Eye on the long term: While the markets are vulnerable to shifts in global risk appetite, the fundamentals supporting growth remain strong

Over the past decade, Indonesia’s capital markets have gone from strength to strength, buoyed by the commodities super-cycle, sustained economic growth and a resilient domestic consumption story. Long dominated by foreign institutional investment, they remain vulnerable to shifts in global emerging market risk appetite. “We are still in the structural bull market that started in 2003,” Erwan Teguh, CIMB Securities’ head of research, told OBG. “Despite externally induced corrections in 2008, 2011 and 2013, investors still seem to believe in the fundamental Indonesian growth story.” Domestic participation has also grown steadily, although it remains dominated by institutional investors. A diversified equities portfolio has allowed growth to rebalance away from natural resources towards domestic-consumption-related stocks, with a steady stream of initial public offerings (IPOs). While new instruments have been slow to emerge, reform of the market infrastructure is ongoing amidst the 2013 downturn.

Growth

At its peak of over Rp5000trn ($500bn) in May 2013, the market accounted for roughly 60% of 2012 GDP – the region’s second-lowest, trailing Singapore’s 224%, Malaysia’s 151%, Thailand’s 102% and the Philippines’ 93% in 2012, but high by historical standards of 50% in 2010, 45% in 2011 and 48% in 2012, according to Indonesian Stock Exchange (IDX) data. The Jakarta Composite Index (JCI) rebounded strongly from its October 2008 trough of 1111 points to reach a May 2013 peak of 5214. The index’s year-on-year ( yo-y) growth cooled somewhat from 86.98% in 2009 and 46.13% in 2010 to 3.2% in 2011 and 12.94% in 2012. Growth has been driven by the steady expansion of share offerings, which rose from 396 in 2008 to 479 by the end of September 2013, and higher share trading that went from an average of 1.81bn shares worth $204m daily in 2006 to 5.8bn shares worth $664m in the first three quarters of 2013. Trading remains concentrated in blue-chip stocks, with the top 20 most-traded equities accounting for 49.35% of the total and 57.4% of market capitalisation in the year to October 2013, according to IDX. Indonesia’s market has been one of the region’s most consistent and strongest performers since 2003, according to Credit Suisse, with four years when the equity market exceeded 45% growth.

Make-Up

The market is dominated by financial sector stocks, which made up 23.4% of market capitalisation in September 2013, followed by consumer goods (20.9%); infrastructure, transport and utilities (13.5%); and trade and services (11.8%). This was not always the case, however, as declining global commodity prices caused mining, energy and agriculture stocks, which were the key growth drivers in the four years to 2012, to slump. “What is unique about the Indonesian market is its diversified offerings, since growth shifted from natural resources to consumer-related stocks and the market kept growing,” Poltak Hotradero, head of research at IDX, told OBG. Agriculture and mining stocks were the worst performers in the year to June 2013, according to IDX, slumping 48.59% and 36.56%, respectively, while property and construction grew 44.45% and basic industry and chemicals were up 41.33%. Trade, services and consumer goods rose by a more moderate 12% and 10.59%, respectively, while finance and infrastructure and transport stocks grew 4.76% and 4.7%.

Infrastructure

The exchange in its present form dates back to the 1987 deregulation encouraging companies to float and foreign portfolio investors (FPI) to participate, while the IDX was born from the merger of the Jakarta and Surabaya markets in 2007. Privatised in 1992, the bourse is mutualised and owned by brokers, with membership costing Rp3bn ($300,000), while its non-profit status requires it to reinvest earnings drawn from membership fees, trading and issuance into market development. Although revision of the 1995 Capital Markets Law has long been mooted as a way to demutualise the exchange, progress in parliament has been slow. The new law is likely to allow IDX to demutualise, which could bring more efficiency and allow it to raise revenue from information alongside that from trading, issuers and members. Since January 2013 the Financial Services Board (Otoritas Jasa Keuangan, OJK) has replaced the Ministry of Finance’s former Capital Market and Financial Institution Supervisory Agency, overseeing capital markets, insurance and, beginning in January 2014, banking. Clearing and settlement, which are segregated between the depository and clearing agencies, takes place on a T+3 basis. IDX also comprises a bond-trading platform, with mark-to-market pricing provided by the Indonesia Bond Pricing Agency, while two parallel commodity-futures exchanges have emerged in the past decade (see analysis).

