure in the short term, it will likely be manageable if it is implemented on a
gradual basis,” the RHB economists wrote in a Sept 24 note, pointing out that the RM43.3 billion spent on subsidies accounted for 20.3% of the government’s total revenue in 2013.

Despite an anticipated moderation in 2014, the RHB economists say subsidies “remain sizeable and are still uncomfortably high”. Subsidies only accounted for 2.9% to 7.8% of revenue in 2000 to 2004, compared with an average of 18.4% a year in 2008 to 2013.

They forecast inflation to average around 3% to 3.4% in 2014 and expect the government to take steps to reducing GST-driven price inflation, which could increase the burden of debt on consumers. They estimate the overall impact on full-year Consumer Price Index to be 1.5 percentage points based on a 6% GST starting April 1, 2015, and expect additional items to join the zero-rated list after public feedback. As it is, nearly one-third of the 944 items in the CPI basket will be zero-rated.

Basic food items such as rice, sugar, salt, flour, cooking oil, lentils, herbs and spices, salted fish, piped water supply, and the first 200 units of electricity per month for domestic consumers are not subject to GST. Services not subject to GST include those provided by the government such as the issuance of passports, healthcare, school education, transport services and highway tolls.

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Higher inflation resulting from the introduction of GST next April could weigh on retail sentiment

RHB’s inflation forecast is in-line with the 3.3% median inflation forecast for 2014, according to a poll of 21 houses by Bloomberg. For 2015, the median forecast rises to 3.5%, with forecasts ranging from Credit Agricole’s 2.5% to Nomura Securities’ 5.2%.

While higher inflation would hamper consumer sentiment, the government needs to make a tough decision to reduce its subsidies to a more sustainable level.

“As a whole, while the government is on course to meet its fiscal deficit target, fiscal reforms must continue so as to instill greater confidence of the country managing its public finances and the economy, thereby leading to a potential improvement in the country’s sovereign ratings,” the RHB economists add.

This article first appeared in The Edge Malaysia Weekly, on October 6-12, 2014.