Monday, June 26, 2017

Indonesian Financials Offer Significant Value

Why do we like Indonesia?

We are bullish on Indonesia.  

With 263 Million people, Indonesia is the fourth most populated country in the world. Demographics are positive, with median age at 28 years and fertility rate of 2.5 (This compares with China, with median age at 37 years and a fertility rate of 1.5).

A commodity slump in 2014 and 2015 led to the closure of thousands of small mines. The GDP growth fell down to 4.8% in 2015, from a high of 6.2% in 2011. Financial markets wobbled and Rupiah depreciated by 10% against US$ in 2015. It was a quick reminder to the investors of what has been all along the classic vulnerability of the country: its reliance on external capital. Any external shock results in this capital being withdrawn. Weakness of its institutions and related policy effectiveness has been another related concern.

However, the response in the face of 2015 crisis enhanced our confidence in the country: despite weakness in commodity prices affecting the government revenue, they were persistent in reining in costs, and maintaining a fiscal discipline. Measures include a cut in Jokowi's pet infrastructure spending plans, continued roll back of fuel subsidies, revision in electricity prices despite economic weakness, and a resistance to cut gas prices for the industries. Stability in the currency took priority over focus on growth. The fiscal and monetary policy worked in sync. Current account deficit fell from 3.2% of GDP in 2013 to 1.8% of GDP in 2016, and likely to be even lower in 2017. Rating agencies have rewarded that fiscal discipline with an upgrade. Moody's, which already had an investment grade rating for Indonesia, upgraded its outlook to positive in February this year, and S&P upgraded the rating to investment grade in May.

We have progressively increased our holdings in Indonesia all of 2016, when it replaced Thailand as our biggest ASEAN market. By May 2017, Indonesia formed 22% of our portfolio, surpassing Hong Kong/China, and our weighing there continues to increase. I am a bottom-up stock-picker. Macro, for me, plays a second fiddle at best over compelling company fundamentals - therefore, the fact that we have 22% of our fund in Indonesia is a mere outcome of the ideas we find there versus other markets.

What do we like in Indonesia? 

We believe that the financials sector in Indonesia is a bargain.

Outside the big four banks, the rest of the sector trades at or below book. The Non-Performing Loans (NPLs) are elevated, but we believe they peaked in Q1 2017 and are on the way to a mend. Banks in Indonesia are well-capitalized, NIMs are better than most other places in the world, and relatively sticky. Our holding includes one such smaller cap bank stock.

Even the insurance companies there trade at book. We have to admit that some of this low multiple could be because of smaller size and lower liquidity of the stocks, but that does not bother us. Penetration levels in insurance are among the lowest in the world, and we like the long runway that presents for growth. We own one insurance stock.

However, the best value we find is in the non-bank financial companies. These companies are mainly in the consumer financing, where the yields are high. Consumer lending in Indonesia went out of control in the post-GFC boom periods in 2011 and 2012. NPLs spiked, the regulator stepped in with control measures, and the loan growth suffered. But the sector has been on mend since the last three years. NPLs are under control now, and loan growth has returned. This sector will be one of the biggest beneficiaries of a sovereign ratings upgrade, due to its reliance on wholesale funding. Funding costs are coming down, and yields are lagging that, so NIMs and profitability are expanding. If we think that the banks are well-capitalized, then the finance companies are super well-capitalized. For our two holdings this sub-sector, capital adequacy runs in the mid-20% range, and yet their ROEs are over 20%. They trade close to book, at single digit PEs, and offer dividend yields reaching 10%.

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