The well-attended Sri Lanka Summit in Singapore organised by the Finance Asia recently had a very useful session on ‘Equity Investments in Sri Lanka’.
Among participants were a large number of portfolio fund managers, investment bankers and individual investors. As a prelude to the panel discussion, Colombo Stock Exchange Chairman Vajira Kulatilaka made a comprehensive presentation.
CSE Chairman invited the near 350 participants at the Summit to be part of South Asia’s strongest growth story. He said the Sri Lankan stock market offered attractive valuations/returns backed by lower risk through strong market fundamentals. The CSE was also identified as good diversification opportunity with little or no correlation to global markets.
Another factor is that low equity market capitalisation to GDP ratio indicates strong growth potential for the Colombo stock market which offers better returns with lower risk. Kulatilaka also said investors could take heart from the fact that CSE has adopted world class risk management practices and offers free repatriation of returns.
Given recent positive developments in the country and policies and projects underway for the future, he said the time was right to invest in Sri Lanka. He said that Sri Lanka’s growth performance had far exceeded that of global economies between 2013 and 2015 and the trend would continue.
He also revealed that CSE ASPI continues to significantly outperform major global indices such as the MSCI World, Dow Jones, FTSE100 and DAX. Additionally, it has significantly outperformed most regional indices such as MSCI Emerging Market Index, Jakarta, Thailand, Philippines, Hanoi and Mumbai.
Sri Lanka’s attractive valuations compared with regional competitors was also highlighted. The Price Earnings Ratio at the CSE is 14.7%, against the 23% of Singapore, 20% of India, 19% of Thailand, 17% of Philippines and 16% of Malaysia.
He also listed some new developments at the CSE. Under market regulation, he said a new SEC Act, which will result in an improved regulatory framework, is in the offing. Under risk management, the establishment of a Clearing Corporation to act as a central counter party for all secondary market transactions benchmarking IOSCO best practice standards and introduction of world-class risk management to the market were explained.
In terms of diversification of product range, Kulatilaka said the CSE would introduce a range of new products such as Real Estate Investment Trusts (REITs), Structured Warrants, Exchange Traded Funds (ETFs) and equity related derivative products.
To improve governance, the CSE was progressing with plans for demutualisation and on market infrastructure, a new back office and order routing system for brokers, upgraded ATS, CDS and surveillance system and information security improvements, ISO certifications and upgrades to exchange Infrastructure were cited.
“Be a part of Sri Lanka’s growth story. It is a sound investment decision stemming from strong capital market fundamentals,” Kulatilaka emphasised.
Following the CSE Chief’s speech, a panel discussion was held featuring Asia Securities Chairman Dumith Fernando, Lynear Wealth Management Managing Director Dr. Naveen Gunawardane and Julius Baer & Co Ltd. Head of Research Asia Mark Mathews with Credit Suisse Head of Frontier Market Research Chate Benchavitvilai as the moderator.
Opening remarks from Dumith Fernando
In Sri Lanka, this is the year where you shop for good houses in a bad neighbourhood. This is because it is a tough market globally and locally but there are astounding valuation opportunities if you follow good analysis, good research. We believe this is a great time to talk about the Sri Lankan market. Putting it in context the performance of the market saw two years of 100% gain in 2008 and 2009 partly driven by loose broker credit and in retail market. Thereafter with strong regulations coming in there was a necessary dip in the market about 9% in 2011. Since then it has been running at flattish rates until 2014 when the market moved up 25%.
Last year with a lot of foreign risk aversion on emerging markets, the market dip by 8% and year-to-date around 10%. That is no different to what has happened in emerging markets across the board. What is exciting about Sri Lanka is if you look at forward multiples, Sri Lanka is the cheapest among peer groups, similar to Pakistan among frontier markets and cheaper than most in Southeast Asia including Vietnam. So there are some great opportunities that people should look at in Sri Lanka.
Foreign inflows were positive for number of years until last year when there was an outflow of Rs. 4.5 billion. It has been flat so far this year. In terms of primary markets, this is something which hasn’t taken off with just one or two IPOs in recent years. This is an area where we expect a little bit more engagement from some of the State-Owned Enterprises with potential listing in the next couple of years once their restructuring is completed. This would add liquidity in a significant manner.
Among issues within the top of investors’ minds is a return of Capital Gains Tax, which was abolished in 1987. The sell-off that happened soon after its announcement offers a fresh round of buying opportunities on top of already depressed valuations.
In terms of ease of trading, the CSE has been an internationally open market for a very long time. Bringing capital in and out has been very easy. There a several good service providers in the market as well, so it is an easy market to trade and valuations are very attractive.