Investors

Despite $26.5bn in portfolio inflows from 2011 to June 2013, according to Macquarie Securities, domestic investors’ share of trading has grown steadily from a low of 19% in the second quarter of 2007 to 44.2% by August 2013. Yet local institutions accounted for 86.4% of this. The number of investor accounts nearly tripled from 160,000 in June 2009 to over 400,000 by June 2013, of which 362,000 were retail accounts in 2012, according to Bahana Securities – roughly 0.15% of Indonesia’s population, essentially high-net-worth individuals. Only around an eighth of these are active, according to IDX, which has pursued an outreach strategy designed to entice younger investors. “We are still struggling to raise retail participation on the market,” Poltak said. “We are thus establishing IDX corners at universities, more than 100 so far, leveraging their current knowledge to increase retail investment.” The most active local institutions are asset managers, pensions funds, insurers selling unit-linked policies and banks offering wealth management services. Domestic investors typically do not rely on margin facilities, in contrast to peer markets like Thailand. “There is very little leverage in the system since most retail investors are high-net-worth individuals, while local institutions are not allowed to leverage,” Erwan told OBG. “We offer margin facilities but these are seldom used.”

While FPI’s share of total trading has declined in the past decade, the type of investors has broadened to more diverse institutions, including pension funds and regional investors like Malaysian mutual funds and Taiwanese and Japanese investors, bolstered by Indonesia’s investment-grade re-ratings since 2010. Higher global interest in Indonesian securities also spurred a significant decline in yields on fixed-income securities issued by both the government and leading corporates (see analysis). Exposure to Indonesian equities through offshore-listed exchange-traded funds (ETFs) has also grown, with five Indonesian-only ETFs and a significant number of EM ETFs with around 10% exposure to Indonesian stocks. By August 2013 foreign institutions accounted for 67% of FPI and custodians (which include both institutional and retail) some 31%. The exchange is seeking to broaden the pool of FPI and rebalance towards Asia. “Up to June [2013] the most active foreign investors were Japanese investors, like elsewhere in ASEAN, but since we have seen significant outflows driven mainly by Western investors,” Poltak said. “This demonstrates the need for us to diversify our sources of foreign portfolio investment towards Asia and ASEAN institutional investors, since the region remains a net capital exporter.” There is clear scope for growth, with less than 5% of cross-border investment into ASEAN coming from the region and with 40% of that located in the Malaysia-Indonesia corridor, according to CIMB and management consultancy Oliver Wyman.

Brokers

While 114 brokers are registered locally, with a minimum capital requirement of Rp50bn ($5m), the top 20 brokers (those with consistent research output) dominate trading by share of daily turnover. The top 10 brokers accounted for 34.7% of trading volumes and 45.96% of value in the second quarter of 2013, according to IDX. The largest brokers by trading value cater to institutionals, although retail brokers like Mandiri, CIMB and Danareksa have been affected by competition from online brokers with narrower margins, like e-Trading and IndoPremier over the past five years. Conventional brokers have followed by launching their own online platforms, including CIMB’s pan-ASEAN integrated platform, although they have had to adapt to lower fees. “We saw a war on commissions a few years ago, but this is now stabilising,” Poltak said. “Average retail commissions have fallen from the 25-30 basis points (on the buy side) range to 17, as a consequence of the growth of online brokers.”

The exchange’s fee stands at 0.054% of margins, while the sell side adds a 0.1% withholding tax. Institutional commissions are negotiable and slightly narrower, in the range of 10-15 basis points. The latest entrants were Morgan Stanley in 2010 and Nomura Capital in 2011. In 2013 certain brokers launched co-branding with global investment houses, including US-based Jefferies with IndoPremier and Japan’s Daiwa with Bahana, which hopes to gain roughly 1% of additional daily market share in the process. “A growing number of local brokers are co-branding to attract more foreign liquidity,” Harry Su, head of equities and research at Bahana, told OBG. “This allows foreign brokers offshore to gain a strong presence on the market and cut costs.”

