Equity Roundtable: Time to take up positions

Portfolio managers who were content with fixed income’s high real returns have shifted assets to favour equity. An award-winning team of equity analysts help unravel the myriad of opportunities

Accepted wisdom that equities offer superior returns in the long term sounded hollow in the Sri Lankan capital market over the last few years – if a long term was defined as three years. However, the outlook has now shifted. Portfolio managers are now chasing listed stocks, based on forecasts that clear government policy, a fresh determination to reform and responsible fiscal management will boost growth and company profits.

Asia Securities’ award-winning team of equity analysts joined a roundtable discussion at Echelon to discuss strategy for 2018 and beyond. The team included Head of Research Kanishka Perera, and research team members Lakshini Fernando, Mangalee Goonetilleke and Naveed Majeed.

Here are excerpts from the discussion:

After two years of dismal equities, we had a slightly peppy first six months. It is still looking pretty damp. What’s your take on this?
Lakshini: Our main concern on the macroeconomic front at the beginning of the year was the condition of our US dollar reserves because this is something foreign investors look into. By March, reserves fell to about 2.7 months’ worth of imports, in line with our expectations. We didn’t expect what happened next: The Central Bank went on a spree buying about $100-200 million each month. This was a good move because the rupee was not artificially propped up either. The dollar buying and the $1.5 billion sovereign bond issue helped build reserves up to 4.5 months’ worth of imports by August. The Central Bank demonstrated its ability to do the right thing at the right time in a transparent manner, and this gives confidence. Take the case of monetary policy. We expected a 25 basis point rate hike, but the first and second quarter GDP growth numbers of 3.8% didn’t warrant a rate hike. In fact, we don’t expect a rate hike for the next six months. We expect monetary policy to be loose in 2018 because the Central Bank is comfortable with credit growth at anything less than 20%. The Central Bank’s main concern is credit growth. We have regular conversations with the Central Bank, and we are told credit growth of less than 20% is desirable. Inflation is mainly driven by food prices, so supply-side interventions like tightening monetary policy are not going to do anything. This is why we believe the Central Bank is setting the stage for loose monetary policy next year.

Regional peers like the Philippines, Indonesia and Vietnam have loosened monetary policy, and we haven’t. So we have more capacity to loosen monetary policy compared to regional peers. We also have growth momentum on our side. The year 2018 will be better, and 2019 will be a good year. We are concerned about how fiscal policy will pan out ahead of the 2020 presidential elections. Despite the IMF programme being in place, expenditure will be difficult to contain in an election year. So far, the government’s approach to fiscal consolidation is commendable. The new Inland Revenue Act gives foreign investors clarity and confidence in the long term. We are quite positive about the next two to three years.

The IMF programme ends in 2019. What then?
Lakshini: The programme is likely to end in 2019 or the first half of 2020, but the IMF will remain engaged, and this is important. The IMF will remain as an advisor to the government beyond the programme. What’s encouraging is not the presence of the IMF, but the government’s commitment to reforms. The 2016 fiscal numbers were better than expected, and that trend is continuing. The government is serious about rationalising expenditure. My concern is that the 2020 presidential elections may result in extravagant spending. However, we see VAT and income tax collections improving. We’re also confident the government is committed to reducing the indirect tax burden.

Lakshini Fernando Vice President – Research, Asia Securities

What’s the growth outlook for 2017?
Lakshini: Our GDP forecast for this year is 4.4%. We forecast 4% growth for the second quarter, which was what it turned out to be. We expect growth to pick up from the third quarter onwards.

If we start with that and take a top-down view, where are the likely opportunities in the market given your GDP forecast ?
Kanishka: People know 2017 is not going to be a fantastic year. This sentiment is evident in the way markets are performing here, and most foreign investors see 2017 as a recovery year if anything.

It’s important to remember that the equity market is not entirely representative of the economy. Market capitalization to GDP is around 25%, and none of the apparel exporters are listed either. But, this doesn’t mean GDP numbers won’t impact the market. It gives foreign investors a sense of comfort. Foreign inflows into the equity market have been disproportionate compared to previous years. Year-to-date, net foreign inflows into the CSE amount to $180 million. That’s 1.7% of total global inflows to emerging markets, which was about $11 billion. In previous years, our share of global investments into emerging markets averaged about 0.7%. From the midddle of the year, the market has been rated downwards a lot; that’s the sense we get. The PE ratio was 10.5 times, compared to the MSCI Frontier Index, which was trading at 12.9 times.

