- In our previous report issued on 8 July 2015 (Rising risk of a PE reversion to the mean) where we cut our end-2015 fair value for the FBM KLCI to 1,650, we pointed out that the market’s PE would revert to the mean, because external liquidity conditions may no longer be supportive of high valuations as the passage of time to a hike in the US Fed Fund rate would narrow in 2H2015. There were also no improvements in the earnings momentum, to take over from liquidity as the next share price driver. Although the market has since corrected from its early August’s high of 1,745 to a low of 1,532 towards end-August, the Fed’s inaction led to a rebound off the lows to 1,665 currently, despite sustained foreign selling for the most part of 2H2015.

- We believe that the market had already navigated the valuation reversion to the mean. At current levels, the market is trading on a PE of 15x based on 2016 earnings. This is at parity to its average one-year forward PE band. As we move into 2016, the fundamental issue is whether EPS downgrades would bottom, forming a base for an earnings-driven re-rating to take place. Earnings visibility is still weak to pinpoint with conviction the trough in the extended negative revision cycle. But on the flipside, expectations are more muted than before. Consensus is now expecting 2015’s earnings to contract by a more significant 5% compared to 1% previously. A low base surely makes year-on-year comparison easier with consensus expecting earnings growth of 8% in 2016 (AmResearch: 8.6%)

- We are raising our end-2016’s fair value for the FBM KLCI from 1,750 to 1,800 by tweaking our fair value PE to 16.8x – at one standard deviation above its mean of 15.5x. Our revised fair value of 1,800 implies a potential upside of 8% from the current level of 1,665. The prolonged negative earnings revision cycle is still a concern considering the downbeat guidance on sales and margins from corporates. Nonetheless, we are unmoved. The market may trade higher in 2016 because of a likely decline in perceived risk premium. We believe that risk appetite may return ahead of a positive inflexion in the earnings cycle. We put forth three reasons;

- First, progress on the restructuring of1MDB debts. The recent sale of 1MDB’s entire ownership of power assets held under Edra Global Energy to China General Nuclear Power Corp for RM9.8bil is a positive starting move. 1MDB also announced that it had narrowed down the final two binding bids for a stake in its massive Bandar Malaysia development, which is earmarked to house the main station for the high speed rail project between Malaysia and Singapore. The successful sale of Bandar Malaysia would lift risk appetite, we believe.

- Second, ringgit/US$ has rebounded off its low of 4.45 in September 2015 to 4.24 currently. AmResearch’s economist is projecting ringgit at 4.16 against the US$ by end-2016. Consensus is now more mixed on the direction of the oil price compared to the bearish stance a year ago. The government is projecting an average oil price of US$48/barrel in 2016 (currently: US$45/barrel).

- Third, domestic institutional funds are already cashed up, while foreign ownership is low (October 2015: 22.2% - not far from its eight-year trough of 20.9% in December 2009). Bearish consensus stance on the market has historically skewed the risk/reward profile to the upside, from the removal of overhanging concerns particularly when valuations are depressed. At some point, the domestic unit trust funds would need to redeploy capital as the market recovery gains traction. Furthermore, a positive incremental shift in foreign sentiment off a low base would also underpin the market.

- The economy appears to be more resilient than feared. We are forecasting GDP growth of 4.6% for 2016. We expect domestic demand growth to be supported by the private sector spending. Private sector investment is expected to lead the momentum of investment growth going forward. Current account is likely to maintain a surplus in 2016, albeit at a slower pace. As a ratio to GDP, current account surpluses may narrow to 1.5% in 2016 as the healthy net trades are offset by the outflows in the services and incomes accounts, but we do not expect a reversal from surplus to deficit.

- We have made some tactical changes in our sector strategy to reflect our view of a return in risk appetite ahead of a positive turn in the earnings revision cycle. We downgraded the gloves sector to Neutral on valuation grounds: PE multiples are more than two standard deviations above the mean and with a stabilising ringgit, the kicker from currency is priced-in. We initiated coverage on the technology sector with BUY ratings on Inari and MPI, but we prefer the former because of its superior growth prospects from optimising its capacity expansion towards its high-margin RF products. It is also a key beneficiary to new outsourcing contracts from key client Avago, which is spending a massive USD37bil for the acquisition of the US-based wireless chipmaker Broadcom.

- We continue to advocate accumulating deep value property stocks with strong balance sheets and good landbank. At an average discount of close to 50% to NAVs, valuations have troughed. We are Overweight on construction given the strong newsflow momentum surrounding the massive transportation projects in 2016. Thematically, the Sarawak-linked stocks may see renewed buying interest in the run up to the state elections. We are Overweight on the plantation sector, with CPO price to be boosted by a shortfall in production due to erratic weather patterns. We are selective on the oil & gas and telco sectors; with BUY on MISC and Axiata. We are Neutral on the banks. Tenaga is a BUY.

Source: AmeSecurities Research - 1 Dec 2015