I explained in my baseline article on emerging markets that the scale bias embedded in funds such as iShares (EEM) can mean aggressive investors need to take a more specific approach to avoid missing out on growth. My first country article featured Thailand. In this article I shift focus to the largest South East Asian Economy - Indonesia.
Geography, History, and Demographics
Indonesia is a long archipelago stretching from just North of Australia to Indochina, which forms the backbone of South East Asia. Known in the 16th century as the "spice islands" the main Islands, Java and Sumatra were colonized by the Dutch. The dominant global trading company of the time, The Dutch East India Company, was founded on the exports of pepper and cloves to European markets. After the East India Company disbanded in 1800, the area was formally colonized as Dutch East Indies, and by 1900 the colony had expanded to the area forming modern Indonesia. During this time, the Dutch developed significant infrastructure on the island of West Java around the capital, Jakarta, but other areas remained relatively unimproved.
Dutch rule ended with a Japanese invasion during WWII. After the war, nationalist leader Sukarno led an armed struggle, which ended with independence for Indonesia in 1949. In 1965, an attempted communist coup was put down by a resurgent military, and after a period of infighting, General Suharto, a fervent anticommunist, seized power. Under President Suharto, Indonesia received significant political and financial support from the West, and Indonesia made major economic strides.
During 30 years of the Suharto Presidency Indonesia developed an economic culture of corruption and cronyism with little redistribution of wealth. The system was so rife, that Indonesians coined the acronym "KKN" standing for corruption, collusion and nepotism to describe it. In the Asian financial crisis of 1998, the underlying economic weaknesses left Indonesia vulnerable to severe currency devaluation and inflation, leading to social unrest, and the unseating of the Suharto regime. Since then Indonesia has developed a stronger democratic process, unraveled much of the "KKN" and undertaken significant economic structural reform. This remains work in progress, and economic and political power is polarized within a small percentage of the population.
Modern Indonesia is home to 250m people, and has a perfect demographic footprint for economic growth. The population is young, with a median age of 28 and growing, with a population growth rate of 1% annually. 44% of the population already live in cities, a proportion which is expected to grow by 1.7% annually to 2015. Literacy is at 90%. Data sourced from index mundi.com
The population is predominantly (85%) Muslim, but there is a general tolerance of other religions, and a low level of militancy compared to other Muslim countries. While some of the main parties have religious affiliations, Indonesia is a secular state. Religious and racial violence have however been a feature of Indonesia's history, with examples such as the Bali bombings and 1998 Jakarta riots.
Indonesia is already a G20 economy, ranking 16th by size globally. With rapidly increasing urbanization, and a fast growing domestic consumption, Indonesia is set to move much higher up the global rankings, potentially becoming the 7th largest by 2020, according to McKinsey Global Institute.
From a traditional base of agriculture and mining, the Indonesian economy has expanded into the industrial sector, and generated a significant domestic consumption base. The sectoral split of GDP shows a picture of a well diversified economy, poised to take the step to maturity.
Oil & gas
Source - Bank of Indonesia
Recent economic performance has shown progress on key indicators:
GDP has progressed at a steady clip, exceeding 6% over the period from 2008-2011, with the difficult 2009 year still generating growth of close to 5% (figures shown in constant USD equivalent values). 2012 GDP growth is estimated at 6.2%, and the government targets 6.8% for 2013. This has been well supported by foreign direct investment or FDI, which has been consistently high, peaking towards 2% of GDP, but the high inflation rate highlights a vulnerability in the economy.
Source - Bank of Indonesia
While the strong and growing consumer demand is a positive for Indonesian manufacturing, the economic growth is heavily influenced by the export sector. The following chart, which compares the percentage increase in exports to oil consumption, shows the dramatically increasing importance of export to the Indonesian economy. The 2009 contraction in exports didn't slow the increase in domestic consumption however, with increasing domestic consumption underpinning the close to 5% GDP growth that year. Note the growth figures are shown in constant USD equivalents.
The high level of imports is now starting to put pressure on the balance of payments, with the current account for Indonesia falling into deficit in 2012. Having historically generated a positive current account, the 2012 negative balance of 2.7% of GDP puts significant strain on the value of the Rupiah. The Indonesian government has responded by seeking to implement protectionist policies to favor local businesses, which would accelerate the process of import substitution, but also potentially deter the inflow of investment which is needed to improve the productivity of the Indonesian economy.
Fundamentally, the future of the Indonesian economy lies in its ability to transition from its current state. The growing consumer base needs access to a broader range of domestically produced goods and services, available at competitive prices, to reduce the dependency on imported products. This will require investment in manufacturing capacity and infrastructure, further distribution of wealth, and the dismantling of a government policy framework that restricts competition. The current system was established during the Suharto years, and insulates the fortunes of the handful of influential families that control the largest corporations. To transition into a period of self sustained consumption, Indonesia must now share the wealth.
Presidential elections are due in 2014, as the current president, Bambang Yudhoyono completes his second and final term. His administration, while shepherding the economy through a successful decade of growth, has disappointed observers with the slow pace of fundamental structural reform.
Much is at stake for the Indonesian economy, so the outcome of the election at this critical juncture is important to watch. Investors will hope for a progressive and open market economic stance coupled with a strong enough mandate to manage tough political choices. These would include a continued economic modernization, encouragement of foreign investment, and reduction of government spending, especially in subsidies that support the current business elite.
One outside candidate could be Joko Widodo, Governor of Jakarta, Indonesia's capital. According to recent press articles Widodo polls well as a potential candidate. I was recently in Jakarta where Widodo is certainly causing a stir. According to popular opinion, he is honest, populist, and focused on the bottom line. This focus includes famously confronting costs and waste within Jakarta's government apparatus, and challenging federal officials on spending decisions.
