Download - T. Rowe Price

FOR INVESTMENT PROFESSIONALS ONLY. NOT FOR FURTHER DISTRIBUTION.
PRICE
POINT
January 2016
Timely intelligence and
analysis for our clients.
Frontier Markets
IRAN—DISPELLING THE
MISCONCEPTIONS, BUT ACCEPTING
THE CHALLENGES
EXECUTIVE SUMMARY
Iran’s historic nuclear deal and the lifting of sanctions should bring the country back
into the global community. For investors, it is being heralded as the return of the
largest economy to the global system since the breakup of the USSR in 1991.
Oliver Bell
Portfolio Manager,
Frontier Markets
Mark Lawrence
Investment Analyst,
Frontier and Emerging
Markets
In this Price Point, Oliver Bell, portfolio manager for T. Rowe Price’s Global Frontier
Markets Equity Strategy, and Mark Lawrence, investment analyst for frontier and
emerging markets, went on a fact-finding mission prior to the lifting of sanctions and
discuss what they found.
Our first trip to the country was a real eye-opener and exposed many of our biases as
wrong. From the smooth, welcoming breeze through customs, to our three days of
one-to-one meetings and excursions outside the hotel, we realized how many of our
conceptions were untrue. Former President Mahmoud Ahmadinejad (personal fortune
estimated at US$30+ billion) did much to fuel the fear that Iran was an “evil state,” but
everyone we met told us that he was a hard-liner whose time had come and gone. In
reality, Iran appeared more like Turkey than Saudi Arabia—Tehran being a very
cosmopolitan city with a much more liberal attitude than we expected, with women
appearing fully integrated into society.
Importantly, the country is educated, entrepreneurial, and asset rich, but remains cash
flow poor because of the sanctions that have been in place since 1979. With those
sanctions being lifted, there is much to like as an international investor.
A BRIEF HISTORY LESSON AND SOME KEY FACTS
 Originally known as Persia until 1935. The population of 80 million is 90% to 95%
Shia and adheres to the Shia interpretation of Islam. It became an Islamic republic in
1979 after the Iranian Revolution when the ruling shah was replaced by the Supreme
Leader Ayatollah Ruhollah Khomeini.
 Today, Iran’s supreme leader is Ayatollah Ali Khamenei. President Hassan Rouhani came to power in July
2013. The Iranian president is elected for four years and can serve no more than two consecutive terms. He is
the second-highest ranking official after the Ayatollah and heads the executive branch of power. However, the
supreme leader remains preeminent as Commander-in-Chief of the armed forces and dictates defense,
security, and foreign policy.
 The Iranian Revolutionary Guard Corps (IRGC) was established in 1979 to protect the revolution. It is Iran’s
most powerful security, its military body, and its most influential economic player, with control over an extended
network of state or quasi-state companies.
 Iran is the world’s largest holder of oil and gas reserves combined (number four in oil, and number one in
natural gas).
 Demographics: Similar to Nigeria, Egypt, and Turkey, Iran has a large and young population, with 60% under
the age of 30.
 Well-educated work force: The third-highest number of engineering graduates after the U.S. and Russia.
 Highest literacy rate in the Middle East and North Africa (MENA) region at 85% from 2008 to 2012, according to
UNICEF, with 99.9% of primary school children enrolled for school from 2008 to 2011.
 Strategic location: A part of the Middle East, the Persian Gulf, Central Asia, the Caspian Sea, South Asia and
having a huge landmass: 18th largest country in the world.
AN ECONOMY OF SIZE…
Iran is the second-largest economy in the MENA region after Saudi Arabia, with a GDP of US$406.3 billion in
1
2014 (roughly the same size as Thailand). Iran’s GDP grew by 3% in 2014 after two years of recession, boosted
by the Rouhani government's strategy of reform and foreign engagement. The government has put in place a
strategy aiming for an economy unencumbered by sanctions, improved science and technology, reform of some
state-owned enterprises, reform of the banking and financial sector, and allocating oil revenues to policy priorities.
Public and quasi-state enterprises dominate.
The World Bank viewed the medium-term outlook as positive if nuclear-related sanctions were eased and the
government enacted reform. It sees growth decelerating from 3% in 2014 to 1.9% in 2015 (based on the Iranian
calendar year, which runs from March). However, now that sanctions have been lifted before the beginning of the
2016 Iranian calendar year, it projects real GDP could rise to 5.8% in 2016 and 6.7% in 2017. The International
Monetary Fund (IMF) forecasts real GDP growth of up to 5.5% in 2016/2017 and 2017/2018, settling at around
3.5% to 4% per annum thereafter.