Corrections

Starting in late May 2013, a foreign sell-off of Indonesian equities sparked a correction in share prices. This movement helped to produce a net outflow of Rp42.3trn ($4.23bn) in the three months to September, according to Bank Mandiri. Although the spark for outflows came from the US Federal Reserve’s warnings of a looming tapering of its quantitative easing programme in May, concerns over macro-economic imbalances related to the persistent current account deficit and rising inflation driven by fuel and food prices compounded the sell-off in securities. While long-term value investors like Hong Kong’s Jardine Matheson maintained holdings of blue-chip stocks, portfolio managers flocked to the exits. “Long-end funds were the first sellers in May as they were concerned about macro imbalances and what they saw as unrealistic valuations,” Erwan said. “They were then followed by Indonesia-exposed offshore ETFs and hedge funds.”

Setbacks

The five Indonesian-focused offshore ETFs took the worst beating: in the third quarter of 2013 alone, Market Vectors Indonesia Small Cap ETF fell 29.2%, followed by Blackrock’s iShares MSCI Indonesia ETF down 24% and Market Vectors Indonesia ETF some 20%, according to Bloomberg. Other ETFs with around 10% exposure to Indonesian equities also fell sharply. With the rupiah breaking the Rp10,000:$1 barrier in August 2013 and benchmark interest rate hikes seen as endangering domestic growth, a second round of sell-offs gathered pace with an outflow of Rp9.8trn ($980m) that month alone. The JCI fell 22% to around 4000 by early September 2013, although the market’s average price-to-earnings (P/E) ratio was down only marginally from 21 times to 17.2 in the period, still above the MSCI EM Index’s average P/E of 11 in early September. In rupiah terms, the share-price drop ranked fifth in Asia in the year to September, but compounded by the 17% drop in the rupiah versus the dollar, the market ranked as the worst performer in Asia.

Valuations

Listed firms’ earnings growth has been strong in recent years, with return on equity (ROE) reaching 32.4% in 2011 and 32.2% in 2012, compared to Thailand’s 16.5% and Malaysia’s 13.5% in 2012.

Although annual growth in average earnings per share (EPS) has cooled from 27.5% in 2011 to 5.4% in 2012, Bahana expects earnings to bottom out at the turn of 2014, with forecast 2013 EPS growth of 4.8% and 9.2%, excluding commodities. Lower earnings helped contain falls in price-earnings (P/E) ratios during the mid-2013 correction, with average P/E ratios dropping only marginally from 21.6 times in 2011 to 19.6 in 2012 and 17.2 by September 2013. “We expect earnings to bottom out by the first quarter of 2014 and recover thereafter,”

Joshua Tanja, UBS Indonesia's managing director and head of equities, told OBG. “P/E ratios have not fallen that much because earnings have also dropped.”

Domestic and long-term FPI investors rotated into defensive stocks related to consumption, particularly consumer goods and telecoms. While the correction has been sharp in many sectors, P/E ratios for consumer goods stocks remained above 20 times on average.

This drop in valuations has presented a buying opportunity for investors who remain bullish on longer-term growth prospects. Crude forecasts for broader economic growth should put a floor under the correction. “We expect nominal GDP growth of 11-12% in 2014, which means the equity markets should theoretically grow by at least that much,” Anton Gunawan, Bank Danamon’s chief economist, told OBG. “The swing factor is market sentiment, which would require a credible signal from government, for instance.” Bahana Securities expects growth in the JCI to rebound from a forecasted 3% in 2013 to 14% in 2014.

New Supply

Although adverse market sentiment has prompted delays in many planned IPOs, the exchange was on track to achieve its goal of 30 new listings in 2013, with 24 new listings by mid-September raising a total of Rp14.2trn ($1.42bn). Encouraging new supply is critical to IDX’s ambitions of becoming the region’s largest exchange by capitalisation by 2015, when it hopes to reach $750bn. The number of IPOs nearly doubled from a trough of 13 in 2009 to reach 25 in 2012, raising a total of Rp10.14trn ($1bn). The market witnessed roughly twice the amount of rights issues, with Rp22trn ($2.2bn) raised by 17 listed firms. The most active underwriter in 2013 was UBS Securities.

