Investing in Indonesia's favourite pastime

Sala Kannan - Tue 20 Jun, 2006

...Like cigarettes in Indonesia, tortillas in Mexico or Tata cars in India, looking for what an entire population buys is a great starting point for scouting investment opportunities...

 
 
I arrived in Indonesia's capital, Jakarta, on World Anti-Tobacco Day. Ironically, I'm here to research the country's thriving cigarette industry. It is the second largest employer in Indonesia. And the country's three biggest cigarette makers are also among the largest taxpayers in the country. The industry contributes 12% of Indonesia's tax revenue.

Smoking is a passionate pastime. The thick, spicy smell of Indonesia's clove-based kretek cigarettes is everywhere. Street peddlers sell kreteks at traffic stops like hot dogs at a baseball game. Children as young as 15 smoke on street corners. And it seems like every wall in Jakarta is plastered with kretek advertisements.

Kreteks are made from a mixture of cloves and tobacco, giving them a characteristic spicy flavor. 92% of all cigarettes sold in Indonesia are kreteks. It is said that an Indonesian called Nitisemito invented kreteks. Claiming that cigarettes relieved his asthma, he mixed tobacco with crushed cloves and rolled it in corn leaves. He began selling these cigarettes in 1906. When one smoked Nitisemito's corn husk-rolled cigarettes, the burning husk made a "kretek-kretek" sound. Hence the name of the cigarette.

I met economist Kahlil Rowter to talk about Indonesia's consumption trends. Kahlil is a knowledgeable and jolly man; he brought along Rani Sofjan, head of equity research at Mandiri Securities. We met in Jakarta's Auto Mall - a mall cum auto exhibition. On the first floor there were Isuzu, Harley-Davidson, Suzuki and Nissan vehicles on display. On the second floor was a line of shops and eateries.

We sat down in a cafe and chatted over cappuccino and chamomile tea. "Do you mind if I smoke?" Kahlil asked, pulling out a pack of Sampoerna A Mild kretek cigarettes. Around us, everyone in the cafe was lighting up. A thick cloud of smoke hung over every table.

Over 50% of Indonesians smoke. The evidence is everywhere - in malls, on the roadside, after work, during lunch - Indonesians are addicted to smoking. And they start young. The Indonesian health department estimates that 22.9% of urban 10-year-olds and 24.8% of rural 10-year-olds smoke.

"It's a rite of passage," Kahlil explained. "In the US, a child is grown up when he gets a driver's license. Here it is when he starts smoking," he joked. Blowing out a puff of clove smoke, Kahlil reminisced. "As a teenager, my father used to say I could start smoking when I had my own money to buy a kretek."

I asked if there have been any nonsmoking regulations. "Look at how full this cafe is," Rani Sofjan said, pointing with her Marlboro Light. "A few months ago, the cafe tried to implement a no-smoking rule. Its sales fell by half. Nobody wanted to come here anymore if they couldn't smoke. Then it lifted the ban and now business is good."

"Guess why Indonesians smoke so much?" Rani asked. "We are a Muslim country. We're not allowed to drink. So we turn to the other vice - smoking," she laughed. And although it is a health hazard, most smokers seem to ignore the negative effects of smoking.

"Nobody is worried about dying from smoking when there is the bird flu, earthquakes, volcanoes and tsunamis," said Rani.

Such complacence on the consumer's part has only helped the cigarette makers. Sampoerna is Indonesia's fastest-growing kretek maker. Its market share has grown from 4% in 1992 to 25% today. The stock trades for just 12 times earnings. In fact, Sampoerna's growth and performance were so attractive that tobacco giant Altria bought out the company last year.

The other significant players in the kretek market are Gudang Garam and Djarum. But Sampoerna's A Mild brand is the most popular. Gudang Garam and Djarum attempted to compete with Sampoerna in the mild segment, but failed. And the failure isn't surprising. Sampoerna has such great brand loyalty that other brands face a tremendous barrier to entry. That also means that Sampoerna can raise prices and easily pass them on to the customer.

"Cigarettes are a good play on domestic consumption," said Kennyarso Soejatman, portfolio manager at First State Investments Indonesia. And with the downward trend in interest rates, consumption growth is expected to pick up in Indonesia. Already, Indonesian households spend more on tobacco than they do on clothing and meat.

J.P. Morgan head of equity research Rizal Prasetijo told me, "The commodity boom has also put more money in people's hands. Purchasing power is on the rise." Indonesia is a significant producer of oil and gas, coal, copper and coffee. Record-breaking price increases in all these commodities have improved revenues for corporations and purchasing power for individuals. Already, demand for kreteks is so high that Indonesia has gone from a net exporter of cloves to a net importer.

Rizal also gave me an important investing tip: "Buy stocks in the nontradable sector." Nontradables are those goods that cannot be dumped in a foreign market when there is excess production domestically. Rizal explained, "For example, if Malaysia built excess telephone lines, it couldn't bring them and sell them here in Indonesia. So telecom is a nontradable sector.

"If China built excess roads, it couldn't export the excess, so infrastructure is a nontradable sector. So are banking and real estate.
The nontradables are buffered from foreign competition.

"Interestingly, kreteks are nontradable. If a foreign country produced excess cigarettes, it'd never be able to export them to Indonesia, because Indonesians don't smoke regular cigarettes. So our cigarette industry is buffered from foreign competition."

Kreteks in Indonesia are a classic case of emerging market consumerism.
Mark Mobius of Templeton Funds says, "Commodities play a key role in an emerging-market investment strategy. But just as important are the consumer-oriented stocks."

Mobius notes that spending power among citizens in developing countries is rising rapidly, and consumer-product companies are benefiting. His favorite picks include telecommunications giant China Mobile Ltd. and South Korea's Samsung Electronics Co. Ltd.

As populations expand and incomes grow, people tend to consume more and more of certain goods. Often, such consumption patterns are culturally defined. Like cigarettes in Indonesia, tortillas in Mexico or Tata cars in India, looking for what an entire population buys is a great starting point for scouting investment opportunities.


Regards,

Sala Kannan
for The Daily Reckoning