SAVING of PROTECTION INVESTMENT

Ari Pitoyo, Analyst

Nowadays, an investment portfolio should be adequately geared against inflation.

Tempeh, a food for the masses made from fermented soybeans, nearly went extinct recently! Well, at least on Monday when producers stopped production to vent their frustration at the presidential palace over rising soybean prices.

That should have come as no surprise. Over the last six months soybean prices have gone up 150 percent. While the price per kilogram of soybean in January 2007 was Rp 3,400, now it has reached Rp 7,500. Separately, pressure has also been felt by other food producers, like small noodle producers whose margins are being squeezed by rising flour prices.

This rising trend in prices brings us to our question of the day: how should we position our investment portfolio in this climate?

Since inflation is used as a benchmark for determining real returns, first of all we should ask ourselves: how far could the officially published consumer price index (CPI) inflation figures be relied upon?

Anecdotal evidence seems to suggest that headline inflation may be understated. Producers have apparently been dealing with the rise in raw material prices through reductions in volume, weight and quality. A producer of household appliances we recently talked to dealt with rising costs by reducing the thickness of their products while modifying the designs to maintain the sense of sturdiness. In the property sector, we noticed one developer building fewer public spaces while offering smaller houses to help sustain margins.

Published inflation figures would probably be of more use to measure raw materials with the same quality and size. But how accurate do they account for price changes in processed or manufactured items, which are subject to tinkering and manipulation by their producers?

Considering this, it may be useful to also look at the wholesale price index (WPI), which measures the change in the prices of goods at the wholesale level. The latest available data for the WPI shows a year-on-year increase of over 16 percent in October 2007, much higher than the CPI increase of only 6.9 percent for the same period.

One interesting observation is that commodity prices have not shown signs of receding even though there are indications of a possible U.S. recession. Perhaps this could be attributed to China and India's unquenched appetite for energy, or to global warming that's affecting food crop harvests. One way or the other, there appears to be a fundamental reason for the rise in prices, and this would not be easily overturned by a U.S. recession. A recession may slow things down or provide temporary respite, but commodity prices may well advance in the long-term.

An investment portfolio, in our opinion, should be able to hedge against high inflation while capitalizing on the still low price of fuel (in Indonesia). But at the same time, it is also wise to have the portfolio's performance hedged against adjustments in subsidized fuel prices.

What should be the required return on the portfolio? We suggest a real return higher than WPI inflation (i.e. in the range of 16 percent in 2007), which we believe is the better measure. Using the WPI as a benchmark would put time deposits and bonds off the table. The one-month deposit rate now stands at 6.5 percent p.a. while the 5-year government bond now has a yield of 9.2 percent p.a. This explains the stellar performance of the Indonesian equity market, wherein the Jakarta Composite Index (JCI) yielded a return of over 50 percent in 2007.

Will the robust performance of equities be repeated in 2008? Although the index may not surge as fast as it did in 2007, it is difficult to envisage a downward trend as long as alternative investments still yield a negative return against WPI inflation. Being selective in stock-picking could still provide good returns, with emphasis on sectors having inflation protection characteristics.

We may have to dig deep since valuations are currently high. Bloomberg estimation of JCI's Price to Earnings ratio was 18.9x, a return of just 5.3 percent. Unless earnings growth achieved on a stock is significantly higher than its return, the stock will not provide adequate protection against inflation.

The property sector may well be a wise pick. Valuations are straightforward. Consider the net asset values of property stocks and look at the cost of capital applied to achieve that value. As long as the cost of capital matches the required return, the company may be worth including in the portfolio.

Another factor worth considering is the size of the property company's developed land bank and completed projects. As they were developed or built while fuel prices were still heavily subsidized, the price of the assets are subject to revaluation when fuel subsidies are eventually lifted.

For 2008, an investment portfolio should have an inflation-hedge characteristic. What inflation? Definitely not CPI inflation.
The writer is head of research analyst at PT Bahana Securities

Posted by Taurida Adinda at 9:19 PM