Foreign investors are giving a more serious look, especially with the macroeconomic outlook improving. Banks are popular investments because it’s essentially leveraging the overall economy: when GDP growth improves, banks’ loan books expand, ROEs improve and valuations pick up. Most foreign inflows have gone into banking stocks rather than listed conglomerates. During the last 12 months, net foreign inflows into banking stocks amounted to Rs20 billion, compared to Rs16 billion for conglomerates. Consumer and construction-related stocks are other key picks for any portfolio going forward. With banks, there are two things to keep in mind: First, Basel III capital adequacy requirements are rolling out, and will be done and dusted by 2019. We recommend those banks that have already made capital issuances or those that have clearly indicated how and when they will do so. Of the large listed banks, Commercial Bank and HNB have already issued capital, and Sampath Bank has clearly announced a capital issue. The rest haven’t been so clear about their intentions. The second important thing to keep in mind is what sectors each bank is particularly exposed to. In other words, are they strong on serving retail, SMEs or corporates, and which of these will grow faster?

Let’s look at retail. Rising inflation and taxation will dampen consumption growth. Loan-to-value ratios are in place for consumer products and vehicles. Construction costs are rising, so we don’t see much growth on the housing side. On the corporate side, corporate banking margins are low, so they need strong trade volumes to generate fee income. Since 2011, our trade volumes have not improved substantially. Our largest export, apparel, has grown around 4-5% annually, which is quite low. So in a sense, banks do not want to lend too much to corporates as margins tend to be lower. That leaves SMEs. SMEs do fairly well when the economy is improving. They tend to generate a bit more non-performing loans, but this is where fast growth will come from. Historically, banks favoured retail and corporate clients. It’s only in the last two years that we have seen a marked shift, and banks are now lending more to SMEs. The interesting thing is that banks are speaking to their corporate clients to identify potential SMEs in their value chains that they can potentially lend to.

Sampath Bank is likely to do better than the rest in tapping the growth potential of SMEs. First, the bank has the footprint to drive SME lending, with over 230 branches. Second, its NPL ratio at 1.9% is one of the lowest in the industry, giving them headway to lend to SMEs where NPLs tend to be high. For a bank with an NPL of 2.5%, lending to SMEs is not possible because it will further deteriorate the loan book.

We believe Sampath Bank has the appropriate checks and balances in place to make SME lending viable. It’s addressing the Basel III capital requirement by raising Rs7.6 billion with a rights issue. We earlier assumed Sampath Bank would raise Rs10 billion, but they changed their dividend policy. Previously, the bank paid half the dividends in cash and half in shares. Going forward, the bank will pay 75% in shares and retain more cash in the bank, which will give them plenty of room to grow the banking business despite the Basel III requirements coming in. So, Sampath Bank is positioned in the right segment (SMEs) and has the necessary funding to comply with Basel III and finance its growth. But, will the bank be profitable? The bank is also investing in automation to replace people where there is natural attrition, so they’re not shedding staff. Cash deposit machines and online banking systems are reducing operating expenses. All loans below Rs25 million can be applied and approved online within a day or two. The bank is also relentless with cost-efficiency. The marginal cost in driving their next rupee of earnings is the lowest compared to the rest of the banking sector. This has resulted in 40% year-on-year earnings growth during the last couple of quarters.

How does Sampath Bank contrast with other banks like HNB, Seylan and Commercial Bank who have significant exposure to SMEs or are pushing to grow this segment?
Kanishka: Commercial Bank’s average loan size for SMEs is around Rs4-5 million, but Sampath Bank’s is around Rs2-3 million. Commercial Bank’s SMEs are almost corporate, so we feel Sampath is better positioned to tap SME potential. HNB is arguably Sampath Bank’s closest competitor, but we don’t see the same focus on costs.

If it is the cost-to-income ratio, Sampath improved it to 47% this year, whereas HNB and Commercial are at bank level (around 42%) anyway. So, the improvement on those on the next rupee is marginal, whereas since Sampath’s operating costs are pretty much where they should be, any additional revenue will fall down into their bottom line straight off. We see that earnings impact coming into Sampath Bank.

