Earnings disappointment continued to extend into 3Q18 with earnings showing their sharpest rate of contraction since 1Q16 with Utilities, Plantation, Construction and Media being the key culprits. Post 3Q18, our revised 2018E market earnings growth is lowered to -0.6% from +4.7%. On a brighter note, most of the sectors with Overweight ratings continued to register earnings growth while stock rating upgrades in 3Q18 exceeded downgrades, possibly indicating that the KLIC has found its bottom. Maintain market Overweight and 2018 year-end target of 1,845.

Larger Proportion of Companies Disappointed

Earnings disappointment accelerated in 3Q18 with a higher number of companies delivering results that were below expectations (47.9% in 3Q18 vs 42.4% in 2Q18) (Fig 1). However, surprisingly there was also a higher number of companies with positive surprises (16% in 3Q18 vs 13.6% in 2Q18) largely from the Telco and Auto sectors, the latter being a key beneficiary from the GST tax holiday period. Notably, we did not see a similar improvement in the consumer retail space (Bonia and Aeon were subsequently downgraded) although the non-discretionary players such as Nestle and Ajinomoto did see better qoq performance. The negative earnings surprise was largely broad based, hitting heavy weight sectors like Plantations, Oil & Gas, Transport and Construction. Building Materials and Media also continued to disappoint.

…but Large Cap Stocks Still Performing Better

Large cap stocks continued to outperform their smaller peers in terms of earnings delivery. Of the KLCI component companies under coverage, 53.8% reported earnings that were in line with expectations (vs 36.1% for our entire coverage of 119 stocks). While this ratio was lower compared to 2Q18, what surprised us was the number of large cap companies that beat expectations this quarter (23.1% in 3Q18 vs 4% in 2Q18). This included Digi, Maxis, TM, RHB, MAHB and PChem.

Magnitude of Earnings Decline Was the Largest Since 1Q16

Because of the larger earnings disappointment, earnings momentum contracted both qoq and yoy. The 9.2% yoy and 5.1% qoq decline in 3Q18 core earnings was largely attributed to higher operating and staff costs at Tenaga and weaker plantation earnings due to higher production costs and lower CPO ASPs. The Construction and Transportation sector earnings were also impacted by slower progress billings especially as the government reviews ongoing contracts while higher fuel cost and lower load factors were a drag on the airlines’ performance.

More Downgrades, But a Few Notable Upgrades

Surprisingly, despite the weak results season, the number of stock rating downgrades declined to 13 in 3Q18 (from 14 in 2Q18) while rating upgrades increased to 11 (from 5 in 2Q18), possibly due to the pullback in stock prices in tandem with the weak KLCI performance. Rating downgrades were largely found in the larger cap names within Banks, Construction and Plantations. In our view, the notable rating upgrades for the quarter included RHB Bank (Buy from Hold), Ta Ann (Buy from Hold) and WTK (Buy from Sell) because of improving fundamentals while the rest were largely due to valuations, after stock-price pullbacks.

2018E Market EPS Growth in Negative Territory

On the whole, our market EPS growth estimates for 2018-2019 have slipped to -0.6% and +6.4% respectively compared to +4.7% and +8.4% (at our last 2Q18 roundup) with the Plantation, Utilities and Transportation sectors accounting for most of the downgrades. Sectors that continued to show growth include Auto, Banks, Gaming, Healthcare, Insurance, O&G, Rubber, MREIT and Consumer, where we have Overweight sector ratings, except for the latter two. Notably, the negative EPS growth for 2018E takes us back to the years of 2015-2016 when the market registered an EPS decline of 1.6% and 2.0% respectively. Nevetheless, while the broader market continues to see weaker earnings, the earnings momentum for the KLCI 30 companies is still positive and we are still projecting 2018-2019 EPS growth of 3.1% and 3.2% respectively.

No Changes to Sector Positioning, Revision to Top BUY Calls

There are no changes to our sector positioning – we remain Overweight on 8 of the 18 sectors under coverage, namely Banks & Financials, Gaming, Healthcare, Insurance, Rubber Products, Utilities, Auto & Auto Parts and Oil & Gas (Fig 17). We make no changes to our Top Buy calls which include Maybank, Serba Dinamik, UMW, Tenaga, Kossan, KPJ, Aeon Credit and QL Resources. In the small / mid-cap space, we like Globetronics and Supermax. (Fig 12). We remove Lafarge from our Top Sell list as its stock price has bottomed out, in our view. We replace it with AirAsia X which we think will likely underperform due to the high fuel cost and intense competition.

Maintain Market Overweight

The US-China trade war ceasefire should provide some near-term relief for the market and may overshadow any pessimism on the disappointing 3Q18 results season. Furthermore, with foreign capital outflows easing off since May 2018 and foreign equity holdings having reached a near-term trough, we think that the risk-reward is favourable. We remain positive on the market as we believe that the structural reforms would gradually enhance country fundamentals while the weak RM (vis-à-vis the US$) provides additional upside to capital returns. We maintain our Overweight rating and our 2018 year-end estimate for the KLCI of 1,845 (based on 18.4x 2018E KLCI EPS).

Risks

Downside risks: i) escalaton of 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 disappointments; iv) deterioration in Malaysia’s fiscal consolidation and sharp narrowing of the 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 Dec 2018