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Friday, 11 May 2018

POST-GE14 : WHAT TO EXPECT FROM THE KLCI AND CRONY COUNTERS ON MONDAY

Holy shit they did it.


To begin with, I'll say one thing : I've never been more delighted to be completely and utterly wrong about something.


Being right and wrong is part of trading : all you can do is adjust the parameters and protect your capital. Yes, we're entering uncharted territory with a new leadership. Volatility in the market is to be expected.


Volatility is really not something to be feared. Identify good value-oriented companies and any downside volatility is a chance to buy. And obviously upside volatility is something everybody can enjoy. But of course, as our new Prime Minister put it last night, 'certain heads will roll' - some stocks will be dumped, and dumped HARD.


Let's take a more nuanced approach and use common sense. There are existing clues to suggest that a horrifying market dive is less likely than you might think. Some counters may take a brief hit before investors see value again. Others may see a complete (negative) shift in their longer term prospects, but it's not something we haven't encountered before.


In other words : Don't ignore the noise. Volatility creates mispricing in good stocks. There are good trading and buy-and-hold opportunities. Some politically sensitive counters will at least shed off that tag and come out stronger - assuming their underlying businesses can back it up.


#1 : WHAT WILL HAPPEN TO THE KLCI?

It was essential for the new administration to close financial markets on Thursday and Friday. Investors would not have taken the events of the past 48 hours lightly : uncertainties range from possible social unrest to a long term constitutional crisis, two possibilities that can be considered as the very worst case scenarios for the markets.


We can take a hint of how the market has been absorbing the news from shares and exchange traded funds that are listed overseas. There's already been strong reactions in the bond markets, though I wouldn't put too much confidence on the ringgit non-deliverable forwards given how illiquid they can be most of the time.


The following is the Nasdaq-listed iShares MSCI Malaysia ETF on May 9 and 10. Note that the selloff peaked around the time it became clear Pakatan Harapan was winning the race for parliamentary seats.



As the day went on, and as it became clear that Tun Dr Mahathir's swearing in will be expedited, prices have largely stabilized. From a trough of 10%, now it trades at about 2.5% below pre-GE14 levels. At least foreign investors got the idea that the transition of power would be peaceful, and the stability shows that this is being priced in. Unlike the past military juntas in Indonesia, the Philippines and Thailand, we are fortunate to have been governed by a civilian government since independence. So the risk premia is more skewed towards our bread-and-butter finances, not so much political instability.


Here's another one : the Singapore-listed IHH Healthcare Bhd. The chart does not show much beyond the obvious, other than the fact that its price movement is rather benign. A 2% price decline? Hell, the Malaysian listed shares have swung that much on an intraday basis many times over the past few months. So no collapse there.



The outlook for Malaysian equities may be far rosier than movements in the ringgit (which partly reflects concerns over the direction of  monetary policy) and bonds (which reflect concerns over our sovereign's creditworthiness, and to some extent, future fiscal obligations). At least with stocks we can narrow down the focus to sectors and companies. To put it another way, it's time to look for value counters again.


But first, let's consider the possibility of the the KLCI taking a huge dive on Monday due to indiscriminate panic selling. My personal projection of a worst case scenario is an immediate 3% dip the index (in other words, a 55-point decline). Why not worse? It's because this selloff would be sentiment based; a real, prolonged collapse happens when there's an underlying macroeconomic or external (global shocks) factor behind it, and I've been through a few cycles of this to be aware of the difference.


It's also apparent that from a technical standpoint, the support point for the KLCI is at 1,800 points. At that point we will only wipe out the KLCI's gains year to date; this is not and end-of-the-world situation. There will be buying support eventually, so my guess as to how far or how little the market will dip is as good as yours.


Not as bad as you might think.

The 3% dip is a threshold. Anything worse means it's a real buying opportunity to exploit the short term market panic. Anything less means that there is already some level of institutional support in the blue chip shares; the big funds are not going to sit on the sidelines indefinitely.


And it gets better. If we consider the potential post-election feel good factor as well as investors returning from the sidelines, we might see a gradual stabilisation in the KLCI but with an upside bias. If you have to chase yields somewhere, the first place to put it is in KLCI component stocks.