Sampath Bank was heavily into gold loans a couple of years ago, and they took a big hit because of that. That’s not the likely path for anybody.
Kanishka: That’s not really a major concern because the bank is looking at keeping the pawning exposure to about 2-3% at the most. In any case, the bank didn’t take a hit because of pawning. What happened was that impairment drove down the value of gold assets. Non-performing loans didn’t increase either.

What other sectors will correlate to the likely benefits banks will enjoy?
Mangalee: We expect loose monetary policy going forward, and ideally, when interest rates are low, consumption tends to increase—people buy TVs, cars or renovate their homes. Construction will benefit from low interest rates, as will most other sectors. But, none of these gains will be significant because of rising inflation and taxes imposed by the government over the last two years. We expect fiscal reforms to continue until 2019, so tax pressures will continue until then.

Lakshini: Things will improve. Next year will be better than 2017. The government is serious about seeing the IMF programme through. In 2011/12, the government drifted away from a IMF arrangement by artificially defending the rupee via the Central Bank. Then, the IMF delayed disbursing the loan until the appropriate adjustments were made. This time, the government and the Central Bank are doing things the right way. The new Inland Revenue Act will generate more corporate taxes in 2018. This will dampen sentiments, but eventually, fiscal discipline will improve and this will benefit the economy. Banks, conglomerates and construction companies are likely to see growth. The government and the Central Bank will promote a bit more loan growth.

Kanishka: We’re looking at a two-to-three year horizon, and this is the best time to invest in stocks. This is when trading patterns shift. For any country in Sri Lanka’s stage of development, banking stocks should be the first choice. Next, infrastructure is improving and there is always a need for housing, so construction stocks will be attractive. Then its figuring out which part of the consumer chain will see faster growth so you can pick consumer stocks that will be the next wave.

So, do you think it’s a good time to get into consumer stocks now, or do you first get into banks and ride that out?
Mangalee: Now’s a good time to invest in consumer stocks. If you look at the equities market, consumer stocks are relatively expensive. This is because they generate better ROEs. Valuations are low at 18 times earnings, compared to 2015-16 when they were over 20 times earnings. We are still 25% cheaper than regional markets, and some of these stocks are exposed to vast consumer play.

The consumer sector has benefited from rising incomes and more women entering the workforce. Food companies stand out in this space. While you need credit growth to release pent-up demand for housing and electronic appliances that benefit consumer companies in these spaces like Singer, there’s so much potential going unnoticed in the food-related consumer segment. Despite rising inflation and taxes, and people spending less than they usually do, food companies have been investing in their businesses over 2015-16. Ceylon Cold Stores is investing Rs3.5 billion on a new frozen confectionary plant and Rs2.5 billion to expand a bottling plant for its fizzy drinks. Nestlé is building a Rs3.5 billion plant in Kurunegala, and Cargills has been busy investing in its business, in addition to plans to add 80 outlets annually over the next few years. Cold Stores will expand its network by 40 outlets annually. Finding real estate for these will be challenging, but I believe Cargills and Cold Stores will roll out their expansion plans, and as a result, their valuations have come down this year.

Kanishka Perera Head of Research, Asia Securities

It appears banks are better priced for short-term gains and consumer stocks  for the long term. How do you pick between the two?
Kanishka: It’s a matter of timing. Initially, weigh the portfolio towards banks and then build up exposure in consumer stocks. You start the adjustment when inflation begins to taper down, and the year-on-year impact of value-added taxes comes down. Keep an eye on how the next budget and the Inland Revenue Act will impact personal taxes.

But right now, banks are better priced than consumer stocks?
Kanishka: That’s true. Consumer stocks always trade at a premium. A bank will not trade at 20 times, that’s very unlikely. But twenty times is ok for consumer stocks. That’s not too expensive, to be honest.

