The M'sian X-Files - Intricacies Of The New FBM KLCI

There is a lot of new information that one can get on the new index, which will help us to understand the index and the markets better. It will also help to get a better grasp as to the "integrity of the FBM KLCI" when it rises and falls.

a) Its just 30 counters instead of the old KLCI which had 100 counters.

b) The new index addresses issues such as liquidity and free float, and let's face it funds in general are really looking at just the top 30... heck throw in another 20 stocks and that's their universe.

c) There is a good chance that the 30 stocks will start to be traded at a premium to the rest as these are the must haves for all indexed funds, by all the big and small local funds, and by most of the foreign fund managers managing Asian portfolio so as to not be under performing the Asian benchmarks.

d) Having said that, part of the rise in the FBM KLCI over the last 2 weeks may be attributed to some of these sustained 'enforced buying' activity rather than by genuine equity players.

e) The new index is a skewed index. Banks and plantations alone have a total weighting of 55%. If you have banks, plantations and telco = 63%. If you add banks, plantations, power, gaming and telco = 85%. So, technically a fund manager need only look seriously at these FIVE SECTORS alone to do well, forget about the rest.

f) The new index will also affect how research houses form their analyst teams. They must cover the 5 sectors, there are 9 sector that are not covered by the new index. It is very likely that analysts in the following sectors better start covering a more important sector in order to stay relevant. The following are the 9 sectors that are deemed as "irrelevant", "need not exist", "unimportant to the Malaysian economy", "unnecessary to look at in order to gauge the overall health of the economy": technology, transportation, property, timber, insurance, construction, building materials, hotels and industrial products. Go figure!

g) The new index will make it that much "easier" for the index to be controlled - conspiracy theorists will agree with me whole-heartedly that this is to allow PNB-EPF-MOF-EPU to control the index better. So, the next time we see a major market correction, we may be able to withstand it better with the new index as all it takes is to mop up the 30 stocks ... even though those stocks outside of the top 30 may be seeing their share prices tumbling like a rock. Managed perception more important la... than real effects to the economy. Hey, like that, we may never ever see a major correction in the FMB KLCI... ever... especially if we keep launching new big funds to mop these buggers up. But I am only guessing here.

h) Now let's consider the sin stocks, gaming and tobacco, they account for 12% of the new index. This is an important consideration as most of the big local funds will not be touching these stocks. Can you "not be in control of the 12% of the index" and still manage funds that is compared to the FBM KLCI benchmark? If these 12% of the new index starts a bull run on its own, most of the local funds will be under performing the new index. Can you all see a danger here??? Staring at you in the face!!! The danger is ... if there ever occurs a situation where you get the gaming and tobacco stocks to be in a strong bull run outperforming the rest of the new indexed stocks ... could we safely say that the EPU-MOF will not be strong-armed or "influenced" by certain parties to "whack down the sin stocks" with excessive punitive measures ( additional gaming and duties above and beyond what is normally expected in a financial year)???

g) If you take Khazanah, Petronas and PNB as the investing triumvirate ... the 3 already control 12 out of the 30 stocks in FBM KLCI. If you are a nasty anti-government critic, you have enough loose thoughts to take this factor to the next level. I am not saying its a negative or a positive, but its a fact that is worth remembering. Be careful, as the greater the influence one has, the greater the responsibility to be prudent, transparent and professional.

h) Though most fund managers will want to stick to the FBM 100 as the benchmark for their performance, it will not be so easy. The drivel, the propaganda and focus have all been set to make FBM KLCI the index to watch, and because it was kinda close to the level where the old KLCI was, most will tend to take to this new index. Its much harder if you switch from a 1,100 index level to a 9,500 one ... kudos to the planners.

i) Of course detractors will point to the fact that the venerated Dow Jones Industrial Index is only made up of 30 stocks, and is an often quoted barometer, even though most professional funds benchmark their performance to the broader S&P 500. The big difference is that it will be a hundred times easier to try to "manipulate" the FBM KLCI than the Dow Jones Industrial Index. Actually, pick just any two stocks in the Dow Jones, I am VERY SURE the market cap of any two stocks will be bigger than total market cap of ALL stocks listed on Bursa - in fact just any ONE stock in the top 10 of DJIA will be enough to cover the entire market cap of Bursa. Not to belittle FBM KLCI but to put things in perspective.

