This article first appeared in The Edge Malaysia Weekly, on June 20 - 26, 2016.

COMPANIES that have reported their first quarter (1Q) results have, by and large, seen disappointing earnings. Data compiled by The Edge show that most sectors reported negative earnings growth, with the consumer discretionary and energy sectors seeing their earnings plunge 97.9% and 83.5% year on year (y-o-y) respectively (see Chart 1). As a result, market valuations have gone up, with the trailing price-earnings ratio for the FBM KLCI now standing at 18 times from 17.5 times a year ago.

As Malaysia’s gross domestic product (GDP) growth slowed to 4.2% in 1Q2016 — the lowest y-o-y growth since the global financial crisis — cyclical sectors such as banking, property, automobile and oil and gas are expected to continue to face earnings downside risks. In 1Q2016, banks’ earnings declined 3.3% y-o-y, dragged down by higher provisions for bad loans, while non-bank earnings fell 22.2%, impacted by slower sales and rising operating cost.

Overall corporate earnings contracted 18.2% or RM4.1 billion, with only industrials and healthcare posting better 1Q results. As shown in Table 1, the main culprits of the dismal results were automobile manufacturers (-RM1.1 billion), oil and gas firms (-RM578.7 million) and property developers (-RM422.6 million). Another key observation is that the underperforming sectors were generally the bigger-cap sectors. However, one caveat to note is that the reported earnings data in the table were not normalised, that is they were not adjusted for exceptional items.

Although electric utilities, casinos and gaming, and plantation were among the worst-performing sectors, the huge reduction in earnings was due to extraordinary items. For example, Kulim (M) Bhd saw its 1Q earnings decline RM1.4 billion due to a RM1.3 billion gain arising from the disposal of New Britain Palm Oil Ltd in the previous corresponding quarter. Tenaga Nasional Bhd’s (TNB) 1Q net profit decreased RM835.5 million, largely due to an imbalance cost pass-through mechanism, while Genting Bhd reported an earnings decline of RM489.3 million, mainly due to disposal gains on financial assets and the reversal of impairment losses in the preceding quarter.

While the overall picture is not exactly pretty, there are still some sectors that posted improved earnings, namely airlines (better passenger yields and low fuel cost), metals (recovery in metal prices), hospital operators (higher number of patient admissions), glove makers (ongoing capacity expansion), non-wireless telecommunications (growing broadband subscriber base), marine ports (higher container volume and tariff), real estate investment trusts (REITs) (positive rental revisions and benign interest rates), brewery (improved cost efficiencies) and packaged foods and beverages (subdued milk powder prices). For shipping and industrial conglomerates, the jump in earnings was mostly due to exceptional items such as the recognition of compensation for early termination of time charter contracts for vessels and disposal gains on businesses and land.

In examining the top 15 sectors that performed the best in terms of year-to-date share performance (see Table 2), it can be seen that corporate earnings are still the key determinant of share price. Nine out of the 15 sectors — airlines, aluminium, soft drinks, retail REITs, diversified REITs, marine ports, packaged foods, breweries and steel — that posted better 1Q results saw their share price continue to rise in May.

In the first quarter, shares of large-cap sectors such as airport services, casinos and gaming, industrial conglomerates and banking rallied, thanks to foreign fund inflows that sought to capitalise on the undervalued ringgit. Nonetheless, their stocks faced selling pressures after reporting weaker earnings in May, though they were also partially affected by the reduced weightage in the MSCI indices.

Table 2 also lists the sector leader that contributed the largest market value to its respective sector. Despite the foreign selldown in the last two months, overall disappointing earnings reports and gloomy economic data, these 15 stocks continued to beat the benchmark FBM KLCI and outperform the market.

Industry-leading stocks that continued to do well in May included AirAsia Bhd (+100.8% year-to-date return), Press Metal Bhd (+56.5%), Fraser & Neave Holdings Bhd (+37.2%), IGB REIT (+15.7%), KLCCP Stapled Group (+4.5%), Kerjaya Prospek Group Bhd (+28.2%), Westports Holdings Bhd (+2.9%) and Nestlé (M) Bhd (+4.9%).

In contrast, industry-leading stocks that faced selling pressure in May, either due to the exit of foreign liquidity or weaker 1Q results, included Malaysia Airports Holdings Bhd (+15%), Heineken Malaysia Bhd (+14.9%), Ann Joo Resources Bhd (+73.1%), TNB (+4.8%), Genting Bhd (+10.4%), Hap Seng Consolidated Bhd (+16.8%) and Public Bank Bhd (+3.5%).

Moving forward, analysts believe corporate earnings will remain weak in 2Q or 3Q, thereby limiting further upside on the FBM KLCI. In a note to clients this month, AllianceDBS Research head of research Bernard Ching says the prospect of weak corporate earnings will remain the Achilles heel of Malaysian equities.