In recent years, the sectors yielding the most IPOs have been the transportation and banking industries. In value terms, the highest-yielding sectors over this period have been banking and commodities. The largest IPOs in 2013 included automotive distributor Mitra Pinasthika Mustika, raising Rp1.5trn ($150m) in May; textiles producer Sri Rejeki Isman, investment firm Saratoga Investama Sedaya and state-owned Semen Baturaja raising Rp1.3trn ($130m), Rp1.5trn ($150m) and Rp1.3trn ($130m), respectively in June; retailer Electronic City, raising Rp1.35trn ($135m) in July; and Siloam Hospital raising Rp1.4trn ($140m) in September. This has not scared off a pipeline of at least six more IPOs in the fourth quarter of 2013, according to IDX: larger planned issues include herbal medicine producer SidoMuncul, which aims to raise Rp1.5trn ($150m), taxi company Bluebird’s delayed listing that would raise up to Rp6trn ($600m) and auto-financer Indomobil MultiJasa, part of the Salim Group.

Buy-Backs

While average returns on IPOs in 2012 reached 92%, the 2013 sell-off caused average returns to slump to 26% in the year to September. Aiming to place a floor under equity prices and demonstrate management confidence, OJK enacted new rules in late August allowing listed firms to buy back up to 20% of listed shares without shareholder approval in periods of high volatility. This rule, similar to one passed in 2008, defines high volatility as a 15% price-drop over three consecutive days, or by OJK’s unilateral announcement. “We are seeing a number of share buy-backs since August, driven by state-owned enterprises (SOEs), but with some private operations as well,” Su told OBG. The cash-rich nature of listed firms gave them ample capacity to fund the buy-backs. The SOEs involved included Telekomunikasi Indonesia, toll-road operator Jasa Marga, Semen Indonesia and coal-miner Bukit Asam, as well as private firms such as MNC Investama, Media Nusantara Citra and Global Mediacom (all part of the MNC Group), Panin Insurance and Intiland Development. Two firms that staged IPOs in the first half of 2013 also announced buy-backs: Electronic City, whose share price had slumped 24% below floating price by September, set aside Rp150bn ($15m) for the buy-back, while Semen Baturaja, whose shares were trading 32% below IPO levels, budgeted Rp100bn ($10m). By October 2013 over 20 firms had conducted buy-backs, although given the mid-cap size of most firms participating, the average deal size ranged from $5m to $20m, with buy-backs covering a three-month period to December 2013. Given the small deal sizes, the buybacks had little influence on share prices, but did demonstrate management confidence.

Reforms

IDX has pursued two reforms to its structure aimed at boosting liquidity and encouraging more retail participation. The first consists of reducing the number of stock-price fraction units, used in buy and sell bids, from five to three. The exchange has the highest buy/sell spreads in South-east Asia at 80-90 basis points, compared to a regional average of 30. By simplifying the fraction unit system, the aim is to narrow this gap, permitting simplified algorithmic trading. The second reform consists of reducing lot sizes from 500 shares to 100, which will allow smaller investors to take positions on larger-cap stocks. Yet given that most shares trade at less than the equivalent of $2/share, minimum buy-in already ranks at a mere $1000. Both reforms were carried out on January 6, 2014. “Reducing the price fractions from five to three will tighten our bid/ask spreads, which together with smaller lot sizes will encourage more liquidity and make it easier to manage portfolios,” Poltak said. The transition to OJK, which will gain jurisdiction over banks from 2014, will bring a more integrated approach to financial supervision and build on recent improvements to corporate governance and trading standards. In recent years the regulator enacted a new rule requiring the disclosure of beneficial owners of principal stockholders with over 20% stakes, stricter rules on annual reporting and restrictions on brokers’ collateralisation of shares on behalf of investors. “Retail investors are already much better protected than three years ago,” Erwan said. “Brokers are no longer allowed to collateralise their shares, while IDX’s early warning systems operate well.” Although a new capital markets law and the long-planned bankruptcy law were still pending in the fourth quarter of 2013, OJK is forging ahead with piecemeal reforms like establishing an investor protection fund to guarantee investor compensation in the event of counter-party default.

