Sri Lanka's Stock Market Outlook With Softlogic Stockbrokers

Mar 26 2014, 9:23pm CDT | by

Sri Lanka's Stock Market Outlook With Softlogic Stockbrokers
Photo Credit: Forbes Business

Softlogic Stockbrokers of Sri Lanka is a subsidiary of Softlogic Holdings PLC, a growing conglomerate that began as an IT company in 1991. Dihan Dedigama has been CEO of Softlogic Stockbrokers for three years after previously working as CEO of Sri Lankan stockbroker Asia Securities for six years. In this interview, Mr. Dedigama provides his insights into Sri Lanka’s capital markets and economy.

When Sri Lanka’s 26-year civil war ended in 2009, the stock market rose euphorically through the early days of 2012, including a gain of over 90% in 2010. Since the 2012 correction stabilized in the fall of 2012, the Colombo Stock Exchange (CSE) All Shares Index has been range bound between 5300 and 6500. Sri Lanka’s GDP has steadily grown at a rate between 6% and 8.2% since the end of the war.

Local market confidence is improving. Treasury Secretary P. B. Jayasundera recently said:

We no longer feel uncomfortable to speak to the International Monetary Fund, the World Bank, the international rating agencies, the international business community, all the visiting investors, because we can positively say what the government should do has been done very well.

The IMF has characterized the room for economic growth in Sri Lanka as significant:

Sri Lanka is a special case, with a long period of internal conflict and now a period of peace… There is a huge room for the economy to grow.

With these dynamics in mind, this is Mr. Dedigama’s perspective.

Jon Springer: There are pronouncements by international firms from New York, London, Hong Kong and elsewhere regarding how well or poorly emerging markets will do as an investment class in 2014. Although every country is impacted by global factors such as the tapering of the U.S. Federal Reserve and China’s growth slowing, each country has a different story. What is Sri Lanka’s potential for investors?

Dihan Dedigama: I don’t think we can go against the grain of emerging markets performance. We will get caught up in these trends. You can see this in the low volumes of trading on the CSE. In the sense of tapering and the generic pull out from emerging markets, this is certainly impacting Sri Lanka.

However, following the Central Bank of Sri Lanka’s intervention in 2012 and 2013, we have seen drastic improvement in exports and other improvements. Sri Lanka’s balance of payments and currency stability are good. Sri Lanka has had a sharp decrease in inflation with the interest rates coming down.

Corporate earnings have shown strong improvement in the last quarter of 2013. From the local side, we expect the market to move upwards in line with expected earning during the course of the year. Particularly, with the lowered interest rate environment, we expect earnings to continue to improve. The Central Bank has indicated rates will be steady or may somewhat reduce.

Another positive is that some of the state owned enterprises have started building again. For the last year and a half, higher interest rates and higher oil prices dictated more caution. Our oil import dependency is high so lower oil prices means less borrowing by the government to subsidize state owned enterprises’ oil needs and more focus by state owned enterprises on expanding.

Springer: How important are foreign investors to the CSE going up? Can the market rise solely from domestic investment?

Dedigama: The volumes will be low without foreign participation but if the sentiment is right, I think the market can really move up from domestic activity alone.

Springer: When I met with the Central Bank of Sri Lanka in fall of 2012, they were still in the process of cooling off the economy to keep it from overheating. What is the forward outlook of the Central Bank of Sri Lanka now, and how will that impact the stock market?

Dedigama: The Central Bank has a strong focus to maintain the economic growth rates by maintaining low interest rates and a low inflation environment. This was laid out in the Road Map at the start of the year. I think through the year you will see the Central Bank achieving their targets of maintaining interest rate levels in the short term, and in the long term having low interest rates.

The Central Bank has also said they want to see a consolidation in the banking and financial sector. They want fewer players with stronger and more sizable balance sheets. We have too many smaller banks and too many smaller finance companies, so they are giving guidance on that front.

[The Road Map is an annual January presentation by the Central Bank of Sri Lanka regarding the country’s economic situation heading into the new year. You can view the 163-slide presentation by Central Bank Governor Ajith Nivard Cabraal on YouTube or in PDF format.]

Springer: Clearly then, we can expect some mergers and acquisitions in the banking sector?

Dedigama: That will happen. The first one will be a pretty significant one. NDB and DFCC have announced they are in talks to merge. This will create a really large development bank that could become a regional player in South Asia. Our banks are very professionally managed and well staffed comparatively within the region, so becoming regional players is quite reasonable to foresee.

Springer: The growth of infrastructure is a major narrative in Sri Lanka’s economic growth story. Can you provide some examples of how improving infrastructure is improving the bottom line for CSE companies?

