Looking for a turnaround story in emerging market equities that is decoupling from the general deterioration in the asset class seen over the last months? The Market Vectors Vietnam ETF (NYSEARCA:VNM) might be worth a deeper look.
As most emerging markets, Vietnam was severely hit by the global financial crisis in 2008/09. As in many other emerging countries, the rapid pre-crisis GDP growth drew foreign and domestic investment into the property sector, resulting in a massive real estate bubble. But unlike in peer emerging markets like the BRICs where the real estate bubble still has to burst, the Vietnamese bubble has already burst and the property market seems to stabilize now.
When the Vietnamese Dong depreciated by more than 30% and inflation accelerated to more than 20% between 2008 and 2011, the Vietnamese central bank reacted with hiking interest rates. A 8 percentage point rise in the benchmark interest rate clearly was enough to bankrupt the highly leveraged property sector and bring the bubble to burst.
Since then, deleveraging has been the secular economic theme in the post-bubble Vietnamese economy. Even as export volume more than tripled since 2009, GDP growth has been on a declining trend.
It should come as no surprise that the Vietnamese stocks have performed very weakly over the last 5 years, both absolute and relative to emerging market stocks (NYSEARCA:EEM) and U.S. stocks (NYSEARCA:SPY).
But these are all past events, and financial markets are by definition forward-looking. While the recent years have indeed been dire, there are strong arguments in favor of a turnaround in Vietnamese stock market performance.
1) Substantial multiple expansion will be triggered by foreign portfolio flows as they rotate out of vulnerable emerging markets into stable/stabilizing, strongly growing, reform-minded countries:
- GDP growth will accelerate, driven by export growth and counter-fiscal economic policy: According to forecasts, exports will grow by up to 20% in 2014 driven by the acceleration in economic recovery in the US, Europe and Japan, which account for around half of Vietnam's exports. In the longer term, Vietnam should not only profit from the volume growth in developed market imports, but also from an increasing market share in global exports for manufactured goods. Wages substantially lower than other Asian manufacturing heavyweights like China or Indonesia have attracted numerous electronic multinationals like Samsung or LG that invest heavily in the country. The finalization of the Trans-Pacific Partnership trade deal and the FTA with the EU will make Vietnam even more interesting for manufacturing companies. Besides, the economy should profit from a package of counter-cyclical policies. Among the measures implemented are tax breaks, a reduction of the corporate tax rate to 20% for small companies and strong government spending that has led to a deficit of more than 5% in 2013. An unprecedented interest rate cut finally has helped credit growth to accelerate as business sentiment has bottomed out and consumer sentiment is improving. Going forward, a high level of bad debt may put a cap on further credit growth. Vietnam reportedly has the highest amount of bad debt in Southeast Asia. To revive lending, the government has set up an asset management company in 2013 that buys loans from banks. By year end, it had already bought about 1.5 bln USD of bad debt, out of a total 5 bln USD in bad debt according to Bloomberg. Purchases of up to 4.7 bln USD in 2014 should be enough to put the banking sector on track again and revive lending as private sector sentiment improves.
- Vietnam's government speeds up structural reforms, privatization of SOE and fights corruption: As until-now favorites of investors like the BRICs, Turkey and Indonesia are crippled by scandals, protests and stagnation in structural reforms, recent announcements of the Vietnamese government suggest that Vietnam can withdraw from this trend. Admittedly, the implementation of reforms was slow in past years, but the government faces intense pressure now as more than 400 SOEs went bust in 2013 alone, causing heavy restructuring costs. Moreover, several high-profile anti-corruption trials were carried out in 2013, monitored closely by western media. Foreign investors indeed seem to believe in the government's intentions, as strong growth in FDI last year shows.
- Opportunistic political measures are unlikely as there are no elections in the near-term: The next elections are scheduled for 2016 and they are merely real, democratic elections anyway. The ruling governments of many emerging countries like Brazil and India face general elections in 2014, thus need to please both voters as well as foreign investors at the same time. While investors may have overlooked opportunistic short-term policies in times of strong economic growth, they are highly unlikely to do so as these economies have slowed down substantially. Needless to say, that we will see further deterioration in investor sentiment and capital flight. Vietnam, with it's relative stability, should profit from a redirection of flows.