And here's the interesting part...


#2 : A CASE FOR BUYING BANKING STOCKS


Banking stocks are the ultimate bellwether of the KLCI. Because of their outsized influence, the index go where they wish to go. Despite their political links, from a value standpoint, banks are unaffected by the GE or a change in administration. They're the bedrock of the economy; dumping bank stocks because of a change in government is the height of stupidity (but of course when you see this happen you'll know what to do).


I'll illustrate with the following - it's a weekly chart for Maybank from 2015 to present day. I break this down into two distinct phases.



Banks live and die by their loan books. The introduction of GST clearly hampered consumption; individuals are not as keen to take up car or property loans. Corporates are no longer borrowing as much as they'd like to; no reason to expand capacity if market demand is weakened by the very same lower consumption. Property prices stayed up but transactions fell.


I'd characterize 'Phase 1' as the time when all the GST shocks are being absorbed by the system. At the same time, banks had a vested interest to tighten their loan books and reduce bad debt. A few rounds of belt tightening occurred, with cost rationalisations. Of course, back in 2015-2016 the lousy sentiment in banks predates the GST : since the beginning of this decade banks had to shore up their capital buffers to conform to new regulations, and this involved billions of ringgit in fundraising and dilution of shares. Investors didn't like this one bit.


'Phase 2' is when the cost controls are further boosted by an improvement in business. Maybank reported all time high net profits in 2017 due to this. The share price trajectory reflected this; now the stock is near an all time high. The phases are analogous to other banks as well; Public Bank also reported record profits as well as a sky-high stock price.


It can be argued that the abolishment of the GST will benefit the banks. An improvement in consumption can boost loan growth over the long term, but think of this as an added bonus - banks are already doing pretty well on their own. Another tailwind is the expectation of benign interest rates going forward and continued continued economic growth, although the latter is something the new government has to ensure. Replacing the GST with a credible alternative will not be an easy task.


As I've said previously, banks, as a group of stocks under the KLCI, are already flirting with all time highs in their share prices. There's a solid fundamental reason behind this, and to some extent the sector itself has carried the broader market on its back at times. Maybe this chart will convince you:


This is a comparison between the Bursa Malaysia Finance Index (the sector benchmark) and the KLCI over the past six months. It basically shows that as a whole, banks have been outperforming the broader market by a large margin during this time. And of course, the many banks that make up the KLCI have been supporting the index during long periods, thanks to their (justified) high stock prices.


To sum it up : banks are a good investment, but they also serve as a hedge against a serious decline in the KLCI. If the market falls, you should buy banking stocks anyway, at least for the next 8-12 months (beyond that time we'll probably know for sure how terrific/awful the new government's economic policies will be). One caveat is that banking stocks will start unraveling if PH's policies consequently lead to a slowdown in economic growth. A recessionary environment is what will drive a real collapse in all stocks.


Now let's look at the fun stuff.


#3 : WHICH STOCKS WILL LIVE OR DIE?




I'll rank the following politically sensitive stocks on a scale of 1 to 5, with 5 being the most likely to get hurt in the short and long term. The purpose of this section is to highlight what the catalysts are, and how much you should worry. These are all my personal views.


MYEG - A breakup of this monopolistic business is to be expected in the future (the new government promised as much). The prospect of open tenders alone would dampen their long term earnings potential. It will still be a highly profitable business, but the expectation of high profit margins may shift drastically going forward. From a sentiment perspective alone, it is one of the most politically sensitive proxies to the previous government.

Rating : 5/5


DRB-HICOM - Proton is Mahathir's baby, so expect him to meddle. The government might push for serious concessions out of Geely, particularly in matters relating to Bumiputera equity and job creation. There will be threats to efficiency, especially if he signals a return to the old days (race-based favoritism towards vendors and suppliers). The major concern is on how DRB's turnaround plan for Proton contrasts with Mahathir's views. Bridging this gap could take time and will come at the expense of improved earnings from Proton.

Rating : 4/5


FGV - An outlier among the politically sensitive counters. The company's stock has already paid the price for a series of bad deals over the years and corruption allegations at the FELDA level. But the plus point is that they're already working on efficiency improvements. The cleanup is already underway under the BN administration and it will continue under PH.


