While there was generally less discontent and more companies reported 3Q19 earnings that were above expectations, the earnings revision trend remained negative, however, dragged by large cap disappointments led by the O&G, Telco and Aviation sectors. The KLCI is likely to register its second consecutive year of EPS decline with a 2019E EPS decline of 1.3%. This, along with limited re-rating catalysts, has contributed to capital outflows and the KLCI’s ytd performance. Nevertheless, downside should be limited by ample domestic liquidity and a current dividend yield of 3.6%. We remain Neutral. As for stock picks, we remove Takaful and Pintaras, and add KL Kepong and Top Glove, to our Top-10 country-pick list.

Earnings in 5th Consecutive Quarter of Decline in 3Q19

Earnings disappointment continued into 3Q19 as corporate earnings for the quarter fell 4.9% yoy, its fifth consecutive quarter of decline. 3Q19 corporate earnings declined by an absolute RM861m yoy (Fig 6) with the drag coming mainly from O&G (-RM714m), Telco (-RM235m), Gaming (-RM189m) and Transport (-RM140m). This was, however, partially mitigated by Utilities (+RM190m), Banks (+RM147m), Media (+RM112m) and Auto (+RM91m). On the whole, except for Construction, our other sector Overweights (EMS, Healthcare, Insurance and MREITS) delivered healthy earnings.

Sector Performance Was a Mixed Bag

Broadly, except for the Gaming (Above) Construction (Below), and Rubber product (Below) sectors, no particular sector showed a significant positive/negative trend, i.e. companies reported results that were mostly a mixed bag with some above expectations while others were below expectations. Contractors’ earnings continued to be pushed back due to slow progress billings on existing projects and delays in winning new contracts. For the gaming sector, despite the weaker earnings (-16% yoy), results were above expectations due to a higher hold percentage in the VIP segment while for the Rubber products, results were generally weak due to higher production costs and labour shortages, which capped productivity.

Companies That Surprised Were Largely Small-mid Caps

Notwithstanding the weaker overall corporate earnings, we saw a higher number of companies that surprised positively (21.8% in 3Q19 vs 16.1% in 2Q19) and fewer companies that disappointed (36.1% in 3Q19 vs 42.4% in 2Q19) (Fig 1). Except for the Genting group, Sime Darby and Malaysia Airports, those that exceeded expectations were in the smallmid cap space (Fig 10), potentially explaining the outperformance of the latter vs the large caps and FBM KLCI stocks.

However, More Rating Upgrades in 3Q19

Surprisingly, there were also more rating upgrades in 3Q19 (9 vs 4 in 2Q19), although again mostly for smaller caps (Fig 9). Broadly, we made across-the-board earnings upgrades for Plantations as we upped our 2020-21E CPO price assumptions to RM2,500-2,600/MT (from RM2,300- 2,500/MT previously) on the back of likely tighter palm-oil supply and higher demand, and some rating upgrades (KL Kepong and Jaya Tiasa).

Notably, Velesto’s upgrade was accompanied by an earnings upgrade on likely better rig utilisation, while that for Astro was on likely lower operating costs. Apex Healthcare is also seeing an operational turnaround at its new oral solid facility which is aiding group profitability while we think that Scicom’s earnings has troughed with improvements at both its e-Solutions and BPO segments. PCHEM and RHB Bank were amongst the larger caps that saw rating downgrades, largely on likely weaker earnings performance and on valuation grounds respectively.

KLCI EPS Likely to See a Second Consecutive Year of Decline

Post the 3Q19 earnings revisions, we still expect a negative market earnings growth trend for 2019E at -0.1%, but improvement for 2020E at +7.6% (from +2.6% and +6.4% previously). For the KLCI companies, we see growth of -1.3% and +3.7% for 2019-20E (from +0.2% and +4.4% previously). Thus, we expect a second consecutive year of EPS decline for KLCI companies in 2019 (barring any positive earnings surprises in 4Q19). The weak earnings momentum has most likely contributed to the lower dividend payout ratio (Fig 4), which has been a consistent trend in 2019 ytd.

KL Kepong and Top Glove Added to Top Buys

We include KL Kepong and Top Glove, the respective top sector picks, into our Top 10 Buys (removing Syarikat Takaful and Pintaras Jaya). KL Kepong is preferred for a play on improving fundamentals in the Plantations space. In our view, its CY20E PER of 28.4x is at an unwarranted 28% discount to that of large cap peers (IOICorp, Sime Plantations Genting Plantation). Top Glove’s stock price has underperformed significantly in the year to date, but we believe that prospects are improving as latex glove demand normalises after the tariff on China gloves imported into the US. We also expect ASP erosion to ease while the labour shortage issue is gradually being addressed.

Maintain Neutral on KLCI

With continued earnings disappointment and a lack of re-rating catalysts, there has been continual capital outflows from the equity market, amounting to RM9.4bn in the year to date (2018: -RM11.7bn). Correspondingly, foreign equity shareholdings have slipped from its recent high of 24.2% in Mar 2018 to 22.7% as at Oct 2019, largely explaining the KLCI’s sharp ytd underperformance against regional and global markets. However, barring any sharp selldown in global equity markets over the near term, we do not envisage a sharp downside for the KLCI, which is supported by ample domestic liquidity and the current dividend yield of 3.6%. We make no change to our 2019 KLCI year-end target of 1650 (based on 18x 2019E market EPS).

Risks

Upside/downside risks to our view include:

i) Continued trade tensions between the US and China, leading to severe disruption in global economic growth. Any easing of the trade tensions would be an upside risk.

ii) A pick-up in inflation in the US, and the Fed reacting by accelerating the interest-rate cycle, which could lead to higherthan-expected outflows of funds from EMs and the region.

iii) Corporate earnings disappointments/improvements. The KLCI has de-rated partially due to earnings disappointments.

iv) The government undertaking contractionary fiscal measures that negatively impact Malaysia’s GDP growth, leading to a sovereign rating downgrade.

v) The government successfully executing reforms that significantly improve its fiscal position, enhancing the country’s investment appeal and thus encouraging foreign equity inflows.

vi) Geopolitical tensions arising from North Korea or the Middle East disrupting financial markets; and

vii) A further selldown in the domestic bond market, which could also have an adverse impact on the RM. Foreigners held 12.7% of the bond market as at October 2019, vs. 13.3% in December 2018.

Source: Affin Hwang Research - 3 Dec 2019