Our 2018E market earnings growth has been revised down to 4.7% from 8% previously largely to account for downgrades in the plantation and telco sectors. In 2Q18, the main drag was the Utilities sector although we think that the higher fuel cost and provisioning for Tenaga was a blip. All in, the larger caps continued to register better earnings quality and delivery compared to their smaller peers. Our Top Buys are revised to account for this, as we now prefer CIMB, KPJ and Globe over Scicom, Bermaz and Inari. We remain market Overweight and believe that the KLCI PE multiple can continue to rerate with the structurally positive government reforms. Our 2018 year-end target of 1,845 (based on 18.4x 2018E earnings) remains unchanged.

Larger Caps Still Performing Better

Large cap stocks under our coverage continued to deliver better earnings compared to their smaller peers. In 2Q18, of the 25 KLCI component companies under our coverage, 76% came in within expectations (72% in 1Q18); and of the total of 119 companies under coverage, the number of companies falling within expectations shrank to 44.1% (from 48.7% in 1Q18), those falling short of expectations widened to 42.4% (from 37.4% in 1Q18), while those exceeding expectations increased to 13.6% from 13% in 1Q18 although here the larger companies saw fewer positive surprises (4% vs. 8% in 1Q18). Suffice to say that the larger-capitalisation stocks continued to perform better but greater earnings disappointment from the rest resulted in our market earnings growth downgrade.

2Q18 Earnings Growth Slowed to +0.1% Yoy

While 2Q18 earnings growth remained positive at 0.1% on a yoy basis, the momentum has slowed from 1.4% in 1Q18. Again, while 10 of the 18 sectors under coverage showed growth, this was negated by the disappointment in other sectors. Our 2018 and 2019 market EPS growth forecasts are revised from 8% and 7.4% to 4.7% and 8.4% respectively. The largest earnings forecast cuts that materially impacted our growth forecast since our last strategy report on 28 June were in the telco (on competition, higher tax charges and regulatory impact) and plantation (on lower production and ASPs) sectors. Although we are cautious on both sectors, we remain Neutral given their size, trading liquidity and Shariah compliance status. We make smaller adjustments to our KLCI EPS forecast - our 2018E EPS growth rate has been lowered from 7.0% to 5.7%, highlighting the better earnings quality of the blue chips. Despite the negative earnings forecast revisions, the current 2018E KLCI EPS growth is still above the 3.8% yoy of 2017.

Sequentially, Utilities Was the Key Drag

Sequentially, while the 2Q18 earnings momentum was weak, impacted by a higher number of sectors compared to 1Q18, the key culprit for the 2.3% qoq decline in market earnings growth was the Utilities sector, in which 1) Tenaga saw a 21% qoq decline in earnings which was underpinned by higher IPP and fuel costs and a debt provision of RM170m, while 2) YTL reported a loss for the quarter. Nevertheless, Tenaga remains one of our Top picks for Malaysia.

More Rating Downgrades Than Upgrades in 2Q18

In 2Q18, we saw fewer rating upgrades (5 vs. 12 in 1Q18) but a higher number of rating downgrades (14 vs. 9 in 1Q18, please see Fig 8). The downgrades were largely in tandem with the earnings disappointment while positive earnings delivery (Pavilion REIT, SLP Resources and MCIL) and valuations (Astro and MISC) were the reasons behind our rating upgrades.

No Changes to Sector Positioning, Revision to Top BUY Calls

There are no changes to our sector positioning – we remain Overweight on 9 of the 18 sectors under coverage which include Banks & Financials, Gaming, Healthcare, Insurance, Rubber Products, Utilities, Auto & Auto Parts, Consumer, and Oil & Gas (Fig 17). However, we make some revisions to our Top Buy calls removing Inari, Scicom and Bermaz Auto, and replacing them with Globetronics (which is expected to see strong earnings delivery in 2H18), CIMB (on valuations and better earnings delivery from its Indonesia operations in 2H18) and KPJ Healthcare (on valuations - still trading at PE multiples below its 3-year mean). Our other large cap Top Buys include Maybank, Serba Dinamik, Tenaga, Kossan and Aeon Credit. In the small / mid-cap space, we also like Supermax and Aeon Co. (Fig 12).

Maintain Overweight and End-2018 KLCI Target of 1,845

Earnings delivery remains a sore point for the KLCI, although we think that there could be some upside in 3Q18 with the GST tax-free holiday. Longer term, we remain positive on corporate Malaysia with the new government in place, which we believe is gradually institutionalizing structural reforms that will be long-term positive – stimulating domestic demand (consumption spending) to ensure long-term economic growth. Near term, foreign equity outflows appear to have reduced significantly and stabilized (US$1.4bn in May 18 to US$23m in Aug 18). Foreign equity holdings have tapered to 23.5% in July 18 from its recent high of 24.2% in Mar 18, although this is still off the low of 22.3% in Feb 2017. In stark contrast to prior years, Malaysia has also better weathered the capital outflows from the region (US$2.1bn vs. US$21.3bn ytd for the Asia-6 markets), potentially based on renewed faith in the new government. We maintain our Overweight stance on the KLCI with a 2018 year-end target of 1,845 (based on 18.4x 2018E earnings).

Risks

Downside risks: i) global trade tensions and a disruption to global trade development; ii) a pick-up in inflation levels in the US and the Fed reacting by accelerating its interest rate cycle; iii) corporate earnings disappointment; iv) deterioration in Malaysia’s fiscal consolidation and sharp narrowing of current account surplus leading to a sovereign rating downgrade; and v) a spillover effect of a currency crisis in emerging markets.

Source: Affin Hwang Research - 4 Sept 2018