Dr. Naveen Gunawardane
We firmly believe there is value in the Sri Lankan market. The market has dropped by 90% during the past six to seven months. The market was trading at over 15 times as per September 2015 earnings and we are roughly about 12.5% times at present. Historically in the post-war era we may have seen it before only once, perhaps in 2011-12 when Sri Lanka was coming out of a consumer-driven credit boom when interest rates went up by about 700-800 basis points.
We have already seen one-year Treasury Bill going up by over 200 basis points. In 2011/12 Sri Lanka too had pressure on the Balance of Payments. But certainly we believe valuations are attractive in the market. We are seeing banks which are trading below book value with 45% dividend yield. Banks can trade below book value for various reasons but in Sri Lanka what we find is Lankan banks are relatively well-capitalised given their size. Their asset quality is good compared to some of the peers in the region.
At the same time we are seeing growth companies which also have very high dividend yield. So I think there is a rally back in the market. As long-term value investors this is probably the time to come in. One caution I like to share is that liquidity is quite tight in the market as you would expect in any frontier market. In terms of timing of your investments to a large extent are driven by liquidity events perhaps with the exception of a few blue chips. So it is difficult to buy stocks that you want. We have seen a couple of foreign funds slowly cutting down their positions, on account of redemptions which in turn have provided a bit of liquidity for some of the local institutions. So there is absolute value in the market and there is liquidity, hence it is a good time to get in.
Moderator question to Mark Mathews: How compelling is the story of Sri Lanka compared with others in the region?
A: I used to do your job; I was a frontier market strategist once. I found everybody wanted to hear the story because it is a fascinating story. I also found out that it’s very little business relative to the talking I had to do. It’s very hard to cut a cheque in these markets like Sri Lanka as they are un-benchmarked and illiquid. So I think that means institutions are not really going to have much exposure there or pay much attention to it. But as an individual who cares about what the institutions think or do, I think Sri Lanka’s story is great.
I see a rare mix of high growth and well-run companies. Usually you don’t find those two together. If the company is well run it’s because it’s very old and is operating in a mature economy. If you have a high rate of growth, then you’re more likely to be in a country which is coming out of some kind of a problem or holding it back. The other reason is good corporate governance. I think Sri Lanka is a great “buy and hold” market. For that matter every market should be “buy and hold” as we lose money by trading a lot and you make money by continually adding and not selling to your portfolio. So I am sure 10 years from now people who would buy Sri Lanka today will be enormously satisfied.
Moderator Q: In the context of frontier markets, how mature are companies in Sri Lanka when it comes to good corporate governance?
Dumith Fernando: This is actually one area where Sri Lanka has stood out for a long time in comparison, not just frontier markets but some emerging markets as well. We have operated under a legal system that comes from the days of British law that was a part of Sri Lanka’s pre-independence. The levels of corporate governance take a cue from that. Well I’m not going to lie to you and there are companies that may not fare well on corporate governance benchmarks, but if you look at most of the stocks in the S&P 20 which are also the largest and liquid stocks, we feel very comfortable with governance.
The reaction from a lot of investors, particularly those who come down to Sri Lanka, is one of amazement. I think they feel the management is much more friendly, accessible, easy to communicate with and transparent. We find it the same when clients come down; the ability to access the C Suites of corporates during investor meetings is actually very easy. There are quite a lot of positives on that. Having said that, I think we also feel that it’s a market where it’s important to follow a good load of knowledge and insights. I think we always encourage people to make a visit, get to know their analysts and companies on the ground before you invest.
In the context of frontier markets I have no hesitation regarding the quality of management which is pretty good. Frankly, our single biggest challenge that has kept some people away has been liquidity, and there are moves to change that. Again to buy and hold investors, we can come back to perspectives on valuation but there are better opportunities in the medium- to long-term.
Naveen Gunawardane: I have to agree with Dumith. I think one of the areas we have been pleasantly surprised in terms of investing in the Sri Lankan market is the quality of the management and importantly in terms of the disclosures and terms of access. If you go back to five to seven years, you would have seen only a handful of companies that actually did investor relations. We have seen that change drastically over the last few years and you have more companies stepping up investor relations and going on road shows. Company management is very open to taking meetings with investors. So it has been a positive sign.
Q: How has been the investor interest on Sri Lanka as a frontier market?
Mark Mathews: I speak from two perspectives. First is my perspective as an employee of Julius Baer. The interest is not that big unfortunately. I’m just being honest. Liquidity is one major issue and the other is awareness. It makes a huge difference. If I say Disney, people will recall quick as they may have watch their movies or been to their parks. If I say Bangkok Bank, most people will say yes I’ve been to Thailand I think it’s a great place. But an average person doesn’t know or hasn’t been to Sri Lanka. So that wall is going to be there for a long time. People don’t like to own what they don’t know.
