Indonesia Market Strategy With a 9% drop, we recommend focusing on valuations - Credit Suisse

● On YTD basis, JCI has dropped 9% (11% from its peak), driven by, in our view: 1) technical factors – strong outperformance, BMRI’s rights issue, PT Garuda IPO, 2) inflation fears, and to a lesser extent 3) valuations. The market is now trading at 13.0x FY11E P/E, which is at a 15% discount to its 1992-97 average.
● Our ten-year bond yield has sharply risen to a ten-month high of 9.2% (from 7.5%). However, based on our analysis of the spread between bond and earnings yield, the spread is now back to its seven-year average and does not yet suggest a buying signal.
● In line with our call in the past three months and on YTD basis, the biggest underperforming sectors are cement (-16%), consumer (- 11%), and automotive (-10%), while the coal-related sector has been the biggest outperformer (+22%). We started to see some valuations of these domestic sectors getting attractive.
● Top six companies with P/E below the market (13.0x), strong management and balance sheets are Astra International, BMRI, BBRI, SMGR, TLKM, ITMG, and INDF

Key reasons behind the recent sell-off
After being one of the best performing markets in 2010, Indonesia’s JCI market has performed poorly so far this year, dropping 9% on a YTD basis and 11% from its peak due to, in our view, the three following reasons:
• Technical factors: Given the strong outperformance in 2010, we believe that Indonesia is vulnerable to any sell-off and redemptions both locally and regionally. In addition, the roughly US$1.2-1.5 bn rights issue of BMRI and the IPO of PT Garuda Indonesia, the country’s largest aviation company, added some pressure as well.
• Inflation fears and BI’s policy rate: While inflation fears have fuelled the sell-off in the market, we also believe that the decision from BI to maintain policy rate put Indonesia into negative real interest rates, making it slightly less attractive.
• Valuations: Based on our regional strategist Shakti Siva’s PBR-to-RoE model, Indonesia has fallen from being the second most expensive market (40% premium) to currently 7% premium to the region. On P/E basis, the Indonesia market is trading at 13.0x P/E vs an average of 15.3x P/E during the pre-financial crisis period of
1992-97.

Spread between bond yield and earnings yield does not suggest a buying signal yet
Due to the fear on inflation and sell-off in the bond market, Indonesia’s ten-year government bond has soared to the ten-month high of 9.2% from the low of 7.5% at the end of November 2008. The current spread between the ten-year government bonds and earnings yields is 1.3%, which is close to its long-term average of 1.5%. Based on our analysis on the spread, we found that the strong buying signal is when
the spread narrows close to zero (-1 standard deviation).

While the selling pressure in both bond and equity would put pressure on the ten-year bond, we do not believe that the bond yield will react a crisis-like periods of October 2008 (17.5%) and November 2005 (14.5%), especially given our view that Indonesia’s potential to be upgraded into investment grade is still on track over the next 12-18 months.

Recommendations: Reduce coal, add domestic sectors
Since we put out our strategy note back in 18 November 2010, entitled Re-rating continues, our Overweight call in coal and less on domestic stocks have done relatively well. In the past three months and on YTD basis, the biggest underperformers are cement (-16%), consumer (- 11%) and automotive (-10%) while metals and mining (largely coal)has been the biggest outperformer (+22%).

We therefore believe that some of the key stocks in the underperforming sectors are getting attractive from valuations standpoint. Based on our top 20 liquid names, Figure 3 shows the key stocks which trades below the market (13.0x) but have strong
management and balance sheet. They are BMRI, BBRI, SMGR, TLKM, ITMG, and INDF.