Earnings growth, higher multiples to lift stocks, says Morgan Stanley's Garner

AS the results of the US presidential elections pour in confirming the victory of President Barack Obama over his Republican rival Mitt Romney, Jonathan Garner, veteran Asia and emerging markets strategist for US investment bank Morgan Stanley, sits in a hotel lounge in Singapore insisting that the results are unlikely to change his view of the world.

"China's business cycle is much more important for Asian equities than the US elections," he declares. "A lot of the foreign money is coming back into the region and driving Asian currencies up." That, he says, is what long-term Asian investors need to focus on right now rather than headlines about the looming fiscal cliff or the recession in Europe.

To be sure, Asian equities have had a fairly good year. The MSCI Asia Pacific ex-Japan Index is up 16% over the past 12 months in US dollar terms. That compares with developed market equities that are up 12% or so in the same period. For the region, the past 12 months have been better than average because, historically, the average annual returns, including dividends, of the MSCI Asian Index are about 10%.

"Asian equities are still relatively cheap on long-run valuation metrics, notes Garner. "We are trading about 1.6 times price-to-book in Asia, when the long-run average is more like 1.9 times." The story with Asian markets last year was that, even as earnings grew slightly, there was a big contraction in multiples as investors saw increasing headwinds.

Garner believes there is a good chance that Asian equities could give investors returns of up to 25% next year. Morgan Stanley is looking at earnings growth of 15%, with the rest of the upside coming from multiple expansion. "If we get further multiple expansion and earnings growth next year, then we can have a rather nice year, like 2005 or 2006, when we saw multiple expansion and earnings growth."

What might drive that? "We believe there is more of a chance for a multiple expansion in sectors that have had negative earnings growth this year like energy and materials such as steel, cement," he says. Continued gains in the consumer cyclicals as well as telecoms and an upside surprise in financials are likely to help drive Asian multiples higher.

The way Garner sees it, the recovery of intra-Asia trade over the last few months has been a key bullish signal for him. "We have seen upside surprises not just for China but also in [South] Korea and Taiwan," he says. "After seven quarters of deceleration, we are now starting to see some green shoots."

What markets will do well over the next 12 months? Garner's top picks for 2013 outperformance are China, Indonesia, Malaysia and South Korea, based on current valuations and expected earnings growth. He has marked Thailand and tech-heavy Taiwan down as the likely underperformers. "Earnings numbers for 3Q in Taiwan disappointed, and the tech hardware sector is likely to be softer" over the next year, he says. Moreover, Taiwan's return on equit (ROE) has been structurally deteriorating over the current cycle, he notes. "Tech business models are quite challenged by labour-cost increases and the whole industry is increasingly structured around mobile devices like tablets and smartphones," he says.

Increasingly, it is branded players such as Apple Inc that have the pricing power. While Thai equities did fairly well in the aftermath of the floods and the rebuilding effort earlier this year, the market is unlikely to match the performance of the past year. "We are still very concerned about the political risk in Thailand, much more so than in Malaysia or Indonesia," he says.

He would rather have a larger exposure to South Korean equities, where players such as Samsung Electronics and Hyundai Motor Co are growing their share of the global market. "Corporate Korea has generally been gaining market share relative to their Japanese peers," he notes. "The yen's strength and, more recently, Chinese consumer boycott of the Japanese really play to Korea's strength."

September auto sales numbers in China turned up upside surprises for South Korean autos and downside surprises for Japanese autos. "Korean companies have done well not just because of a favourable won/yen rate but also through innovation, building brands and genuine technological leadership in many industries," he says.

Garner is also fairly bullish on Indonesia, where he sees relatively robust earnings growth. "While we have some issues around its current account, Indonesia was the only market in Asia in which earnings actually beat estimates in the last quarter," he says. "We like Indonesian banks, cement names and telecom companies." Indonesian banks give investors a bigger and better exposure to the overall economic growth story, adds Garner, who believes the country's coal sector might be due for a rebound. "Coal hasn't rebounded off its lows the way iron ore or copper has, but I believe coal, particularly thermal coal, might do better next year," he observes. "There have been early signs we might see extremely cold winter in Europe, even in China" and that, he says, augurs well for coal prices and the beaten-down coal sector.