Innovations

As part of its development plan, IDX aims to develop more hedging products, encourage more retail participation, and enhance transparency and governance. Despite these efforts, new product launches have failed to attract significant liquidity of issuer interest. Five equity ETFs have launched since 2011, starting with IndoPremier’s LQ-45 Index tracker, but Indonesian retail investors’ preference for active investing or diversified mutual funds has constrained liquidity, while most major brokers have shied away from the instrument. “At the moment about 7% of all the money in Indonesian financial services are dedicated to mutual fund products. This is still very small but we see the appetite increasing every year for retail accounts,” Agus Yanuar, president director of Samuel Aset Manajemen, told OBG. According to Erwan, “Brokers who market ETFs onshore are those that don’t have active fund management affiliates. Most mutual fund investors are quite risk-averse and prefer balanced funds that are diversified across a range of asset classes.” While new rules in 2007 paved the way for floating real estate investment trusts (REITs), the market has seen only one such issue, in 2012. Further issuance will likely require changes in the tax code, unlikely given the government’s drive to increase tax revenues. “While we witnessed the first REIT launch, we do not expect a high pace of issuance until the tax office changes the tax structure for REITs to that of a pass-through vehicle,” Poltak said. Leading property developer Lippo Group listed a REIT via its asset management subsidiary Ciptadana in late 2012, with its Solo Grand Mall with around Rp400bn ($40m) in assets underlying the trust. “The Lippo REIT is more of a conventional property fund,” Erwan said. “It has been used by Lippo to divest from Solo Mall and they still have to pay dividend tax.” The exchange also plans to develop more hedging instruments by introducing on-exchange securities lending and borrowing (SLB) and re-launching single-stock and index futures in late-2014 (see analysis). While SLB is available via the Indonesia Clearing and Guarantee House (Kliring Penjaminan Efek Indonesia, KPEI) since 2001, with a list of 91 eligible stocks, 98 clearing members and three custodian banks acting as market makers, IDX plans to allow SLB in the secondary market in 2015 once regulatory changes by OJK are enacted in 2014. The lack of secondary-market SLB is seen as a hindrance to growth in ETF trading, given the inability to short-sell on the secondary market. KPEI recorded only 139m such transactions worth a total of Rp309.1bn ($30.9m) in the first three quarters of 2013.

Private Equity

Falling equity prices may have a calming influence on acquisition prices in private equity (PE) deals, which rose to 16.2 times earnings in 2012, according to a 2013 Boston Consulting Group report. The target sectors for PE funds – mainly consumer-related sectors like consumer goods, banking, infrastructure and natural resources – have witnessed a total of $3bn in deals, of which $900m were in 2011 and 2012 alone, according to research firm Preqin. Higher valuations are a function of strong earnings from consumption-related firms, as well as competition between a growing array of PE players – with some 31 active funds in 2013, according to the Emerging Market PE Association. Domestic players dominated by the big four – Saratoga, Ancora, Quvat and Northstar – account for $2bn of investment since 2007, while international players running South-east Asian funds, including major names like KKR, Carlyle, Abraaj and CVC, account for around $1bn. CVC’s $700m investment in retailer Matahari in 2010 accounts for $700m of this, however.

Global PE funds traditionally focus on deals above $100m. KKR made its first investment via its asset management arm only in 2013, investing in a food producer, while Blackstone (operating out of Singapore) had yet to close a deal by the fourth quarter of 2013. The sector has witnessed several successful exits in both trade sales and IPOs, with Saratoga delivering successful IPOs in 2008, 2010 and 2012. Preqin estimated in early 2013 that both types of funds aim to invest $8.2bn combined. Saratoga’s IPO in June 2013, the first for a local PE fund manager, marked a watershed. Although the market sell-off led its share price to fall 17% in the first day of trading, Saratoga followed the example of major global fund managers like KKR and Blackstone in tapping public equity markets.

Outlook

Despite the challenges that have been caused by global volatility, most investors have maintained a bullish long-term outlook. Indonesia’s reliance on FPI to finance its current account deficit is a cause for concern. All the same, its consistent growth record, resilient corporate earnings and dynamic private sector highlight its strong prospects for expansion going forward. The coming year will be marked by government attempts to steady the pace of growth and to ease strains on the balance of payments. While short-term portfolio investment may be subject to temporary swings, investors with an eye on long-term horizons will find acquisition opportunities as the pricing of assets corrects to more realistic levels over the coming year.