- Vietnam will be relatively unaffected by Fed tapering: Vietnam has shown a strong current account surplus of around 5% recently. External debt amounted to 30% of GDP in 2012 and shows a long maturity. Moreover, short-term external debt and external debt payments amount to not more than approximately 60% of FX reserves, thus being adequately covered. Indeed, the capital freeze index provided by the Economist ranks Vietnam as relatively invulnerable to sudden stops in capital inflows.
- Momentum-driven foreign portfolio investors will soon be attracted: Foreign portfolio investors typically are heavily driven by momentum as they rotate capital between countries. The Vietnamese stock market's substantial outperformance relative to its emerging market peers over the last quarters slowly makes it into western financial media's headlines, grabbing portfolio investors' attention.
- Portfolio investment rules are relaxed, making it easier for large asset managers to invest: With a market cap of around 33 billion USD at the end of 2012, combined with strong limitations on foreign stock ownership, the Vietnamese stock market simply was not attractive in for larger foreign asset managers. Vietnam's government now is easing foreign portfolio investment restrictions for bank and non-bank companies significantly and privatizing several large SOEs, thus increasing market depth.
- Vietnamese stocks are inexpensive: A P/E ratio of approximately 11 and P/B ratio of 1.4 may not be considered as deep value, but definitely inexpensive when compared to other emerging markets. At such multiples, it's unlikely that growth prospects have been priced in fully.
2) Moderate EPS growth will be driven by significant revenue growth outpacing compressed profit margins and shareholder dilution:
- Revenues should grow strongly, driven by accelerating GDP growth: As already described above, there are significant indicators that suggest that we will see an acceleration in GDP growth. The Market Vectors Vietnam ETF (VNM) is positioned in the right growth areas. The 26% share in financial companies will directly benefit of the stronger demand of consumers and businesses for loans as sentiment improves. As the cleanup of bad debt progresses, the banks will be in a good position to cope with demand. Besides, investment gains may be realized as the property and stock market stabilizes. The non-bank companies in the ETF (24% energy, 13% industrials, 10% materials, remainder consumer staples & discretionary, utilities) will see an uptick in demand at first because of (indirect) export demand and later due to domestic credit growth.
- Profit margins will be compressed amid cost pressure: Banking margins have come under significant pressure recently as banks have been competing for deposits through higher deposit rates, while lending rates have declined substantially. The interest rate spread now is less than 3% on average, from 5% a few months before according to a Vietnamese bank CEO. Other sectors in VNM will be hit by an approximately 12% increase in wages in 2013, with a similar forecast for 2014. Besides, electricity prices controlled by state have risen by 5% in 2013, but are still far below the level utilities would need to make profits. Thus, strong rises in energy demand will inevitably lead to further price rises amid a supply shortage in the not-too-distant future. Still, growth in costs might somewhat be tamed by the slump in prices of globally-traded industrial and agricultural raw materials as well as a 3 percentage point reduction in corporate tax rates for in 2014.
- Slight earnings-dilution of stocks held by VNM: More than a third of the companies are majority-owned by the Vietnamese state, i.e. are SOEs. As SOEs account for around half of the country's bad debt, a recapitalization of some of the ETFs' holdings is likely. Nevertheless, the weighted expected dilution should be limited and may probably even not have an impact on stock prices at all as it could already be priced in.
While there are many positive trends, imminent tail risks shouldn't be neglected:
- A possible further deterioration in real estate market may put a cap on private sector's ability and willingness to borrow and spend as well as banks' ability to lend out
- Government's efforts to clean up bad debts may not be sufficient in improving banks' ability and willingness to lend out if more debt is downgraded to bad debt
- Stronger-than-expected dilution of shareholders as a higher capital emerges
- Social unrest, especially among the young population, as 2016 elections approach and more democracy is demanded. The government currently heavily represses pro-democracy movements, which could lead to an outburst of public anger at one point
Indeed, should these tail risks realize, then Vietnam's stock market will hit the wall. But it's a very similar situation to the U.S. during the financial crisis in 2008/09. Like in Vietnam now, the U.S. stock market back then was dependent on a stabilization of the real estate market, government efforts to revive private sector spending and bank lending as well as a bailout through export growth and cost cutting.
As we know now, optimism was rewarded generously back then. As always in financial markets, situations with the highest risk tend to offer the highest returns when a turnaround happens. Vietnam will be no exception to this rule...