Garner also likes Malaysia, which he says has a strong sovereign balance sheet and a currency that is likely to strengthen. "You are not getting there the sort of GDP growth or earnings growth that you get in Indonesia, but valuations are still reasonable," he says. A big plus for him is the supply-demand balance in the equity market. "There are now lots of pension funds and local institutions that are buying," he notes.

Moreover, Malaysia emerged as the IPO capital of the world this year, as new listings were delayed in other larger markets such as Hong Kong and New York, with several large listings that helped add more depth to the market. Also, early next year, Malaysia goes to the polls and, later in the year, Indonesia enters its own election cycle and, normally, elections are a plus for equity markets in the region, he says.

Morgan Stanley also likes China, where Garner sees a strong structural recovery underway. "We upgraded Chinese banks to 'overweight' about four months ago and that's been a good call," he says. His top sector pick Industrial and Commercial Bank of China (ICBC).

The trailing price-to-earnings ratio for Asia is now about 13.5 times. That is due partly to beaten-down equities in China, but the question is: Should China be so cheap at this point in the cycle? The dividend yield on stocks in the MSCI China Index is more than 3.5%, which is more than double the risk-free rate in the US. Chinese shares are trading at 10 times trailing earnings, or 9.5 times next year's earnings. China A-shares in Shanghai are about 11 times this year's earnings.

One of Garner's major cyclical calls is the capital goods sector in China. Many of the companies in the sector had a bad year, but he says that, with government investment projects picking up, they should do a lot better next year.

"We think more pro-growth cyclical sectors will do better in Asia next year, so we are very light on things like telecom, utilities, healthcare, consumer staples or the kinds of sectors you should get into when growth is peaking."

In China, Morgan Stanley is also "overweight" the real estate sector. "It was very controversial when we did that nearly a year ago," he recalls. Indeed, he has been fairly bullish on key real estate names in Asia that are trading on substantial discounts to net asset values (NAVs). "In Hong Kong and Singapore, dividend yield on some of the real estate stocks is substantial," he notes. "In this environment of a weak US dollar and large capital inflows pouring into the region, the real estate sector is a straightforward way of playing the re-rating of Asia."

Hong Kong property giant Cheun Kong (Holdings) is on Morgan Stanley's "Focus List" of top stock picks. "It's not as cheap as it was but it is still very reasonably priced," Garner says of billionaire Li Ka-shing's flagship.

Morgan Stanley remains neutral on India for now. "We were underweight India for over 18 months but went to 'equal weight' five months ago when the rupee got to 60 to a dollar and the market just looked oversold to us," recalls Garner. Since then, India has moved to re-accelerat its reform agenda. A favourite secto of his right now is software and ser­vices, which has quality global names such as Infosys.

What might go wrong? Garner says investors should watch out for any signs of a deceleration in China or a stronger US dollar, which he believes would be bad for Asian equities. Moreover, he argues that inflation could rear its head again in the region if money keeps pouring into Asia, pushing up asset prices.

"Two years ago, the story was Asia overheating," he says. "We were worried about the consequences of monetary tightening in Asia and slower growth. Over the last two years, we have had seven quarters of deceleration in Asia."

Now, with inflation under control, that cycle can turn again. "We might not see the sort of growth we had in 2005 through to 2007, but we will probably see stronger growth than we have in recent years," says Garner.

Morgan Stanley's big picks for the 12-month cycle include Indonesian stocks such as PT Bank Rakyat Indonesia and PT Indocement Tunggal Prakasa, Malaysian regional cellular play Axiata Group, Hong Kong-listed Chinese property firm Country Garden Holdings and Macau casino play SJM Holdings.

Although Garner still has Samsung Electronics, which has nearly doubled since its lows in October last year, on his Focus List, he concedes tech is one area in which things may not turn out as planned next year. "Two back-to-back stellar growth years for the tech sector may be very demanding," he says. All in all, 2013 might well turn out to be another good year for Asian equities.

This story first appeared in The Edge Singapore weekly edition of Nov 12-18, 2012.


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