Dedigama: There are some companies that have seen a lot of growth with the large-scale infrastructure projects currently going on. For examples of companies benefitting, there is Tokyo Cement Company, MTD Walkers, Access Engineering, Alumex and ACL Cables.

Some other sectors are benefitting from the improved road network. This has made the tourist industry more accessible in locations around the country as 2 hour drives become 40 minutes and 10 hour drives become 5 hours. This not only increases the travel of foreign tourists but has increased domestic tourism as well.

Garments and manufacturing industries were already situated in proximity to transportation so there is not a significant improvement to their bottom lines yet. However, they may begin to use the rail network and other better-developed transportation access points to improve efficiencies over time.

We are also seeing energy infrastructure additions in thermal, hydro, wind, solar and coal power. This is having a significant impact on the 24-hour delivery of electricity. The government is assuring investors that they will have continuous uninterrupted electricity for their businesses.

Springer: The two main indexes for the CSE are the All Shares Index (ASPI) that encompasses all listed public companies on the exchange based on market cap weighting and the S&P Sri Lanka 20 (SL20) that represents the 20 largest companies on the exchange. It look as though the ASPI has been outperforming the SL20 by 1% to 2% most of this year, does this show any signs that smaller companies are trying to lead the CSE up, large companies are leading the CSE down or something else?

Dedigama: There has been a bit more selling on the larger companies over the last few months. There are smaller companies – as we have spoken about – such as infrastructure players and manufacturing companies that have come out with strong valuations. This has led to increased activity among the local institutions – and even foreigners – are now looking more at the smaller cap companies.

Springer: The market has had some good runs up the last two years with the ASPI most recently rising from 5,605 in September of last year to 6,255 on January 24 of this year before pulling back. Yet, the market seems range bound since the correction of 2011 and 2012. What does the market need to happen for it to break to the upside of 6,500?

Dedigama: We were expecting in January 2014 for the momentum to carry us into 6500 and beyond. Unfortunately, this whole negative emerging markets sentiment came into the local fund managers’ mindset as well. They just want to watch and see about the direction of things.

At the end of the first quarter if we see strong earnings from local companies again, then I think we should see the index breaking 6,500 without a problem. On valuations, Sri Lanka is very reasonable compared to regional peers. We expect to see 12% to 13% earnings growth in companies on average this year.

The market overall is trading at 12 times earnings, though this varies by sector. If the stable or lower interest rates continue, the market will eventually have no choice but to go up.

Springer: In the post civil war climate, how much of Sri Lanka’s growth is domestically driven? Is growth coming more from domestic factors, exports, foreign remittances, FDI or other factors?

Dedigama: As for as domestic growth, there has been the wave of construction and infrastructure, as well as higher consumer spending. However, the last six months, growth in exports, particularly in the garment sector and value-added trade. The garment sector has done well over the last two years, really.

Foreign remittances continue to also be significant with 10% year-on-year growth.

Springer: When I was in Sri Lanka last in fall 2012, there was quite a bit of talk about lower skilled garment jobs rotating out toward Bangladesh. Has production involving more skilled workers expanded?

Dedigama: On the garment side, Sri Lanka was indeed letting some lower end manufacturing go out to Bangladesh because we were concentrating on the higher end where there’s more money in it. This affected some of the smaller factories. But, the big players are concentrating on the high end. This has been true the last two years and we see this coming in.

Springer: Also, Business Process Outsourcing (BPO) was a growth area. Is this still the case?

Dedigama: Huge. There’s a tremendous potential for BPO. We’re seeing companies setting up pretty large operations now. The fact that Sri Lanka is English speaking is a significant plus for Sri Lanka in this market.

Springer: A lot of the FDI seems to be Chinese driven with their significant investments in the expansion of multiple ports around Sri Lanka and other projects.

Dedigama: Correct.  Chinese investment in Sri Lanka is massive between the Port of Hambantota’s and City of Colombo Port alone.

Springer: As a result, are any other countries trying to compete with the influence of Chinese FDI?

Dedigama: India is doing a lot of work in the north and east of the country. India is doing some work to develop the ports and railways in the north. They are somewhat obliged to do this or China will do that also. India is already left out of many major projects so they are trying to get whatever piece of the activity they can.

Springer: What industries are shrinking and what industries are growing in Sri Lanka?

Dedigama: Some of the commodity-based industries have been slowing down such as the rubber industry. With tea, we are seeing competition from Vietnam and Kenya and those type of countries; the issue is the uncertainty in the Middle East. These are key markets for tea: Egypt, Libya, Iran and Iraq.