The Investment Opportunity
According to the model that I outlined in a previous article, Indonesia scores highly on a balanced risk and opportunity basis, and justifies an overweight position in an emerging markets portfolio. Indonesia represents 2.7% of the current weighting of iShares Emerging Markets ETF. My hypothesis is that investors seeking to allocate to emerging markets to capture growth opportunities will have better access to high growth economies if they add to ETF weightings by overweighting to the more promising economies within the ETF. Below I will analyze some alternative strategies for those wishing to overweight Indonesia.
IDX is the older Indonesia specific ETF, established in 2009. IDX seeks to track the Market Vectors Indonesia Index which provides exposure to publicly traded companies that are domiciled and primarily listed in Indonesia, or that generate at least 50% of their revenues in Indonesia. According to Bloomberg, IDX trades at around NAV, pays a 1.58% dividend yield, with an expense ratio of 0.58%, and at current prices has a P/E ratio of 15%.
Competing with IDX is the iShares ETF EIDO, which tracks the MSCI Indonesia index. started in 2011, EIDO has an equivalent expense ratio of 0.61%, also trades close to NAV, and trades at a similar P/E ratio. EIDO yield has been slightly lower around 1%
The top ten holdings of each ETF has a large overlap. With EIDO having larger holdings of CP Indonesia, and Unilever Indonesia, and IDX preferring Indofood Suksess, and Integrated Pharma. EIDO has a slightly deeper holding base, strictly market weighting the index, while IDX seems more selective, and thus less representative, which generates a different sector holding. While there seems little to choose between the funds, I personally prefer IDX which has a higher weighting to consumer staples, energy, and materials, and lower to financials, playing better to fundamental rather than cyclical growth.
Indonesian Closed End Fund
Aberdeen Asset Management offers a closed end fund for Indonesia (IF) which has a markedly different profile to the more market weighted ETFs. As an actively managed fund, IF has a higher expense ratio, at 1.42%. Stock selection is based on fundamental analysis using Aberdeen's proprietary research managed by a Singapore based team. The fund has been running since 1990.
The declared top ten positions show a similar sectoral bias, but the individual stocks in each sector are different, with a bias towards subsidiaries of international firms.
For example, IF has its largest consumer discretionary holding in Unilever Indonesia (9.45) compared to 2.5% Unilever weighting for EIDO, top bank holding (8.2%) in OCBC Indonesia, a subsidiary of a Singaporean bank, (compared to EIDO which holds 10.2% of its assets in local bank Central Asia), 7.5% in Holcim Indonesia compared to EIDO with 3.8% in local cement maker Semen Indonesia, and 7.9% in international motor distributor Jardine Cycle and Carriage, compared to EIDO which has 11.6% of its exposure in local leading distributor, Astra International. Astra also appears on the IF top ten.
In total, 15% of the IF holdings are domiciled in Singapore and UK, the latter consisting of a holding in MP Evans plc, a palm oil plantation manager. This puts more than half of the IF stocks with major control from outside Indonesia. This should be a serious consideration for investors concerned with Indonesian governance standards.
The sector allocation of IDX vs. EIDO and IF is as follows :
|Source - Van Eck, iShares, Aberdeen Asset Mgt||100%||100.0%||100.00%|
Performance vs. SPDR S&P 500 (SPY)
The following chart shows the relative performance of these different funds vs. SPY since 2011 when they have all been active. As can be seen, the broad based EIDO has been the best performer over this period. With a more selective and less market weighted approach, IF demonstrated significant volatility, with a large correction in late 2012 shifting its performance from best of the selection to the worst performer. Both the Indonesian ETF's have managed to outperform SPY significantly, with SPY making up ground in the last months as EM stocks have underperformed SPY.
^SPX data by YCharts
The picture is however markedly different if we extend the period of analysis to 2009 when IDX was founded, over this period, both IDX and IF have beaten SPY hands down.
For the sake of completeness, here is how IF has outperformed SPY since inception in 1990. This demonstrates both the high growth opportunity available in Indonesia, but also the significant volatility in the short term.
Investments in Indonesia has huge potential for the long-term investor, but investors with a low risk appetite should be cautious. As an economy which has been dependent on exports for earnings but imports for consumption, the higher emerging market risk profile is compounded by currency risk.
Indonesian ADRs Traded in the U.S.
There are several ADRs traded in the US, which offer direct access to individual Indonesian stocks to U.S. investors. This site lists 50 in total, 7 of which are sponsored, and the rest unsponsored. It is possible to invest in the main growth sector leaders via ADRs in individual stocks. Given that the main opportunity in Indonesia arises from the growth of domestic consumer demand, growth potential should be broadly based in a number of consumption based sectors. This logically steers the investor to a fund based approach rather than individual stock selection.
The Last Word
Indonesia has been a key part of the global economy over centuries of trading, during which it has been prominent as an exporter of agricultural and mineral assets for overseas consumption. The future of Indonesian wealth will be based on the strength of the maturing domestic focused economy. This bright future needs strong political stewardship, which Indonesia has sadly lacked. A new breed of Indonesian leaders, such as Joko Widodo, governor of Jakarta, promise change on this front.
As a current G20 member, Indonesia is already a major economy, and has clear potential to move into a top ten position over the coming decade. In order to reach its full potential, Indonesia needs to share the wealth both through the emerging middle class, and the emerging regions outside West Java.
My EM model indicates that the fundamentals are strong enough to deserve an overweight position in my growth portfolio. IDX and EIDO offer similar opportunities, while IF is a more focused play on specific growth stocks. All three seem to offer a viable way to participate in this growth story.
Additional disclosure: The author is a private investor and not an investment advisor. Nothing in this article is intended to be advice and should not be used as investment advice. Investors should take professional advice.