You like supermarket chains and FMCG companies. What about white goods retailers?
Mangalee: When incomes improve, the changes in spending patterns are seen in supermarkets. Right now, people are not spending on sauces and other premium foods because of high taxes and inflation. They just buy basic food items like veggies and meats, because people must eat. But, as inflation and the impact of VAT tapers down and incomes improve, that’s when they start spending on premium foods, so supermarkets will be the first to benefit when things improve. The next stage is white goods retailers like Abans, Singer and Softlogic. During the last year or so, pent-up demand has been building. People have put off buying a new fridge or washing machine. It’s just a matter of time before this demand is unleashed. If you are looking at consumer stocks, I would first look at FMCG, the food retailing space and then the white goods space.

For Softlogic, consumer electronic sales – mobile phones, tabs and laptop – have grown this year. This is due to the fact that the company is investing in marketing to work around weak consumer sentiments: when Softlogic introduced the new Nokia range, pre-order levels were pretty good. This strategy is going to feed into the next couple of quarters.

Conglomerates are not what they used to be some years ago, but is this an area of interest?
Mangalee: John Keells Holdings always attracts foreign interest because of its size in the market, irrespective of how the company performs. Interestingly, there’s interest for Hemas as well—a share traded at over Rs145 at one stage, close to our target price. We’re seeing investors shift from John Keells to Hemas. Investors are also looking at other stocks that can give them better returns. For example, Cold Stores went up to Rs900 a share, and some people invested early at Rs600.

Is there a discount coming in?
Kanishka: It’s got to happen at some point. But, it depends on what sectors a conglomerate is exposed to. There could be many businesses held by a conglomerate that are not growing. So, the first question you need to ask is, what is in the conglomerate? Second, is the investment generating returns equal to your cost of capital? If the answers to both questions are generally positive, then you should not have a discount. It’s fantastic to talk about it, but conglomerates discount in a tradable liquid market. In a frontier market like ours, it’s difficult. If you look at it from a foreign investor’s perspective, more emerging market guys would say, “With JKH, I get leisure, logistics, consumer, all in one go. I speak to one company and everything is done.” It’s practically easier to cover because allocations in Sri Lanka are small. Hemas is also a fantastic opportunity like that. But, when you take frontier-focused funds which are about $50-100 AUM, that is where we’ve seen the bigger difference, rather than say 2011, where you saw larger funds. They have the patience to invest for the long term. You might see them buying quantities in illiquid stocks.

Cold Stores is a good example. They would buy the stocks over six months. They are not constrained by liquidity and they exit at very good prices later on as well. The type of investor that is coming into the market is also slowly shifting. That’s one of the positives coming out of the IMF being involved.

So, which conglomerates will you pick?
Mangalee: We’re bullish on Hemas. They a good pharmaceuticals business, and acquiring J L Morrison was a boost, particularly now since they’re developing capacity and entering into buyback programmes with the government. The group has a strong FMCG presence. They’ve invested in five or six brands that are taking up more shelf space in supermarkets and competing with Unilever brands. In the transportation segment, Evergreen has been fantastic. Operating margins have improved from around 11% to 30%.

Their Far Shipping business makes 15% margins. Hemas’ logistics park will open for business in 2019, setting up for big opportunities in the end-to-end logistics business, pitting themselves head-tohead with the market leader Hayleys Advantis.

The leisure segment, which includes the Anantara and Avani brands, is a bit of a concern. The informal sector poses a formidable challenge that nobody is addressing. The risks are considerable. Formal sector occupancy levels are falling because they’re mostly attracting cheap tourists that want to dump their bags somewhere, walk out and experience the country. Hemas’ Anantara five-star range initially did well because the global partner helped bring in visitors, but occupancy has since tapered. Supply is increasing in terms of room numbers. Competition is intense because tourism arrivals are low. The government has been delaying the tourism promotion campaign for the past three years.

Is it fair to say you’ve had to change your outlook completely because of the formidable emergence of the informal sector?
Kanishka: The government is looking at regulating the informal sector, which is attracting more backpackers with online booking sites and Airbnb coming into the picture.

About 50% of accommodation now is informal, and this is growing. The government wants to shift from an arrivals-based strategy to one that generates more revenue. That means they are targeting travellers who can spend more. If not, Sri Lanka will to end up like Thailand, where there are too many low-spending tourists. The government wants to attract tourists who will spend around $200 a day, as this will uplift the industry as a whole.

Lakshini: The government regulating this area is key. If the government decides to tax the informal sector, this will benefit the formal sector, which is now priced a bit higher.