Remember that Felda settlements in Johor is now PH's vote bank; the government will do all they can to repay the faith. Expect populist measures at the Felda level to benefit FGV in some ways (the board of directors will be reshuffled again, but board interference and corruption have largely been dealt with). Things look more positive now - at least they can focus on the plantations.

Rating : 2/5


GAMUDA - It will not be in the government's best interest to disrupt ongoing mega projects. MRT projects do not elicit an emotional response the way highway projects do. Expect the MRT Line 2 project to continue in its present iteration. It's making good progress anyway, and Gamuda is not known for excess or incompetence - they're the right company for the job.


The government will inherit hundreds of large scale infrastructure and development projects belonging to funds and GLCs - the economic rationale is to continue them provided the benefits are sound (if there are no elements of corruption or malfeasance). The outlandish ones, such as the ECRL, will probably be put to a halt.

Rating : 2/5


PAN BORNEO HIGHWAY COUNTERS -  How the government plans to utilize DanaInfra will ultimately determine what's going to happen. The main issue is that now the federal government is dealing with two  East Malaysia states under opposition control. Imagine if the Penang government is asking the federal government to foot an RM30 billion bill for its overly ambitious undersea tunnel project (oh wait... actually now that will happen for real).


The new government can wield its stick if it wants to as the entirety of the Pan Borneo project is supposed to be financed and guaranteed by federal assets. Who's to say that they won't prioritise, or even create, new infra projects in Penang or elsewhere? Expect prolonged negotiations with the state governments over this issue. Some counters will immediately suffer at the first hint of a delay in new contracts.

Rating : 5/5



Monday's going to be an exciting day for equities indeed.












Monday, 7 May 2018

[GE14] BRIEF THOUGHTS ON TRADING THE ELECTION : BUY KLCI CALL WARRANTS

Malaysia goes to the polls. Image link (and great article) here.



In my previous posts I've expressed my enthusiasm on the general election as a trading catalyst. I can only speak from the perspective of a risk averse trader with limited funds and a desire for capital preservation, but I will not hesitate to pull the trigger if I see a good trade in the short term.


While there are pockets of opportunities (banking stocks) to be found in what has been a horrendous decline for the KLCI over past few weeks, you can't be too risk averse that you deprive yourself of the opportunity to achieve short term yields of at least 5% on your stocks portfolio. You can only get this by accumulating a position before May 9, somehow, somewhere.


This is not a post about interest rates, Federal Reserve policy, inflationary expectations, or the trampling of emerging market currencies. This post is about my expectations on how the market will look on May 10, and the possibility of taking on a trade with a very favourable risk-to-reward ratio - this is all that matters.




But first, let get the unseemly stuff out of the way. You need to make up your mind about the state of Malaysian politics. And given the poor media coverage of the state of the country and the failure of our so-called experts to understand the Malay/Chinese/Lain-lain psyche, you won't get any help from the outside; these things you will have to think for yourself.


There are a few potential angles and possibilities that I'm considering to justify my main theory : that the market is overpricing risk and underpricing a larger than expected Barisan Nasional victory. This means only one thing : FBM KLCI call warrants are underpriced right now. You can trade them on the expectation of a large one-day gain on May 10, if status quo prevails.


This is the part where I list out the reasons why BN can win big in short and sweet sentences without turning this post into a biased, totally out-of-touch political thinkpiece (nobody wants to read that) : redelineation of urban seats will weaken the Opposition's strong foothold in these areas, the infighting between Opposition component parties, particularly in PKR, the lack of a coherent strategy for Pakatan Harapan, the parachuting of new PH candidates from out-of-town into supposedly 'safe' seats (potential complacency there?), PAS splitting the Malay votes, three and four-cornered fights in key state and parliament seats to hurt PH representatives the most, money politics, expected status quo in both Sabah and Sarawak, money politics, etc, etc...





That wasn't very interesting, was it? Moving on.


I believe that the markets are underpricing the following possibilities at the moment. This basically means that the FBM KLCI is fully pricing in prevailing concerns and risk aversion, but not the potential upside (and downside) catalysts :


1) A decisive victory for BN, defined as : a recapturing of the popular vote (51%), and a better than expected number of seats won/recaptured. An added bonus would be a decisive majority in Perak and Kedah, as well as the potential capture of Kelantan (it's probably their best shot at winning the state in at least 30 years). 