Sectors that are growing are infrastructure, manufacturing, garments, BPO and tourism. Last year tourism had 35% growth in terms of earnings.

Springer: Is the growth in tourism revenue at the high-end or mid-market?

Dedigama:  We’re shifting from a lower end market to a mid- and high-market mix. We are going from predominantly have visitation from people in India – often with shorter stays – to more Chinese, Far East and Australian visitors. We are also targeting the Middle East market that is a very lucrative market with good margins for the people that handle those accounts. So, yes, they are more high spenders.

Springer: Which sectors does Softlogic Stockbrokers favor for investment at this time?

Dedigama: We are favoring the banking, manufacturing and energy: the banking sector because with the merger and acquisition activity we see opportunities; in manufacturing we like the companies we mentioned, Tokyo Cement Company, MTD Walkers, Access Engineering, Alumex and ACL Cables; and in energy we like Lanka IOC and Lanka Gas.

Springer: The stability of currency exchange rate is important for foreign investors. Since February 2012, the Sri Lankan Rupee exchange rate has been reasonably steady, holding between 125 and 135 Sri Lanka Rupees for one U.S. dollar. Declines in the Sri Lankan Rupee in late 2011 and into early 2012 were in part assessed to be in concert with the declines of the Indian Rupee. However, in 2013, the Indian Rupee declined significantly against the U.S. dollar (more than 10%) while the Sri Lankan Rupee held steady. Can the Sri Lanka Rupee hold steady and resist temptation to catch up with the Indian Rupee’s declines?  What is the outlook for the Sri Lankan Rupee’s stability?

Dedigama: The Sri Lankan Rupee has held steady. We don’t expect any significant depreciation in the currency. Most of the government institutions are making profits. There is no reason for the currency to further weaken. It should be relatively steady and stable in the short to medium term. We expect a maximum depreciation of 3% in the coming year, if at all.

Springer: GDP growth is still staying within the window of 6% to 8% growth per year?

Dedigama: Yes, they are looking for 7% growth this year. Last year, we had 7.2% growth. As long as we continue above 6.5%, it is more realistic and steady. That’s what Sri Lanka needs.

Springer: Political stability is also important to foreign investors. Currently President Rajapaksa’s United People’s Freedom Alliance party has the majority of seats in parliament through 2016. Is there any outlook for any party changing laws to be less favorable to foreign investors now or beyond 2016?

Dedigama: It is early but the way the politicians are going about their business, I can’t see anything shifting the power base right now. The government is also pushing “Doing Business In Sri Lanka.” We are improving on all indices that rate ease of doing business, transparency and the like. There are also doing things to make the country more attractive to foreign investors with some legal changes. We are seeing an uptick in delegations visiting Sri Lanka looking for business opportunities. So I can’t see anything absolutely negative for the government from here. The private sector is going ahead; and all the government needs to do is avoid drastic mistakes and let things grow.

We will have elections at the end of March in the Western Province and Southern Province that will provide some indication where public sentiment is. If we see the government get less than 60% of the vote, then we can say this government is starting to get stale in people’s minds. But, anything more than 60%, and it is clear that government does not have any issues and we can expect them to win in 2016 as well. President Rajapaksa is eligible to run for his third term in 2016 and we expect him to run and win.

Springer: It is normal in a country after a civil war or revolution that the victorious party has some extended grace with the voting populace. President Rajapaksa and his Freedom Party oversaw the end of the Sri Lankan civil war. Does this buy them a certain amount of stability with the voters?

Dedigama: Of course, I think so as well. At least until the 2020 elections.

Springer: What is your outlook for the CSE for the 2nd half of 2014 and into 2015?

Dedigama: To be honest with you, the second half of this year is going to be pretty positive on the back of the earnings in the first two quarters of this year and the last quarter of 2013. Inflation will continue to be lower. Interest rates will be down. I can’t see any reason for the markets not to do well unless something drastic happens globally and emerging markets get hammered. With the market average PE valuations at 12 times, interest rates coming down to single digits and improving earnings, I can’t see any reason why the market should not perform well. Everything will happen on justification and not sentiment alone.

To subscribe to Softlogic Stockbrokers’ free daily and weekly reports on the Colombo Stock Exchange, e-mail research@softlogicequity.lk. Fees for stock brokerage firms in Sri Lanka are regulated and standardized. The only way to differentiate one brokerage from another is by service provided. Investors considering investing with a brokerage in Sri Lanka are advised to speak to multiple brokerages before choosing one. The list of members and trading members at the CSE website combine to provide a complete listing of brokerage options.

Source: Forbes Business

 
 

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