The IMF sees Iran boosting global oil production by 600,000 barrels per day (bpd) in 2016, based on the rollback
of EU and UN sanctions, rising to 1.2 million bpd over the medium term. That would be equivalent to
approximately half of global oil demand growth in 2016.
Inflation has dropped from a peak of 45% in 2012 to the low teens today due to tough monetary policy. We expect
interest rates to fall and potentially one more large adjustment in the Iranian rial/dollar exchange rate from the
current R36,300/US$. As banks reconnect to the outside world post sanctions, capital flows should follow, while
oil can only increase its importance within the economy.
1
Sources: Thomson Reuters and Morgan Stanley Research.
PRICE PO INT
2
2
2
…BUT IN NEED OF FINANCE
A number of executives told us that the Iranian government was out of cash and that the country needs to issue
more debt. It certainly has a liquidity issue and needs further capabilities in risk management (there are currently
no rating agencies) and legal frameworks (bankruptcies and liquidations cannot be easily facilitated) to meet this
demand.
Longstanding state involvement and weak governance combined with several years of sanctions has left the
banking sector in a relatively weak state. The banks we met with were heavily exposed to non-core assets in real
estate, franchises, equities, etc., probably due to restricted investment alternatives imposed by sanctions.
Compared with other emerging market and Gulf peers, credit penetration is at the higher end of the range at
2
67%. However, the sector is highly fragmented, with the five largest banks accounting for just one-third of the
system assets. This relatively crowded market may help explain the comparatively low profitability, alongside the
apparently elevated level of unproductive delinquent loans.
The Tehran Stock Exchange (TSE) operates two exchanges, with 540 listed companies on the main bourse,
US$120 billion market cap, US$40 billion turnover volume per day, and a somewhat staggering 107 brokers. The
daily limit up/down is set at 5%. ETFs were launched in 2013, and 11 are currently listed on the TSE. The index
trades at 6x P/E (having been as low as 4x to 5x P/E) and an average dividend yield of 14%, but with negligible
foreign participation. A huge government-led privatization drive in 2006 put a wide range of corporates back into
the private sector. The top 10 listed companies account for 50% of the TSE’s market cap, with seven of those
3
having been registered as part of the government privatization programs.
A RESOURCEFUL NATION
During our visit, it struck us that Iran is already operating pretty well despite sanctions. It has developed smallerticket items itself or has shipped from neighboring countries. The shops were fully loaded with goods, many items
that you would buy in the West (Figure 1).
Most products are also much cheaper as the Iranian rial (IRR) has undergone two large devaluations—in 2002 by
almost 80% (against the U.S. dollar) and in 2013 by 50%, resulting in the overall real depreciation of 50% since
2000. Measured on purchasing power parity (PPP), the value of the rial is 30% of what is implied by the PPP
levels calculated by the IMF (goods are 70% cheaper than the comparable basket in the U.S
RISK AND REWARD
We believe there is money to be made for first movers coming into the market in early 2016. Longer term, the
road looks more uneven and the chances of having stranded investments are just as likely. The purpose of the
trip was to acquaint ourselves with Iran and its idiosyncrasies, which we have done in part but need more time
with companies and government officials to become truly comfortable investing. Although, the quality of meetings
we had during our visit was much better than anything we had when we first visited the Gulf Cooperation Council
(GCC) back in the mid-2000s. In some ways, it felt like our first trip to Saudi Arabia in 2006/2007.
The banking system does cause concerns as it is undercapitalized and has a high rate of nonperforming loans,
and there is no plan for recapitalization yet. However, there is a lot of interest from foreign capital, and many of
the Iranian banks are already talking to international banks.
The oil and mining sector dominates the economy and the stock market and is desperate for capital/foreign
cooperation. Therefore, there is a narrow, rich seam to play in the stock market, and it may be a crowded trade.
2
3
Source: Morgan Stanley Research.
Source: Tehran Stock Exchange
PRICE PO INT
3
3
3
Also, the IRGC is a major force in the economy, with stakes in a wide network of state-owned and quasi-state
businesses and influence in the private sector.
Figure 1: Western Brands Easy To Find
Source: T. Rowe Price.
Issues such as business transparency and corruption are also central in the development of any frontier
economy. In transparency terms, Transparency International’s 2014 Global Corruption Index ranked Iran 136 out
of 175 countries. Meanwhile, in the World Bank’s 2015 Doing Business survey of 189 countries, Iran ranked 130.
However, interest in Iran will only grow going forward because of its reintegration into the global economy, its
huge hydrocarbon power, and its positive demographics (which will be key to future growth prospects). Iran has
also historically been seen as part of the “Next-11” (a term coined by Goldman Sachs) group of countries that
have the potential to become significant emerging market economies.