Mangalee: It’s not about boutique hotels either, but people renting rooms via Airbnb. Regulating the informal sector down to this level will probably be impractical, but the government should do it because it guarantees safety and standards. At the end of the day, Sri Lanka must be a safe place to travel.

Naveed Majeed Vice President – Research, Asia Securities

What other sectors stand out?
Naveed: Construction has been a sector to be in. There’s been a boom, with most construction companies growing at 20-30% over the last two years. However, there is a slowdown right now, with companies growing at 9% over the last couple of quarters and bottom lines taking a hit due to rising global commodity prices. It’s not a great time for construction companies, but growth potential is still there in the residential and infrastructure segments, so now’s the time to invest in construction costs.

Tokyo Cement is growing at about 7.1%, of which 6.1% was price-based growth. In terms of volume, growth is around 1-2%. This is mainly due to the slowdown in infrastructure projects, which we expect will pick up once again and benefit everybody in this space – from construction and cement, to aluminium and cable manufacturers.

A slowdown in the residential segment is affecting listed tile manufacturers like Royal Ceramics because of high interest rates, droughts and floods impacting consumer sentiments.

Even though official data is unavailable, we feel the overall disposable income level of the economy declined, impacting demand for housing. Going forward, loose monetary policy should see residential demand pick up again.

Sri Lanka still has a low urbanisation rate, which will improve, especially with the Western Province Megapolis project rolling out. The slowdown in infrastructure and residential construction will continue throughout the year, but will gain momentum in the short-to-medium term; so it’s a good time to get into construction-related stocks. If demand picks up, companies will also be able to pass on rising commodity costs to consumers.

Kanishka: Construction companies are borrowing to bring in new equipment. This raises a few concerns because companies incur high interest and equipment costs but demand is low. We believe construction volumes will pick up towards the second half of 2018.

Tile companies are in a heavily protected sector. Doesn’t that concern you?
Naveed: Listed tile manufacturers face stiff competition from cheap imports, which account for 60% of sales here. This is a concern. Royal Ceramics is expanding across all segments to counter the competition, and Lanka Tiles is manufacturing overseas to sell here.

Kanishka: The big question is what will happen to these listed companies if import duties are lowered or waived. Royal Ceramics and Lanka Tiles are building strong brands and emerging more like retailers than manufacturers.

What about manufacturing in general? There’s a romanticised notion that manufacturing will drive the economy.
Kanishka: If we have something like the proposed Economic and Technical Cooperation Agreement (ETCA) with India in place, we can import labour to do our manufacturing. But of course, there are political and perception problems. When we talk to the BOI, they tell us that foreign investors enter Sri Lanka to make use of bilateral arrangements only to find that they can’t find labour. They incur high costs in training. The opportunity for Sri Lanka is to attract investments into the services sector, which is also more lucrative. We have an educated workforce. With the number of CIMA graduates we have, there’s potential to attract more investments into BPOs and KPOs.

We’re trying to attract investment into manufacturing when we don’t even have land and the appropriate infrastructure to support large-scale manufacturing. The other area with potential is education. If students have options to study in India, Sri Lanka or Bangladesh, where would they choose? Without a doubt, Sri Lanka, but that option is not really available. The services sector holds much promise. Historically, we’ve pushed for a manufacturing hub here, and the result is low FDI flows. The Hambantota port deal is good for the economy’s prospects, and the government is making arrangements to sort out the Mattala Airport as well. That would give a bit more leverage on the infrastructure level. But, how long is it actually going to take for things to fall into place?

Is there anything interesting in the listed manufacturing sector?
Naveed: Manufacturing stocks are coming out of two quarters of losses. Rising commodity prices have impacted earnings for companies like Teejay Lanka, a fabric manufacturer. The reinstatement of GSP Plus will result in a 9.6% saving on duty, but it’s not going to reflect in Teejay’s bottom line because the benefit will have to be passed on to buyers to be attractive. Margins can be improved by increasing volume. What we have to keep in mind is that Sri Lanka will be a middle-income country by 2020, and no longer eligible for GSP Plus concessions. We’re going to have to make the most of it while it lasts.