My second perspective as someone who knows Sri Lanka I must recall is that the last time I came for a Sri Lanka seminar was 10 years ago. It was at Sheraton at Scotts Road in Singapore, the interest was low. Today look at all the people in the room. I’m amazed about how many are interested about Sri Lanka and I think they should be. Frontier markets are always going to be a hard sell but I think some of them, and Sri Lanka is one of them, have very interesting attributes and you should invest in them regardless of what the rest of the world thinks.
Q: Have you seen increased foreign participation on the equity side?
Dumith Fernando: I will take Mark’s point. But I would also remind all that Warren Buffet rarely invests where everyone else is buying. I think the smart investors will look for opportunities when things are not in favour. There are a number of things we can control and a number of things we cannot. I think fundamentals are very solid stating from macro growth numbers. Earlier the banking sector was referred to. Banks are trading below book value. The sector has seen assets grow at 17%-18% a year for the last five years. Net NPL ratio of 1.7 as of last year, total equity capital ratios are over 16%, the ROEs are 16%-17% range. To buy a banking sector stock with those characteristics at that price, well good luck. It’s just one example why I think the sell-off can be questionable.
You’ve got to understand what’s happening. Post-war there were a lot of large US and European funds who came in and brought large stakes. They’re facing redemptions at their emerging markets fund level. Now these are not choices made by the analysts and portfolio managers but when their retail investors redeem, they have to sell down. That has led to some forced selling on some Sri Lankan equities in large part. Therefore, fairly large liquid S&P 20 stocks have actually come down in valuation because it’s those types of quality investors who were in fact with them and with the recent sell off they have become much more attractive.
It’s not that there are highly illiquid small mid cap stocks that we are trying to tell people to buy. But there are actually the large cap and liquid ones that people attending this summit would be interested in and the ones that are the best proxy of the economy. If you look at earnings as well, stock price performance of the banking sector for the most part it’s now proxy to the Sri Lankan market. Once it was the conglomerates. There are a number of other sectors but clearly I feel that as little interest there may be, it’s for those who are looking for value.
Q: On what macro indicators should investors be looking out for the next 12 to 18 months and what stocks should they focus on?
Naveen Gunawardane: We need to watch out for the pressure on the balance of payments as well as the IMF facility. For the next 12 months GSP+ will have a very significant impact on our market. From a regional point of view, keep an eye on regional currencies so if the regional currencies depreciate it could put some pressure on the LKR as well. So those are some things we should look out for.
In terms of areas or sectors where we should be bullish on, one of the sectors is construction. If you look at last year, it was a relatively a dull year for the construction sector because with the Government transition many projects came to a halt. But even being a dull year what we saw was construction companies doing quite well. That was because the private sector was taking up that slack left by the Government sector.
This year we see a lot of the Government sector projects coming back online. Last year was more of a consumer-driven story in Sri Lanka. That could potentially slow down a little bit with the increase in taxes, depreciation of the rupee and rise in interest rates. For the next three to five year horizon it’s very much bullish towards the Sri Lankan consumer-related players. We also have the manufacturing sector on the exports side; what you would see there is quite a few companies which are trading decent multiples with good dividend yields and 20%-30% growth.
Dumith Fernando: I like to add that in terms of risks, I too would add balance of payments. We need to get some comfort, whether it be via asset sales or other methods. Another is the extent and length of the Middle Eastern conflict and the softness of oil prices. Because most of our remittances, which is 10% of GDP, comes from there. The other is fiscal consolidation which is connected to the balance of payments issue and the Government is addressing it.
In terms of positive things and future growth sectors, the issue is how quickly the construction agenda starting from the Megapolis to infrastructure projects get going. The construction industry has grown by 18% over the last three to five years. We expect that to continue along with great opportunities. The consumer sector is another. It benefitted from a raise in wages last year, boosting consumer spend. On the other hand, high credit growth will have a bearing on the banking sector asset quality.
Q: There was reference to liquidity. Could you talk about it a little bit in the context of the free float of the companies that are listed and how privatisation would help?
Naveen Gunawardane: With the exception of probably a handful of companies, one of the biggest issues large institutions investor face in Sri Lanka is actually buying the quantity they want. Quite a lot of companies in Sri Lanka that are listed have been family-owned companies so they still want to keep quite a bit control, but I think that is changing. We have seen companies addressing the free float. We saw a family-owned company increased the free float by bringing in institutional investors.