“Heavyweight sectors such as telecoms and plantations continued to face earnings risk from intense competition and poor fresh fruit bunch (FFB) yield respectively. While the banking sector has, by and large, held up in the 1Q2016 earnings season, selective corporate account exposure still led to asset quality concerns in Maybank but this is unlikely to point towards systemic risks in the sector,” he says.

Given the lack of broad-based rerating catalysts for the market and the negative bias in corporate earnings revisions, RHB Research head of research Alexander Chia believes that drivers for the market will be mainly external. “The high-profile bond default by a certain government-owned investment company and Malaysia’s reduced weighting on the MSCI AXJ has weighed on investor sentiment. Domestically, we see downside support for the market, given that many funds remain underinvested,” he says.

Maybank Investment Bank Research regional head of research Wong Chew Hann points out in a June 2 note that in the near term, there are two external and two domestic developments worth keeping an eye on.

“Into June, we are mindful of two developments — the US Federal Open Market Committee’s meeting on June 14 and 15, and the Brexit referendum on June 23 — which will influence capital flows and sustain volatility in the global markets. Domestically, we singled out two major things to look out for — the 2Q2016 GDP, to be released on Aug 12, and the ensuing Monetary Policy Committee statement on Sept 7 as well as the telco spectrum fee details, in mid-2016 or 3Q2016, as there has been no clarity since January 2016,” she says.

“Details on the telco spectrum fees may induce relief, depending on the amount. And, a potential overnight policy rate cut may provide a relief to the broad-based consumer sector — negative for the banks and ringgit but positive for exports,” she explains.

Last week, the US Federal Reserve decided to maintain its accommodative monetary policy, leaving the target range for the federal funds rate unchanged at 0.25% to 0.5%. While the median of the Fed’s projections for 2016 still indicates two rate hikes this year, there appears to be a softening of the Fed’s position, with six members now expecting one rate hike increase this year, up from just one three months ago.

Given the headwinds from the US interest rate hike, Brexit and 1Malaysia Development Bhd, coupled with uninspiring growth prospects, most brokers advocate a defensive equity strategy going forward while some advise a trading-oriented stance to accumulate quality stocks on market weakness. In terms of the stock selection strategy, AllianceDBS Research prefers exposure to stocks with low beta, strong earnings resilience and/or good dividend yields while Maybank IB Research believes that there are pockets of opportunities in thematic plays such as construction as well as plantation, which could continue to benefit from the El Niño-induced crude palm oil rally.

In the short term, the market reflects the consensus opinion, if there is a clear consensus. To determine the consensus sector allocation strategy recommended by the sell-side analysts, we compiled 10 strategy notes issued by foreign and local brokers. Assigning a positive one score to an overweight recommendation and a negative one score to an underweight recommendation, Table 3 shows the results of our tabulation.

Construction and electric utilities are the clear winners with a score of nine out of a full score of 10. Banks, plantations and REITs are also favoured with an equal score of three. It is noteworthy that there is no underweight recommendation on any of these sectors. The column on the far left of the table also shows brokers’ top picks that are viewed as top buys by at least two brokers.

Moving down to the second part of the list, we have the top five sectors that brokers think we ought to avoid. Telecoms and auto are the top “to-avoid” sectors among the brokers, with a negative score of two and four respectively. However, brokers’ sentiment on property, healthcare and oil and gas are more mixed — property and oil and gas are trading at attractive valuations but both face uninspiring growth prospects. While healthcare stocks such as hospital operators are richly valued, they continue to enjoy stable growth, albeit at a low-teens rate.

Finally, we compiled the brokers’ top picks that were chosen by at least two brokers as top buys. Table 4 shows the results of our tabulation, with the potential upside calculated by the difference between the last price and consensus target price, and valuations metrics such as price-earnings ratio, price-to-book ratio, dividend yield and return on equity.

The list of top picks is rather construction-centric with six out of 24, or a quarter of them, being construction companies, followed by three banks and three plantation companies that together accounted for another 25% of the list. TNB and Gamuda Bhd are the clear big-cap favourites of the brokers with seven brokers picking them as their top picks. In the small to mid-cap space, AirAsia and Kimlun Corp Bhd stand out after surprising analysts on the upside in their latest results.

For investors seeking capital gains, SKP Resources Bhd, Muhibbah Engineering (M) Bhd, Prestariang Bhd, Mitrajaya Holdings Bhd, Ta Ann Holdings Bhd and SapuraKencana Petroleum Bhd provide significant upside potential of 20% to 44%, assuming the shares converge with their consensus target price.

For investors seeking yields in a low-growth environment, UOA Development Bhd, Malayan Banking Bhd, Pavilion REIT and Sunway REIT offer above-market-average dividend yields of 4.9% to 7.2%. Attractive yields notwithstanding, it should be noted that earnings growth for banks and property developers are unlikely to be exciting as banks are now focusing on asset quality and have tightened their credit policy, which has, in turn, impacted developers’ sales. For REITs, the continued delay in the US rate hike and a potential cut in domestic interest rate could be positive catalysts to rerate the asset class. 

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