Institutional investors, however, will probably face some challenges in areas of liquidity and corporate
governance. Challenges such as these are not uncommon as markets open up, and there are always areas for
experienced investors to uncover neglected companies with healthy or improving operations.
Ultimately, with a focus on quality, investment in Iran could prove rewarding, especially given the very low
valuation starting point. In addition, with Iran being one of the last great frontier markets left to invest in, it could
potentially provide one of the final pieces of the investment puzzle for some investors.
PRICE PO INT
4
4
4
Important Information
This material, including any statements, information, data and content contained within it and any materials, information, images, links,
graphics or recording provided in conjunction with this material are being furnished by T. Rowe Price for general informational purposes only.
The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries
the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction. Under no circumstances
should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price. The material does not constitute a
distribution, an offer, an invitation, recommendation or solicitation to sell or buy any securities in any jurisdiction. The material has not been
reviewed by any regulatory authority in any jurisdiction. The material does not constitute advice of any nature and prospective investors are
recommended to seek independent legal, financial and tax advice before making any investment decision. Past performance is not a reliable
indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less
than the amount invested.
The views contained herein are as of January 2016 and may have changed since that time. Unless indicated otherwise the source of all
market data is T. Rowe Price.
The third party logos in the photographs contained herein do not imply any endorsement, affiliation, approval or sponsorship by T. Rowe Price
of such parties' products and services.
Australia - Issued in Australia by T. Rowe Price International Ltd (ABN 84 104 852 191), Level 50, Governor Phillip Tower, 1 Farrer Place,
Suite 50B, Sydney, NSW 2000, Australia. T. Rowe Price International Ltd is exempt from the requirement to hold an Australian financial
services licence in respect of the financial services it provides in Australia. T. Rowe Price International Ltd is authorised and regulated by the
UK Financial Conduct Authority under UK laws, which differ from Australian laws. For Wholesale Clients only.
Canada - Issued in Canada by T. Rowe Price (Canada), Inc. T. Rowe Price (Canada), Inc. enters into written delegation agreements with
affiliates to provide investment management services. T. Rowe Price (Canada), Inc. is not registered to provide investment management
business in all Canadian provinces. The investment management services provided by T. Rowe Price (Canada), Inc. are only available for
use by Accredited Investors as defined under National Instrument 45-106 in those provinces where it is able to provide such services.
DIFC - Issued in the Dubai International Financial Centre by T. Rowe Price International Ltd. This material is communicated on behalf of T.
Rowe Price International Ltd by its representative office which is regulated by the Dubai Financial Services Authority. For Professional Clients
only.
EEA - Issued in the European Economic Area by T. Rowe Price International Limited, 60 Queen Victoria Street, London EC4N 4TZ which is
authorised and regulated by the UK Financial Conduct Authority. For Professional Clients only.
Hong Kong - Issued in Hong Kong by T. Rowe Price Hong Kong Limited, 21/F, Jardine House, 1 Connaught Place, Central, Hong Kong. T.
Rowe Price Hong Kong Limited is licensed and regulated by the Securities & Futures Commission. For Professional Investors only.
Japan - Issued in Japan by T. Rowe Price International Ltd, Tokyo Branch (KLFB Registration No. 445 (Financial Instruments Service
Provider), JIAA Membership No. 011-01162), located at GranTokyo South Tower 7F, 9-2, Marunouchi 1-chome, Chiyoda-ku, Tokyo 100-6607.
This material is intended for use by Professional Investors only and may not be disseminated without the prior approval of T. Rowe Price
International Ltd, Tokyo Branch.
Singapore - Issued in Singapore by T. Rowe Price Singapore Private Limited, No. 501 Orchard Rd, #10-02 Wheelock Place, Singapore
238880. T. Rowe Price Singapore Private Limited is licensed and regulated by the Monetary Authority of Singapore. For Institutional and
Accredited Investors only.
Switzerland - Issued in Switzerland by T. Rowe Price (Switzerland) GmbH ("TRPSWISS"), Talstrasse 65, 6th Floor, 8001 Zurich, Switzerland.
For Qualified Investors only.
USA - Issued in the USA by T. Rowe Price Associates, Inc., 100 East Pratt Street, Baltimore, MD, 21202, which is regulated by the U.S.
Securities and Exchange Commission. For Institutional Investors only.
T. ROWE PRICE, INVEST WITH CONFIDENCE and the Bighorn Sheep design are, collectively and/or apart, trademarks or registered
trademarks of T. Rowe Price Group, Inc. in the United States, European Union, and other countries. This material is intended for use only in
select countries.
2016-G L- 327 1
1/16