If you look at Hayleys Fabric, what they are doing is moving away from cotton and moving into more synthetic products. This is something they have been testing the waters with for the last two years. Moving away from cotton is a good thing because cotton prices have been on the rise, and synthetic fabrics should help improve margins as well. Hayleys Fabric is also shifting away from the EU market more towards the US. Two years ago, 98% of exports were to the EU; now, it’s down to a quarter percent, with exports to the US accounting for 75%.

EU markets are experiencing slow growth, and there’s stiff competition from Bangladesh and Vietnam. European buyers constantly haggle over prices, unlike the US, which is a much faster market and where the focus for the future is going to be. They don’t want to increase their exposure to the EU because of GSP Plus. It’s not going to last forever. There is nothing significant about it.

Lakshini: The IMF expects the US to grow at a much faster pace. In 2017, GDP growth should be around 2.3%, and 2.5% in 2018. I think 2019 will be good. Sri Lanka may have an advantage following Trump’s decision not to enter into the Trans Pacific trade agreement, and denying trade concessions to competitors like Vietnam.

While you are fairly bullish about banks, it does not look like you share that same sentiment about non-bank finance companies. Is there a particular reason for this?
Lakshini: Finance companies have taken a battering over the last few years. The Central Bank is tough on regulations to ensure loan quality is maintained. Loan-to-value (LTV) requirements were introduced to ensure that finance companies maintain safe exposure to certain types of lending and appropriate buffers. The last budget increased the LTV on car loans, the breadand-butter for most finance companies, and this has dampened sentiments. Overall, we’re not positive about the finance company sector, with the exception of People’s Leasing, which has significant commercial exposure.

Nearly 80% of buses in Sri Lanka are leased by People’s Leasing, but the company is not aggressively pushing vehicle leases. Its results for the past few quarters are also not great, but loose monetary policy in 2018 will improve prospects. We expect demand for buses to increase as the road network expands, which will benefit companies like People’s Leasing that have ventured into commercial leasing. But overall, it’s not a sector we are too bullish on at the moment.

Is this an opportunity for finance companies to diversify into SMEs?
Lakshini: They are trying, but it’s not going to be easy to compete with banks. In the past, heavy exposure to SMEs and micro lending undid some finance companies. Commercial Credit aggressively pushed lending to this segment and took a hit as bad loans piled up. The company is now consolidating its loan book and targeting higher-end SMEs. The LTVs will make it even harder for finance companies to compete with banks, even if interest rates come down next year.

The reason that LTV came into play was to make sure that NPLs are maintained at a healthy limit and to prevent too many loans from going bad. In a situation where you have loose monetary policy and lower import duties, you will see NPLs decline. Now’s the time for the Central Bank ensure finance companies’ exposure to SMEs and that micro lending is regulated, before the government starts relaxing import duties ahead of the 2020 presidential elections.

What about insurance?
Naveed: We rated down life insurance after the new Inland Revenue Act was passed in parliament. Insurance companies used to be taxed on a net income basis, but the new law will also tax life surplus transfers to shareholders, compared to zero tax earlier.

Life insurance investment incomes to policyholders will be taxed at the normal rate. If anyone takes out a life policy as an investment, that attractiveness simply disappears. Life insurance is not something you need, it’s something that is good to have. It’s probably the last thing you will think of buying when your income levels go up. You will buy food, a fridge or a new car, and after you’ve bought everything, you may think that you should buy life insurance. The moment you need money, if you have a life policy, you will surrender it or not renew it in the first place. This is what we saw during the recent floods.

The floods really showed us that life insurance is still at the very edge of growth. It is a largely untapped market. But, if you were to tell me that our GDP is going to go from 4,000 to 5,000 next year, I will say to bet your house on that. But, that is not going to be the case. Probably in 2020, we might recommend you that it is time to invest into a life insurance company.

The general insurance industry is going through some positive changes. Policy prices are moving upwards and we are seeing some market consolidation happening in the industry. Fairfirst acquired the general insurance businesses of Union Assurance and Softlogic. They may be looking at another acquisition. Market consolidation reduces the need for price competition. General insurance is a homogenous product. If you look at a motor insurance policy, people look at prices. Nobody cares what else they get as long as their vehicles are insured. So, consolidation and pricing improvements are positive factors, but should you bet your money on insurance right now? Not really.

