About Time For Turkey

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Includes: TKF, TUR
by: Victor Lai, CFA

Summary

The Turkish Lira and stock market have been sliding for years, but the sell-off has accelerated in 2018.

There's no single, simple explanation for why; it has to do with a combination of issues that have been brewing for years.

The question is whether it's time to buy the dip in Turkey.  We'll take a closer look in this article.

About time for Turkey?

No, this is not about your upcoming Thanksgiving centerpiece. This is about Turkey with a Lira that's down 90% vs USD and an equity market that's down 70% from its highs.

Chart TUR data by YCharts

When others are fearful

To be fair, emerging market equities have sold off broadly year-to-date. But the markets seem especially scared of Turkey. So what's everyone so afraid of?

Chart EEM data by YCharts

First, let's review how we got here. Turkey's long-time, president/prime minister Recep Tayyip Erdogan is a stimulative policy bull. He likes keeping interest rates low, encouraging bank lending and supporting heaving infrastructure spending. He's gone as far as claiming that high-interest rates are the "mother and father of all evil." His approach may be eccentric, but Erdogan successfully grew Turkey's economy judging by GDP.

Chart Turkey GDP, Current Prices data by YCharts

But the aggressive policies come at a cost. For example, after a long quell, inflation crept up to almost 25% and some fear inflation could return to the runaway levels of the 1990s.

At the same time, Erdogan's disdain for raising rates, his increasingly authoritarian tendencies (he recently consolidated power over the central bank), and a litany of bizarre statements about monetary policy ("higher rates lead to higher inflation") has markets terrified that Erdogan will fail to keep inflation in check.

Perhaps an even bigger fear stems from outside Turkey. During its growth binge, Turkey attracted ever-increasing amounts of foreign investment, and in the process also accumulated large amounts of external debt (or debt denominated in foreign currencies). As of July 2018, Turkey's external debt to GDP was over 54% based on data from the World Bank.

The confluence of inflation, rising debt, and falling Lira spread fear that Turkey wouldn't make good on its debts. This caused an outflow of foreign capital, which made things even worse. Adding insult to injury, a spat with the United States over a detained US pastor led the Trump administration to announce tariffs and sanctions on Turkey. This was all enough to send investors fleeing for their lives.

A good look

There's a lot of scary things in Turkey, yes. However, in times like these, it can pay to take a step back and take a good look at the bigger picture.

Turkey is no stranger to financial crisis. In fact, it's had one every decade over the past thirty years. Not surprisingly, each time, the crisis follows the same routine. Step 1, inflation rises and currency falls. Step 2, everyone freaks out about financial crisis and recession. Step 3, markets get oversold and things aren't as bad as expected. Step 4, there's a v-shaped recovery and markets rally hard. "This time" is rarely any different.

But there are a few things that make the current situation less scary. First, the Lira has fallen for the past decade and already looked relatively cheap prior to the accelerated sell-off. In contrast, the Lira looked relatively expensive heading into the previous crisis in 2008.

Chart Turkish Lira to US Dollar Exchange Rate data by YCharts

Second, Turkey has been one of the fastest growing emerging markets, clocking an average GDP growth rate of 7% per year. It's most recent read was a "weak" 5.5%, which relatively speaking doesn't look that bad compared to developed economies clawing to stay above 3%. Despite the short-term turmoil, Turkey's long-term trajectory remains intact. Goldman Sachs includes Turkey in its "N11" or list of next eleven countries poised to drive global economic growth, much like the "BRIC" countries did in recent decades. Likewise, Fidelity names Turkey in its list of four "MINT" countries.

Third, despite Erdogan's stubborn persona, he may be more flexible than he appears. In September, Turkey's central bank hiked short-term rates to 24% which was not only contrary to Erdogan's public position but also significantly above expectations. Then in October, after refusing to release a detained US pastor, Erdogan unexpectedly did just that, improving US relations in the process. The point is Erdogan may be more rational than he's given credit for, and conditions are already turning out better than expected.

Fourth, in a world of ever-increasing valuations, Turkey's equity market is a rare find. The table below shows a comparison of price multiples and dividend yields for the iShares MSCI Turkey ETF (TUR) versus other market-ETFs. Its hard to argue Turkey doesn't look cheap on a relative basis, and even harder to argue that one of the N11/MINT markets will trade under 5x earnings and 0.77x sales for good.

Valuations

Source: ETF.com, Thomson Reuters, BCM

I know, I can hear it now, "but Turkey has all kinds of problems and no upside catalyst which justifies lower multiples." The argument makes sense, but I think it misses the point. Turkey doesn't need a complete turnaround or standing ovation, it just needs to do less badly than expected. Right now, the hurdle is quite low.

For the record, I heard similar arguments against my call long call for Russia in September 2015 (+58% in 2016), my long call for Greece in October 2016 (+35% in 2017), and my long call for Nigeria in April 2017 (+34% in 2017).

No pain no gain

There are risks, as always, and Turkey certainly has its share. Should the market continue to lose confidence in Erdogan's ability to fend off inflation things will get worse before better for both the Lira and Turkish stocks.

Also, if capital outflows accelerate, Turkey may seriously have trouble defending its currency and servicing its foreign debt due to its limited foreign currency reserves. If the situation gets bad enough, Turkey would likely need to fall back on the lender of last resort, the IMF, for bailout loans as they have in the past.

One last concern, Turkey's prior crises corresponded with recessions. This time around, that hasn't happened, but we're not in the clear yet. It's still early and we don't fully know what the impact will be on Turkey's business cycle.

All of these issues are still uncertain, and none of them are market-friendly, to say the least.

The bottom line

In the near-term, there are plenty of uncertainties surrounding Turkey. And those who cannot look beyond the rampant short-term volatility in Turkish markets should probably just look away.

I don't know if the Turkish stock market has found a bottom, and there could certainly be more downside from here. But pessimism is pervasive, expectations are in the gutter, and prices look low enough to warrant some serious consideration.

Unless Turkey implodes, it gets past the current crisis and resumes on its positive long-term trajectory. I think a patient position in TUR at current prices or better will prove to be an excellent value. My estimate for fair value is $38, or 58% above the current $24 handle.

If you take a position, do your homework, build it on price weakness over time, and don't bite off more than you can stomach.

Disclaimer

The information in this article solely represents the personal opinions of Victor Lai. None of this information represents advice. Investing is inherently risky and involves the potential loss of principal. You should conduct your own due diligence and/or consult with relevant professional advisors before making any investment decisions.

Disclosure: I am/we are long TUR.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.