The CSE has come up with some initiatives where they require listed companies to maintain a minimum free float. Therefore I think the existing listed companies will probably increase their free float. At the same time, to attract foreign investors it’s critical to do some sort of listing of the State institutions because the market cap of some of the large companies are still quite small compared to international standards.
Dumith Fernando: The only thing I would add about the free float what we see at the moment is there has been a lot of concern of the free float; people have found creative ways to get in and out of positions. There are some companies like JKH and Commercial Bank which are pretty much all free float. Then you have Ceylon Tobacco, another favourite of foreign investors, which has a very minimal free float. So people who want to look at proxy stocks for a certain sector have been going after these stocks. We now also encourage people to look at maybe sector baskets where you don’t get hit by prices getting in and out but you get the technical equivalent and exposure. That’s certainly something where you have an opportunity.
In terms of Government sector I’m fully aware there is political sensitivity for privatisations or listing but all other sectors, the State banking sector, the larger insurance companies and a number of good performing assets which are potentially much more politically sensitive and will hopefully become better with time. I keep reminding that everyone from communist China to India got a listed state bank, and listed state insurer. Overtime there is no reason why we should set ourselves apart. I think the noncore assets being put on the market is a good starting point. That would be essential and those that come will be chunky sizes as well.
Q: What new investment products are being developed at the CSE?
Dumith Fernando: There are plans. Once the Central Counter Party (CCP) and DVP take place, which should be early next year I think, it will open up opportunities for ETFs and REITS products.
Q: What stocks or sectors are recommended for buying?
Dumith Fernando: We believe the construction sector will do very well and on that Access Engineering for a number of reasons; they just raised Fitch rated debt of Rs. 5 billion before the rates went up, so they have plenty of capacity available for a two- to three-year pipeline of Rs. 3 billion, although some of their margins will come down because the Government is looking at projects in a more cost-efficient manner. I think we expect the private sector projects to increase and that will help AEL.
A slightly less liquid stock is Tokyo Cement, we feel that regardless of the sector growth in terms of construction, whether it’s residential, infrastructure or water works, there is lot of demand for concrete and cement. Apart from being one of the leading manufacturers, Tokyo Cement also has a connection with Nippon Coke and with the Japanese funding more projects going forward we feel that there is an option for them to enhance their sales. They have also integrated operation with biomass energy reducing their fuel cost, so I think there is a good story there.
In the manufacturing sector going back to GSP+ assuming that it come early next year, we feel that Textured Jersey is a very interesting stock. It has got lot of capacity that they can double up very soon if they have to and with GSP+ I think apparel manufacturers will have to source their material locally, which means TJL will benefit and they are a very well-run operation.
In the banking sector, certainly Commercial Bank. Very strong bank, very solid book quality, solid management and strong growth.
On the consumer sector it is Hemas Holdings. Strong franchise, great brands, leading local drug manufacturer with 22% of the distribution market. They are also in healthcare and also expanded in Bangladesh with success. It is also moving up the value chain tourism sector. These are the guys who have the local hotel venture with the Minor Group in Thailand. Another stock is Dialog Telecom.
Naveen Gunawardane: We are bullish on the construction sector with Access Engineering and Tokyo Cement being our favourites. On the banking side I would have HNB with its non-voting share being very attractive. One other company I would like to add is Dialog Telecom a part of Axiata and we are bullish on Dialog on the data side. If you look at the telecom infrastructure in Sri Lanka, both Dialog and SLT have invested quite a bit in terms of increasing the bandwidth coming into Sri Lanka. Our smartphone penetration in Sri Lanka is only about 20% and data margins are quite healthy. Another is Textured Jersey.
Mark Mathews: Usually if I want exposure to a country I will buy the best company in every sector and have a basket of five and not pay much attention to the sector. But I think banks are attractive in Sri Lanka. In preparing for this panel discussion I discovered that there are over 50 names in banks, finance and insurance sector, for a market this size. What I have also seen is that when there is lot of M&A or potential in the sector it tends to do well. I know the Government is encouraging M&A in the financial sector because there are over 50 listed companies, which is ridiculous.
First part of Daily FT coverage on Sri Lanka Summit in Singapore was published on Monday and more coverage will appear in the next few days. The Summit’s International Lead Sponsor was Standard Chartered Bank. Co-sponsors of the Summit were Asia Securities and Perpetual Treasuries. Colombo Stock Exchange was the Strategic Partner. Supporting organisations included the American Chamber of Commerce, Ceylon Chamber of Commerce, European Chamber of Commerce SL, Oxford Business Group and the Singapore Sri Lanka Business Association. SriLankan Airlines was the Official Airline Partner and Daily FT the Media Partner.