Are there stocks that you have a contrary view on, or a view that’s not reflected in the market?
Kanishka: We’re a bit bullish on Dialog. Ever since the VAT and broader tax impositions from the previous two budgets, we believe the market has underestimated the broadband story—the data story. Back in 2015, we initiated coverage on Dialog, and then the taxes came in. We were bullish on the data story, and the taxes actually impacted the voice side. When the market settled down, telcos were still under a cloud because the government announced its intentions to increase the tax on data to 25%. When the government later announced that the tax on data would be removed altogether, the telcos very happily announced 10% free data to subscribers. The marginal cost of adding another MB is virtually nothing. The data story is back in play and the market will give the sector a more positive break. If you look at the last quarter, earnings for both SLT and Dialog recovered. They’re doing a lot to recover it, be it through data or voice. We believe the cap on data growth has come off, leading to a significant increase in earnings; and Dialog is in a better position to exploit this potential.

Mangalee Goonetilleke Vice President – Research, Asia Securities

Do have any views on Lion Brewery and Chevron?
Mangalee: Lion enjoyed a major tax advantage over hard liquor. They lost this advantage in 2016 when the government increased taxes on beer. People began consuming hard liquor instead. Then came the floods, inundating Lion Brewery. The company is recovering from the flood, but it’s unlikely they’ll reach pre-flood levels. It’s not just high taxes and people switching to hard liquor. While Lion was out repairing its brewery, other beer products like Tiger and Anchor flooded the market to take its place. Even after commencing production, people are not ready to switch back to Lion Beer, and so volumes have taken a hit.

Kanishka: For Lion, the advantage turned into a disadvantage. Sri Lanka banned advertising alcohol products. The moment the product was out of the market, there was a gap that people wanted to fill. Once Lion began brewing again, it couldn’t advertise its return.

Mangalee: If you look at Distilleries, their volumes are declining because of illicit and illegal liquor.

Naveed: For Chevron, the floods resulted in a 15% loss in volumes, but that’s a one-off impact. Chevron has been losing market share for lubricants for some time now. The decline is dramatic, down from 50% three years ago to about 43%. We expect market share to continue to decline.

In the last quarter, Chevron made the mistake of increasing their prices when global oil prices rose. Its competitors in the lubricants market, like Ceylon Petroleum and Lanka IOC, did not raise prices. Chevron took a hit and lost market share. Ceylon Petroleum and Lanka IOC deploy their island-wide gas station networks to sell their lubricants, a luxury Chevron never had. The company had to rely on placing their products at oil marts, and expect them to market and promote Chevron products as well. Even now, Chevron is yet to adjust its prices downwards. It’s investing in marketing and promotion campaigns instead. Chevron is not having a good year. On the construction side, Tokyo Cement is a strong pick in terms of rising infrastructure and residential demand. Most construction companies have increased capacity in anticipation of this demand, and Tokyo Cement expanded its capacity by 56% to 2.8 million MT. That’s one of the key positives, and compared to its competitors, they enjoy market leadership of 43%, compared to 36% for Lafarge Holcim, its closest competitor. I believe Tokyo Cement will continue to dominate the market. The company has its own power plant and they manage their own operations at ports, which gives them cost advantages. Overall, we feel Tokyo Cement is better placed to benefit from the construction boom.

Kanishka: From a macro point of view, this is a year where things are getting fixed. From next year onwards, we are going to see the impact of that coming into companies. When you are building a portfolio, how should you do it? You need banking and consumer exposure. Those are two things that tend to pick up when the economy turns a corner. Then, on the consumer side, you should focus more on the first things that people buy, and not those further down the value chain.

It is a matter of fact that Sri Lanka has a fair amount of infrastructure development yet to be done. You are going to see construction demand picking up, and the inevitable factor is that you need cement no matter what you do. The amount or percentage of cement use may decline, but you still need to buy cement.

Naveed: When you select stocks, you should look at what foreign investors are buying because they are the ones that drive prices. There’s no point buying something that is the best thing since sliced bread unless it is tradable and there is foreign interest in it. Generally, that is what we recommend. If you draw a chart ten to twelve months from when foreign inflows improve, the overall market, as measured by the All Share Index, picks up. Cold Stores, Hemas and Sampath Bank went up on foreign buying. Basically what we’re saying is, pick fundamentally sound stocks.