Turkey's Strongman Erdogan Poses Weakness for Stocks

(Bloomberg Gadfly) -- There’s a new strongman in town. Recep Tayyip Erdogan won a referendum on Sunday that gives him broad authority over Turkey’s government, judiciary and economy.

Erdogan’s supporters hope that he will use his new powers to fire up Turkey’s economy. As Bloomberg News reported on Sunday, some analysts are even predicting that Erdogan will attract new foreign investment into the country. So far, Turkey’s stock market seems to agree with that upbeat sentiment. The Borsa Istanbul 100 Index is up 0.8 percent since the referendum through Wednesday.

But even if Turkey’s flirtation with authoritarianism proves to be a boon to its economy -- which I highly doubt -- it will most likely be a bust for stockholders of Turkey’s companies.

Erdogan’s coronation raises serious questions about the rule of law and private property rights in Turkey going forward, which means greater uncertainty for Turkey’s companies. It also means investors in those companies are likely to demand greater compensation for taking more risk. Invariably, that risk premium comes about through a repricing of assets.    

For a preview of what’s ahead for Turkey’s stocks, just consider Russia. Over the last two decades, Vladimir Putin has seized power and eroded Russia’s rule of law. That hasn’t hurt the profitability of Russia’s biggest companies. Earnings per share for the MICEX Index -- a collection of the 50 most liquid stocks on the Moscow Exchange -- grew by 13.3 percent annually from 2004 to 2016 (the longest period for which numbers are available) and have never been higher.

But despite that earnings growth, the price that investors have been willing to pay for Russia’s stocks has trended down since 2003. The one-year trailing price-to-earnings ratio for the MICEX Index has shrunk to 7 from 9.5 in December 2003.

There are two notable consequences of lower valuations in Russia. First, the price growth of the MICEX Index hasn’t kept up with earnings growth -- the index has lagged earnings growth by 1.4 percentage points annually from 2004 to 2016. Second, investors are demanding a much higher expected return  than they did a decade ago. The index’s earnings yield is 14.4 percent today, compared with 10.5 percent in 2003.  

Analysts expect a similar repricing in Turkey. Earnings per share for the Borsa Istanbul 100 index are expected to grow by 20 percent in 2017 and by 19 percent in 2018. Despite that earnings growth, however, the index’s P/E ratio is projected to shrink from 10.9 to 7.6 by the end of 2018.

Just as in Russia, lower valuations in Turkey would mean that stock prices fail to keep pace with earnings growth -- a frustrating result for current investors in Turkey. It would also mean that future investors require an earnings yield of 13 percent to invest in Turkey’s companies, which implies a risk premium of nearly 45 percent over the current earnings yield of 9 percent.      

A repricing of Turkey’s stocks isn’t the only thing investors have to worry about. A meaningful portion of the gains from stocks have historically come from expanding valuations -- or the willingness of investors to pay ever greater prices for stocks over time. As long as questions about the rule of law persist in Turkey, that isn’t likely to happen.    

In the U.S., for example, earnings per share for the S&P 500 grew by 5.7 percent annually from 1981 to 2016. But over the same time, the price of the S&P 500 Index grew by 8.1 percent annually. That additional 2.4 percent annually can be attributed to the fact that investors are willing to pay more than twice as much for the S&P 500 today as they were in 1980. The one-year trailing P/E ratio for the S&P 500 has ballooned from 9 in December 1980 to 21.4 today.    

That additional 2.4 percent is also a large chunk of the risk premium that investors were paid for owning stocks during that period. The S&P 500 has outpaced the Bloomberg Barclays U.S. Aggregate Bond Index by 3.2 percentage points annually from 1981 through March. In other words, without the willingness of investors to pay more for stocks over time, it’s not clear that the return from stocks would have been worth the additional risk.  

In the wake of Erdogan’s power grab and resulting uncertainty, it appears that Turkey’s stocks will have to remain cheap to attract investors. And that means investors will have to rely on companies’ earnings for their reward. Let's hope that the 51.3 percent of Turkish voters who voted for the referendum are right about Erdogan’s magical powers over Turkey’s economy.   

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

To contact the author of this story: Nir Kaissar in Washington at nkaissar1@bloomberg.net.

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net.