Can I have my Datukship now??!! (yea, I don't really need one or want one... but I want to get on and off my plane faster la...).


p/s photos: Yukie Nakama

The ONE PERCENT's Significance

In August consumer prices dropped 0.1% from the previous month. In September it was unchanged. The just released figure for October saw a 1% drop from September. This one percent month on month decline is very significant. Firstly, forget about inflation, we now have to seriously talk about deflation. We are only starting to see consumer prices feeling the effects of months of real estate price plunge and stock price decimation. A trend once established is hard to reverse. You people know how difficult prices take to come down. When it goes up, it goes up quickly.

When trade slows, when inventory builds up, consumer prices are very sticky in coming down. The fact that it did not just ease down is highly critical. One percent month on month decline has never been registered in the US, except during the Great Depression. Take a few seconds to reflect on that one percent now.

Proper tracking of consumer prices only started in 1947, and this one percent was the largest ever since tracking started. Deflation has many implications - the one percent decline shows how serious every sector is facing the crisis, it is felt in every sector basically. Consumers are delaying purchases in a deflationary environment. That's no good. The Fed is now setting its interest rate target at 1%, and there is a very good chance we could see zero interest rates before things turn around.

When I studied economics, zero inflation is not a good thing. It indicates that things are not moving, things are dying, industries will constrict, there will be cost cutting, there will be layoffs, there will be a great incentive to hoard and save.

The positive would be the one percent will cause the Fed to speed up spending policies. The Fed would be moved to lower rates faster than it need to. The Fed will have to pump liquidity into the system with more urgency.

Usually even in a downturn the consumer prices would be easing down month on month, not by the one percent we just saw. That indicates that the trend has just started and will see at least a few months of negative consumer prices month on month. That one percent will be enough to cause all commodities producers to drive down inventory, sell at all cost, even at losses, stop plants functioning, even if it means lowering capacity utilisation and incurring losses. 7,300 here we come. CPO prices, Rm1,200 here we come.

p/s photo: Grace Park

Opinion On CPO

CS view: The 1985 recession in Malaysia led to a 23% and 37% drop in new planting in 1986 and 1987. The 1998 recession and the sharp drop in palm oil prices in 1999 led to a 73% drop in new planting in 2000. Historical cycles for palm oil prices (trough-to-trough) lasted from 37 to 46 months. If history repeats itself, we should be close to the trough for palm oil prices, as the current cycle is in its 44th month. CS assumed that palm oil prices will average RM1,400 for the rest of the year (FY2008 - RM2000) while FY09 forecast RM2,250 and RM2500 for FY10.

Macq view: Our expectations of improvement in the stock-to-usage ratio of edible oils as well as strong CPO production growth in Indonesia in the coming years, we believe that CPO prices will continue to decline over the next two years, as the market increasingly factors in the strong supply outlook. Long term price for palm oil at about US$400/t or RM1,400/ton

JPM view: CPO prices traded at a trough level of M$660/t (US$190/t) historically since 1996 to mid-2006. However, higher cost of production currently we believe will likely help keep CPO prices above the historical trough level. we see a floor in CPO prices at the M$1,500/t level (US$440/t). This is close to the long-term 10-year average CPO price stripping out the bio-diesel impact of the past two years, and is also close we believe to the production cost per ton for the marginal CPO player.

UBS view: CPO price assumption for 2009 US$450/t, 2010 US$480, 2011 US$510, long-term CPO price assumption lower from US$740/t to US$570/t.

Production

CS view: Slower production growth due to cutback in expansion plans, tree stress due to higher fertilizer cost.

Macq view: We expect Malaysian production to stagnate at 17.6m tonnes next year due to a decline in the yield cycle. For Indonesia, we expect a jump of 2mt; we also expect world production to increase by ~2.4mt. Further, if we assume consumption growth will slow to 2.5mt (vs 3.8mt previously) due mainly to the slowdown in biodiesel and oleochemical usage, we expect the stocks-to-usage ratio to potentially rise from last year's level. Post 2008, we expect CPO production growth to slow in 2008–09 to 2.4mt from 4.9mt in 2007–08 due to expected biological stress cycle on the trees after a record production year. Other industry sources such as Oil World expects palm oil production growth to slow to as little as 2mt next year.

JPM view: Oil World is forecasting global supply growth to moderate from 13% in 2008E to 6% in 2009E, just slightly below demand growth of 7% estimated for next year.