2) Significant gains for PH without winning a simple majority at the Parliament level, defined as : Victory in Perak and Kedah, plus a huge swing in the voting demographic in key BN vote banks of Johor, Sabah and Sarawak. Status quo for PH elsewhere, including in Penang and the major urban seats.


3) A hung parliament where neither side has the requisite number of seats to form a government. This is where PAS and minor component parties become kingmakers. Take a guess on who they will side with? (hint : there's only one direction this dacing is going to sway).


4) A huge, historic win for PH. But if the markets were taking this possibility seriously the KLCI would've tanked a long time ago.


The one thing that the market is pricing in properly at the moment? Pessimism, global market uncertainties, and the staying-in-the-sidelines mentality.


My personal opinion is that (1) is much more likely than (2). (3) and (4) are unprecedented; we don't know if such a thing will bring about martial law, social unrest, or peace on Earth. So they're the least likely possibilities.


Visions of a post-apocalyptic Malaysia. Image link.


Here's another personal political viewpoint for you : I firmly believe that the election results will swing strongly in one way or another, making a hung parliament situation unlikely. But the key here is this; even if BN performs meekly during GE14, let's say with roughly similar results to GE13, the market rebound will still be strong. The expectation of a status quo will be enough to propel the KLCI upwards on May 10, not to mention the promised infrastructure projects and relative economic stability.


My expectation is this. Obviously I can be completely wrong on any or all of these points :


A) Status quo prevails.

B) A larger than expected BN victory is an added positive boost for the markets.

C) A conservative projection of an immediate increase of 3% to 5% in the FBM KLCI in the week immediately after May 9.

D) The current pessimism in the market is causing a short term mispricing in the FBM KLCI. This is purely a short term sentiment thing, not so much a reflection of valuations or fundamentals.


So what can you do with this? You can accumulate FBM KLCI call warrants. They're cheap, they cover the breadth of the index, and they're much easier to accumulate than buying a basket of politically sensitive stocks. Think of them as a short term index fund.


Here's the caveat though : the favourable risk-to-reward expectation lies in the assumptions that BN's going to win, that the market is underpricing the upside, and that the market is disregarding a larger than expected BN victory. The downside is very real (consider situations (2) and (3)) , so your convictions must be strong enough to pull of this trade.


In other words, you must be willing to lose 5% to gain 15%.


Consider one of the many call warrants out there : FBMKLCI-C3V. Assuming that the current relationship between the breakeven point (1,862.50) and call warrant price (0.125) holds, these would be the call warrant's price given a market rally scenario, using today's price:


1) FBMKLCI gains 3%, based on current KLCI price of 1,828 (11:30AM, May 7) =  1,882.84
    Theoretical FBMKLCI-C3V price = 0.165*
    Potential upside = 32%


2) FBMKLCI gains 5%, based on current KLCI price of 1,828 (11:30AM, May 7) =  1,919.4
    Theoretical FBMKLCI-C3V price = 0.23*
    Potential upside = 84%



Note that these are for illustrative purposes only. But I believe they do help convey the potential magnitude of gains that are feasible from an immediate market catalyst, such as a post-election relief rally.  


To sum it up : investors' risk aversion may have caused the market to be undervalued right now. Once the election is done with, there is real cause of optimism on the state of the Malaysian economy (I'll go into PE ratios and GDP expectations on another day).


Still unsure of the KLCI's prospects? Take a hint from the banking stocks; these behemoths ultimately determine the market's direction due to their outsized influence in the index, of course.


Big names like Public Bank, Maybank and CIMB are already flirting with their all time highs in recent weeks. Some of them made record profits last year in spite of benign interest rates.What do you think will happen to their stock prices once all the uncertainties are over? 


Let's see what happens on May 10.


* This is purely based on the current relationship between the call warrant price and the KLCI's price. This link can fluctuate at any time, so approach with caution. The basic calculation is this: (1,882.84 - 1,800 (the call warrant's exercise price) / 500 (the exercise ratio) = 0.165
   















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