GEM Strategy - Turkish equity outlook warrants further share price gains

We would expect a fresh round of upgrades after the release of June earnings

The positive surprise to March quarter earnings was 12-13%, on average, lead by banks and food retailers. We reckon the analyst revisions between now and September should be closer to 20%; that is because (a) 12-13% surprise does not take into account the earnings momentum which has gained pace in the lead up to the results, (b) more than 50% of corporates, in their earnings calls, sounded upbeat about the remainder of 2017 and (c) earnings growth is driven more by revenue growth than cost savings leading us to believe EPS is likely to accelerate through 2H17, which is why analysts would/should raise their estimates to the tune of 20%, if not more. If this is the start of a new cycle, earnings momentum will spill over to 2018, which should also be a strong year for earnings in Turkey. 

Commodities outlook is soft in historical context - Turkish GDP should continue to surprise to the upside

Commodity trends continue to favor Turkish assets. The outlook is not adequately reflected on estimates. We have all seen how low and wrong the street economists' GDP forecasts have been so far this year.  The sources of surprise to economic activity is firmly tilted towards the upside. Below is an incomplete list of observations related to the state of economic activity.

1. Downward trend in commodities, in particular oil and gas, helps Turkey contain cost inflation and boost its external accounts
2. Consumer confidence has overall improved this year and is likely to get better in the remainder of 2017
3. We have seen marked improvement in PMI readings 
4. There is recovery in tourist arrivals.
5. Turkish banks' March quarter financials showed strong turnaround both in margins and fee income with lending activity unambiguously gaining pace.

With these in mind, we have concluded that the element of positive surprise to Turkish GDP growth, its external accounts, corporate margins and, above all, earnings, has just gotten bigger. 

The consensus multiples overstate valuations - earnings outlook warrants 25% upside

Looking at the turnaround in economic activity and strong earnings momentum, both of which are not yet fully recognized by the market, we reckon the equity valuations are low despite the gains this year. The consensus multiples are misrepresent the valuation by at least 10% on 2017, and possibly more on 2018. Thus, the trajectory for share values remains up not down. We see at least 25% upside potential in the index between now and the year-end

Relative values favor EM/Turkey assets against the DMs, the valuation gap to narrow

EM/Turkey analysts tend to underestimate earnings while their DM counterparts overestimate

EM analysts tend to be more bearish than their DM counterparts. More than 50% of the time, over the past three decades, EM analysts’ January forecasts have underestimated full year earnings. The forecast record of DM analysts, on the other hand, is rather the opposite. The consensus for US earnings is a case in the point. Over the past four decades, the analyst estimates for corporate earnings in the US as recorded in January each year have been too high a staggering 85% of the time. Taking a closer look at the tech sector, which not only commands the highest weight in the index but is also the single most important driver for S&P earnings, has lead us to suspect that the US analysts may again be exaggerating forward earnings. The consensus tech sector earnings show 12.6% hike in 2017 EPS. Using the history in tech as well as the index itself and the analysts’ own record in forecasting future earnings, we reckon the probability that 2017 consensus currently underestimate EM earnings -notably Turkish- but overestimate, possibly significantly, the US ones is fairly high.

The valuation gap between DMs and EMs -in particular Turkey- is too wide relative to their history

We carry on and look at the implications for relative valuations between the US and EM stocks. The S&P 500 is currently trading at 17-18x on 2018 consensus assumptions – the tech multiples are much higher. In those years when the long-term bond yields adjusted for inflation lied below 1%, one-year forward price to earnings ratio on S&P 500 has averaged circa 12.5x. If you trust the 180 years or so of history of one-year-forward PER on S&P, the stocks which make up the index, are overvalued on average, possibly significantly. We are not here to judge the US valuations. However, we are interested in the gap between the EM multiples and those of the DM, where we use the US as a proxy. We don’t have a similar history on EM front but we do have reasonably reliable multiples going back 30 years. With the records we have, we see price to earnings multiples in most emerging markets, in particular Turkey, are nowhere near their historical highs, and the PER gap between the DM (US) and EM remain well above historical averages.

Risks

Geopolitical tensions in the neighborhood coupled with idiosyncratic political risk in Turkey could dampen investor appetite, in particular those of global funds, and put a cap on upside in share prices. The most risk averse investors may still want to stay on the sidelines. We would argue there is room both in equity and fixed income valuations to mitigate some of the risks. The market is trading at rather undemanding 8 to 9-times earnings on 2018 consensus estimates. The interest rates are high enough to weather nasty surprises with the implied risk premium close to 17%.

Sector allocation and stock ideas

The sensible thing to do is to remain O/W financials. The banks have beaten estimates better than 10% this year driven by revenues. Both margins and F&CI have come in better than expected. We would expect the banks to deliver strong earnings in the remainder of the year. Earnings should be driven more by overall volume growth and loan originations rather than margins in the second half of the year. We would also expect earnings growth to spill over to 2018, the year we expect the pent-up demand to lead to fresh lending activity, consumer as well as enterprise.

Migros - room for further analyst upgrades

We are bullish on confectionery and retailers space. The retailers are benefiting from the near-term spike in inflation boosting revenues. The retail price inflation has indeed been below wage inflation lifting food retailers' margin. Migros earnings beat consensus estimates in its March quarter. Sell-side analysts have revised their numbers to take into account the surprise but the chances are that they may have to go back to the drawing board to redo their math at least one more time before the year-end. More importantly, the wider spread between the consumer price inflation and wage inflation has benefited Migros just when the company needed a boost and probably reduced the time needed to break-even following its acquisition of Kipa. 

Ulker - benefiting more from falling sugar and cocoa prices

The confectionery producers are set to benefit from continued declines in sugar and cocoa prices. Price of sugar is down by a massive 21% on the month, price of palm oil and cocoa are down by 11% and 8%, respectively, also month-over-month. Prices of other oils used in food industry have also moved in the same direction. What is also important is the downward trend has actually gotten worse. The weekly declines are looking BIG -the week to 21 June. One stock this particular trend is relevant for is Ulker, especially on the cost of sales side. The management mentioned in its March earnings call that the company's EBITDA margin hit a historical high (14.3%) -in part because of weak cocoa and sugar prices. Now, we know the downward trend is even stronger so there is good probability Ulker's margin will set yet another record in June quarter. The question is if the analyst estimates factor in the continued weakness in sugar and cocoa. My guess is they do not. Ulker will most likely surprise the market to the upside come June. The stock price did react to strong March quarter earnings but the share price should remain very strong and continue posting gains throughout the year.