UBS view: Inventory remains persistently high because of weaker demand—we think demand will continue weak and therefore it will take longer for inventory to clear.

Demand

CS view: Global edible oils consumption has never contracted, even during global recessions, but the growth rate is normally lower than during boom times. Demand for edible oils increased by 2 mn to 4 mn tonnes per annum (t.p.a.) between 1980 and 2004. Between 2005 and 2008, edible oil demand grew 6 mn to 8 mn t.p.a., boosted by rising demand for biodiesel.

Macq view: The USDA data for the past 30 years indicate that on average, there is fairly stable consumption in food items such as coffee and palm oil in volume terms. Consumption of palm oil has grown on average by 9%, soy oil by 5% and produce such as coffee by 2% pa for the past 30 years. Even during periods of weak economic conditions, contraction in volumes, if any, is small.

JPM view: Based on Oil World''s forecast, global palm oil demand growth is forecast to moderate from 10% in 2008E to 7% in 2009E, During the previous Asian crisis in 1998, global demand growth for palm oil still rose, but at a much slower rate of 3%.

UBS view: The significant cut in our assumptions is based on new lower global GDP growth and crude oil forecasts made by UBS on 30 October 2008. UBS's crude oil forecast for 2009 was lowered from US$105/barrel to US$60/barrel, a cut of 43% compared with our CPO price assumption cut of 31%. UBS also lowered global GDP growth from 2.2% to 1.3%.

Comments: If you look at too many indicators, you would end up being confused. Best to isolate a few that really matters. Predicting a price for CPO for the next 12 months is difficult and largely a moving target. On the way up, CPO price had a high correlation to oil price jumps - there is a strong involvement by hedge funds and commodity funds in ramping up long positions in all soft and hard commodities. On the way down, it looks like a positive correlation as well but that isn't really true because its a de-leveraging process. I believe oil price and CPO have decoupled and now trades on purer fundamentals of supply and demand. CPO price may see some volatility as producing nations try to bolster the supply-demand equation with new regulations.

To spot good entry levels, we need to monitor the monthly inventory levels. As at end Sep 08 the inventory was at a historic high of 2m tonnes, with a similar situation in Indonesia. Octo and Nov should see inventory rising further to 2.2m tonnes. Hence there is NO HURRY to go long on CPO stocks, you can and should trade them but not buy and hold yet. CPO should only start a genuine recovery trend when inventory reaches around 1.6m tonnes. As it gets closer to that level, you can start buying. Hence we may very well see RM1,300-1,400 for CPO as the bottom of the barrel.

The present discount gap between soy oil and CPO was at a staggering US$300, far from the average US$100 per tonne. Watch the spread closely, if it starts going below US$200, that is a sure sign that genuine buying has resumed. Right now end users are keeping a low buying inventory as they expect demand to be uncertain and CPO prices volatile with a downside bias. They can only keep a low inventory for so long.

The measure to blend 5% of palm biodiesel with diesel is a good move but MUST be properly thought out. The move is good because it takes 500,000 tonnes of CPO a year. It would be bad if its not a permanent strategy as that would hurt the biodiesel industry again. Has the government given sufficient consideration if CPO price were to be at RM3,000 again, would the 5% still make sense. Theoretically it should as with CPO at RM3,000, the price of oil should also be higher, maybe at US$110. But, what IF CPO price were to hit RM3,000 and oil stays at US$70... does it still make sense. If its to be a good long term strategy, I would make the ruling permanent. Stress test it with various combinations of both prices, and stick to it through thick and thin. Only then can investors and entrepreneurs invest properly into a viable and sustainable biodiesel industry, and valuations be properly accorded. Implement and then take away is not sound for business. Having said that, the policy will only take effect in 1Q2010, which will not play any part in the demand supply equation for the next 12 months.

I expect a high low of RM1,900-1,300 for the next 12 months, with a higher bias further down the road, and a bias towards the low end in the short term. That being the case, its pointless to look at P/BV or ROE. Just look at CAGR, PER and dividend yield going forward. Under those measures, the Malaysian CPO firms are not attractive compared to regional players in Singapore and Indonesia. Astra Agro and Golden Agri both looked much more attractive. Best among the locals are IOI Corp and Hap Seng Plantations.

p/s photo: Elanne Kong