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It’s time to go ‘hunting’ in Turkey

Kalim Aziz
August 24, 2016

Instead of tracing what has happened since the first visible incidence of ‘Gulenist movement’ (as named by the AKP) and the two elections that took place last year, we would like to focus on what we believe are the key objectives/positions taken by the main player(s?) of the ruling party. We believe it is clear to the market (hopefully by now) that Turkey is an ‘autocratic democracy’ (an oxymoron): the government is elected through a democratic process with an aim to rule as an autocracy.

Irrespective of the ‘office’ held, Mr. Recep Tayyip Erdogan (currently in the office of a neutral President) wants to rule the country despite holding a ceremonial post. The power in Turkey officially rests in the office of Prime Ministership which is occupied by the leader of the ruling party (currently, Mr. Binali Yildirim).

It is an open secret that President Erdogan is trying to engineer amendments in the constitution to ‘upstream’ power to the presidency and rule the country. His actions so far indicate his desire to control and manage outcomes as he sees fit. This is in line with his interference via commentary on interest rates, prosecutorial activities, and strategy towards PKK and Kurdish elements in Turkey, involvement in Syria, etc.

It was one of the most poorly executed coup attempt that we have witnessed for more than a quarter of the century and was easily foiled. The act of attempted coup was condemned internationally with some health warnings also sent to President Erdogan regarding judicial process and fair trial for those who were considered to be involved in the coup.

President Erdogan took full advantage of the coup to purge ‘Gulenist’ elements out of the government and detained and/or forced resignation of personnel in the judiciary, military, education and other civil services to the tune of over 50k people (c16k detained, the rest asked to vacate their offices). Parallel to this, the President set out a state of emergency for 90 days (which would allow him to amend laws without a need of parliamentary vote), got CBT to open liquidity facility and set-out Mr. Simsek (deputy PM) to start communication with the market participants regarding ‘Turkey is still open for business’.

What surprised us positively (not to take it mildly) include:

  1. Instead of continuing with a hard stance and using the state of emergency to amend the constitution and upstream power, the President is trying to build consensus across all parties to ‘deal’ with potential coup attempts.

  2. Instead of insisting on hard stance against Russia (downing of a jet), the President apologised to Putin and met with him to re-kindle relationship with Russia

  3. Instead of bringing back the death penalty (which was mooted just after the failed coup attempt), discussions have quietly died down.

Reading the ‘tea-leaves’ indicate to us that in his heart the President, knows that the only way to continue to rule is by delivering economic growth and well-being (History has showed us that Turks, whatever happens, vote with their wallets; the fatter it gets, the longer a party can stay in power). The President also needs some allies outside of Turkey to fund its external deficit as well as needing Turkey Inc. (i.e. Turkish private sector) to be a functioning profitably for AKP to have a shot at winning in the next general election. We think that there will be upstreaming of power to the Presidency, but, given the route (i.e. consensus building rather than brute force), the path may be moderate.

Market Reaction/Valuation/Attractiveness:

We can start with allowing the charts and numbers to do the talking from looking at how Turkey has performed in the past and where it is today in relative terms:

As it can be seen from the above chart, by and large, Turkish equity markets have performed in the same direction as the global emerging markets with one significant difference: on the upward moves, it has almost always outperformed global emerging markets and on the down move, it drops more and falls to levels equivalent to that of global emerging markets. The two ‘straight lines’, the one above and the other below are suggestive of historic ceilings and floors (barring Global Financial Crisis period). As it stands today, the Turkish market has significantly under-performed global emerging markets (which in turn have under-performed since the Global Financial Crisis). Relative to global emerging market levels in absolute terms, Turkey is about 15% below, a level that we have not seen since the MSCI Turkey Index was established. Relative to the MSCI World Index, the level is about 30% below (all of these measures are US$ based).

The relative performance tells us that the investment community is pricing Turkey lower than it has since 2007. After considering prices (index levels), we look into the valuation paradigm based on consensus estimates (source: Bloomberg):

As it can be seen (barely) from the above table, Turkey is trading at an unprecedented discount to MSCI World or Emerging Markets aggregates both on earnings (P/E) and book value basis (P/BV). Here is more:

Turkey, on an aggregate basis, still offers significantly higher ROE relative to MSCI world and global emerging markets despite trading at the highest level of discount in terms of valuation.

The three charts combined demonstrate to us that the market is pricing an extraordinarily negative scenario (more than what we have seen over the last 10 years). Put another way, we remember Turkey trading at significant discount (2007) to emerging markets and world indices when Turkey had a significantly higher central bank rate (19-22%). Given that the rates are about half of these levels, valuation discounts in excess of what we saw in 2007 seems excessive to us. It is true that the growth outlook for Turkey in 2007 was brighter (aswas the case for the rest of the world), however, we believe halving of the interest rates has more than compensated for the lower growth outlook.

So where is the ‘Sweet-spot’?

In a word: Banks. The following table adds colour to this view:

Banks, on the basis of earnings and book value, are trading at a discount of 25%+ to the Turkish market aggregate, despite delivering RoE in line with that of the market. I.e. the banks are trading at an even deeper discount to the global emerging markets and world markets than the Turkish equity market.

In a world with very low inflation (with more than half of economic world in deflation actually) and low interest rates (1/4 of the sovereign issues have negative yield to maturity), financial sector (be it banks or insurance companies) are facing significant headwinds on the operational front and questions on capital adequacy on the regulatory front. Turkish banking sector offers a diametric opportunity compared to what is prevalent in most of Europe – inflation, positive interest rates and low leverage (i.e. no capital adequacy headwinds). Also, given that the banking sector accounts for roughly half of the Turkish index, we believe the rally in the Turkish market is not sustainable with the participation of the banking sector.

We have not tried to bias this view with stock selection (which is our forte), but the note here is to highlight that in any which way one looks at it, the market looks quite ripe for a rebound.

Things to Monitor, Catalysts and All that:

We believe in the law of averages and mean reversals which makes it much more tempting for us to go in when we think the valuations are at extreme (it can become more extremer), but in any case, we would like to time increasing exposures to the market a bit better if we can. For this, we are looking for the some signs or events as follows:

  1. Ratings agency announcement which is scheduled for 19th of August which may either result in continuation of negative watch or downgrade of Turkey from investment grade to junk. Should a downgrade happen, there is a significant chance that the market may sell-off a bit as bond holders’ liquidation of c. US$10bn is forced (due to event) which will affect the currency and possibly affect the market. After this event, the timing is likely to be more appropriate.

  2. More signs of calming down regarding news on the international front and the detention of ‘Gulenists’ as well as less hostile communique with developed world.

  3. Signs of consensus building becoming firmer and upstream of power being channelled through proper routes.

‘Let’s go Turkiye’!!

Kalim Aziz
Kalim Aziz
Senior Analyst at Duet Asset Management LLP, London
Mr. Kalim Aziz spent more than 20 years analysing companies in the global emerging markets. Kalim served as a Head of EMEA Research managing over 30 analysts at ING Groep in London and later headed Equity Research of the EMEA Region at UniCredit Banca Mobiliare in London together with Centralny Dom Maklerski Pekao in Warsaw and Koc Yatirim in Turkey, altogether covering more than 100 companies in the region. In 2006, he moved to the buyside as a Co-fund Manager of Kairos Eurasian Fund with Guido Brera. Kalim now helps managing equity fund at Duet Asset Management in London. Besides, he owns a consultuancy company Kiradvisory Limited, an affiliate of Helgi Library on various analytical work.