TWO UNPRICED STOCK OPPORTUNITIES: A SMALL BANK AND A GOOD GOVERNANCE PREMIUM

WE ASKED TWO STOCKBROKER CHIEF EXECUTIVES TO IDENTIFY A TREND THEY THINK IS NOT YET PRICED IN

MARKETS NEVER STRIKE EQUILIBRIUM. They underperform or overshoot, and when faced with wildly unfamiliar conditions, react with similar unpredictability. In 2018, listed equity investors are heading into unchartered territory. Candor Group Director Ravi Abeysuriya and Asia Securities Chairman Dumith Fernando weighed in on two opportunities, one market-wide and the other a company, they felt weren’t priced in.

THE LITTLE BANK THAT COULD

DUMITH FERNANDO, CHAIRMAN AT STOCKBROKER ASIA SECURITIES, SPOTS A SMALL BANK AT THE CUSP OF A WAVE

As far as financial indicators are concerned, Sanasa Development Bank (SDB) highlights its high risk appetite. In banking, a conservative business as depositors’ money is used in the business, a high risk appetite is usually frowned on.

Sanansa is a small, specialised bank. Unlike commercial banks, it cannot offer checking accounts that can provide other deposit and lending products.

Smaller local banks often build a business case by lending to the sub-prime segment: consumers and small businesses. SDB’s strategy has a similar focus. However, the consumer and small business segments have many niches, and SDB’s aggressive growth focuses on niches that other financial institutions aren’t serving, according to stockbrokerage Asia Securities Chairman Dumith Fernando.

“Their penetration into areas where others don’t compete, combined with great shareholders and a strong management team, has positioned the bank well.”

Despite its relatively small size, at a market capitalisation of Rs5.5 billion, SDB is a stock researched by Asia Securities due to its large public holding and strong growth position.

In May 2017, Dutch investment firm FMO and IFC, the private funding arm of the World Bank, invested Rs1.4 billion in Sanasa, a significant development, due to the profile of its new shareholders, raising the bank’s capital closer to a level required by the new minimum capital rules that will be effective soon.

Capitalisation is a challenge for any bank with rapid loan growth. Sanansa, led by lending to small businesses mostly in rural areas, has been growing its loan book by around 20% annually, compared to 15% at large banks. Its net interest margin of 7%, Fernando believes, will decline a notch during the next three years, but even at 6%, it’s double what large banks are able to achieve.

“Its strong small business focus is the principle reason we like the bank. We project loan growth to continue at 20% for three years,” he forecasts.

Around 15% of bank credit is to small businesses, but SMEs contribute around half of GDP and account for over 75% of private ventures in the island.

Of the island’s cooperative societies, SDB is associated with 600 active ones, which introduce new customers and help establish their creditworthiness. Recent technology upgrades have resulted in leaner branches and staff have been re-trained to take up sales roles. However, its cost-to-income ratio, a key measure of productivity, at 70% suggests that the bank has not yet benefited from the new systems or restructuring. Asia Securities forecasts the ratio will decline to 50% in three years, a competitive level for a bank with high net interest margins and focused on small businesses.

High operating and credit costs have impacted the bank’s return on assets, which at 0.8% are below industry levels.

Eighty percent of Sanasa’s branches are outside the Western province, compared to the industry’s only 60% of branches outside the province.

SDB’s high risk appetite may not suit every portfolio. However, Asia Securities forecasts that earnings will grow 50% in the next financial year, by 40% in the year after and around 25% in the third year, raising return on equity to around 15%.

 

INDEPENDENT DIRECTORS AND STOCK PRICES

By Ravi Abeysuriya

The Institute of Chartered Accountants of Sri Lanka (CA Sri Lanka) released the latest Code of Best Practice on Corporate Governance in December 2017. The Code of 2017 builds on the previous codes to strengthen best practices in governance relevant to Sri Lanka. Some significant changes from a capital market perspective identified in the Code are board composition, the role of the audit committee, the introduction of a related party transaction committee and expanded corporate reporting. The criteria for identifying the independence of directors have been clearly defined.

An annual review has been proposed by the code of the board composition against pre-defined criteria such as skills and knowledge, consideration of being fit and proper, and an increase in the number of independent directors.

The role of the audit committee has been enhanced on internal controls and risk reviews. Corporate reporting has been expanded to integrated reporting, where directors and key management personnel are required to make an affirmative declaration in the annual report that they are compliant with the Code of Business Conduct & Ethics. This code expressively prohibited “conflict of interest”, “bribery and corruption”, and actively soliciting or demanding any form of “entertainment and gifts”.

Truly, independent directors have become a mandatory element of the new corporate governance paradigm. An “independent director” is defined as a director who does not have a material or pecuniary relationship with the company/majority shareholder or related parties, except sitting fees.

The change of directorships and share price performance of companies that got into difficulties amply demonstrate that stock market investors, financial analysts and the financial press have failed to highlight the lack of independent directors in these companies during their heydays

The composition of boards has dramatically shifted towards independent directors, from 20% to 75%, in companies listed in major stock exchanges internationally. For example, the New York Stock Exchange requires listed companies to have boards with majority independent directors, and audit and compensation committees comprised solely of independent directors.

The standard for independence has also become increasingly rigorous over the period. The objective is to commit the firm to a shareholder wealth maximizing strategy, best measured by stock price performance. In this environment, independent directors are more valuable than insiders.

Listed companies in Sri Lanka appoint independent board directors largely based on the close relationship the individuals have with the management or the majority shareholder, and not based on independence, skills and knowledge.

Incidents of the government or Central Bank appointing independent directors to listed entities who do not qualify or fit proper criteria were not uncommon in the past.

Except for a few insiders, the fact that such directors are appointed and are not truly independent is difficult for analysts to identify and may go unnoticed.

An affirmative board announcement to the CSE that a purportedly independent director has “no material relationship with the listed company” – including “as a partner, shareholder or officer of an organization that has a relationship with the company” – may be a solution.

The claim here is that poor governance practices, like not having truly independent directors, aren’t reflected early in the share price of Sri Lankan listed companies until it’s revealed by the company itself. Although stock prices are considered the most reliable measure of a firm’s performance, it may not get reflected if the market does not price in the governance aspects as a result of financial analysts and the financial press failing to expose them.

The change of directorships and share price performance of companies that got into difficulties such as Touchwood Investments PLC (TWOD) and Central Investments & Finance PLC (CIFL) amply demonstrate that stock market investors, financial analysts and the financial press have failed to highlight the lack of independent directors in these companies during their heydays.