Sri Lanka’s investment landscape in 2025 presents a cautiously optimistic outlook as the country transitions towards fiscal stability and controlled economic growth. The conclusion of external debt restructuring and recent macroeconomic reforms have bolstered investor confidence, setting the stage for a promising equity market environment. However, challenges remain, particularly in attracting significant foreign investment and navigating currency risks.

Bimanee Meepagala, Director and Chief Executive of CT CLSA, Asanka Herath, Head of Equities of Lynear Wealth Management, and Udeeshan Jonas, Chief Strategist of CAL, joined a roundtable hosted by Echelon’s Shamindra Kulamannage, where they discuss the economic recovery, taxation, debt restructuring and the evolving investment landscape.

Excerpts of the discussion follow:

Today is December 30th, 2024. The market is up 45% for the year, a reasonably unprecedented rise. It’s rare for a market to go up 45% in any country. Things have shifted from one plane to another as far as equity valuations are concerned. Is that the case? How do you define this?

Bimanee: The strength of the current market lies in strong macro fundamentals. The fiscal environment remains positive, which is beneficial for equity markets. The price-to-earnings (PE) ratio is currently around 8 times. However, if we exclude exceptional gains, the PE ratio might rise 11 times. Historically, the average PE ratio has been around 13 times, suggesting growth potential and implying that the market could experience a re-rating of around 25 to 30% in the coming year.

So, when you say the market PE is 8 times, do you mean the last four quarters of reported growth of all listed companies, excluding the exceptional gains?

Bimanee: The market trades at a PE ratio of 8 times, including exceptional gains. Excluding outstanding gains, the PE ratio is around 11 times. However, the market is now trading at a discount compared to the historical average of 13 to 13.5 times. Moreover, if you look at past interest rate cycles, the market has typically traded at a PE ratio of 14 to 15 times whenever interest rates were in the single-digit range. This trend suggests there is potential for continued market re-rating.

That sets the foundation for the discussion. Interest rates are at single digits now, and what does this mean for the market? Following up on what Bimani said, is this a re-rating of the level? We’ve been trading at eight times, and now it’s 11 times. What is driving this?

Udeeshan: The key factor is the established macroeconomic stability. Following the IMF programme, fiscal discipline has improved, and we are no longer running a primary deficit. Instead, we have a primary surplus of about 1.5% of GDP. Our balance of payments has also turned positive, with a current account surplus. This overall macro stability has bolstered investor confidence, and the resulting impact has been on interest rates. With interest rates now in the single-digit range, investors seek alternative asset classes, and equities have become a key area for potential investment. Additionally, with tax rates rising, higher brackets now taxed at 36% and withholding tax at 10%, investors are increasingly looking for alternatives, especially as T-bill rates trend below 9%.

Bimanee: A positive aspect has been that, unlike previous instances where political changes led to drastic policy shifts, such as significant fiscal stimulus measures that deviated from fiscal discipline, this time, there has been seamless continuity in both fiscal and monetary policies. This consistency is providing stability to the market.

Let’s talk about the macro fundamentals. Economic stability has returned to Sri Lanka from what it was five years ago. What does Sri Lanka’s equity market history teach us about current valuations?

Asanka: The market is materially undervalued, according to historical trends. There are three fundamental reasons for this. First, the current Average Weighted Prime Rate (AWPR) is close to 9%, and if we apply a premium of 200 basis points (ranging from 9% to 11%), market interest rates have remained in this range for about 20% of the time over the past 15 years. The market’s PE ratio was 20 to 25% higher during those periods. Second, over the last 15 years, investments in government securities benefited from substantial tax exemptions, and the top tax rate on fixed income was never as high as it is now. These two factors alone suggest that domestic funds should find the current PE level in the PE market much more attractive than at any point in history. Finally, on foreign flows and corporate earnings, foreign holdings in Sri Lanka were historically low in the post-war era. Foreign holdings peaked in mid-2017, and between then and March 2022, Sri Lanka lost $800 million worth of foreign holdings. Since March 2022, there has been some recovery, but foreign holdings are still substantially lower than ever. For example, in December 2019, 32% of HNB, 23% of Hemas, and 11% of Chevron Lubricants were held by foreigners. Sri Lanka had already lost about $400 million in foreign holdings by then. Today, foreign ownership has dropped to just 6% of HNB, 5% of Chevron Lubricants, and about 11% of Hemas, highlighting the significant potential for foreign flows into Sri Lanka, which should increase the market’s PE ratio.

What will the market look like a year from now?

Bimanee: As discussed earlier, excluding exceptional gains, the market’s current PE ratio is around 11 times. Historically, PE ratios have been about 13.5 times, suggesting a potential re-rating of around 25% to 30% in line with the historical average. One key factor to consider, as Asanka mentioned, is the taxation. Equities are a very tax-efficient asset class, especially with tax exemptions still in place. The historically low interest rates have typically supported higher PE ratios, which could further contribute to a market re-rating.

Another critical point is the forecasted earnings growth. Excluding exceptional gains, we expect a 15% earnings growth next year, driven by strong macro fundamentals. With improving wallet sizes due to lower inflation and a stabilizing currency, this growth should support the market’s upward movement. We expect about 15% growth in earnings, driven by several factors. First, the capital expenditure cycles in Sri Lanka, which have been halted, are expected to restart. The new mandate should benefit local manufacturing and the construction sector. 

When factoring this in, the PE ratios will likely remain marginally below 10%, which presents further potential for a PE re-rating. Based on these factors, we foresee 25-30% market growth in 2025.

You mentioned that interest rates have been this low only 20% of the time in the last 15 years. What kind of earnings growth are we looking at? How does that translate into the price-to-earnings ratio one year from now?

Asanka: I’ll offer a slightly different perspective. While we don’t invest directly in the index, we focus on a substantial number of stocks we consider investable. Based on our analysis of these stocks, we expect earnings growth of 30% to 40% over the next 18 months.

How many stocks are you analysing, 30, 40?

Asanka: We consider only about 75 stocks from the index to be investable in Sri Lanka and actively cover around 40. So, our positions are typically in 30 to 40 stocks.

Interestingly, our team conducted an analysis and found that we will likely see 40% to 50% earnings growth over the next 12 to 18 months. When we compared this to history, we discovered that such high earnings growth was only seen in Sri Lanka during the two years from FY09 to FY11. While we can debate whether this was due to Sri Lanka hitting bottom, the key takeaway is that this is the intensity of earnings growth we can expect.

Market PE typically responds to growth prospects. So, when earnings growth is high, the market PE tends to rise, particularly in the select group of stocks with strong growth. In this case, with 40 to 50% earnings growth, the PEs of these companies are likely to be inflated, as earnings expectations directly influence the price-to-earnings ratio.

We’ve discussed history, but Sri Lanka is still a frontier market compared to the region’s other emerging markets. What does that tell us about current equity valuations?

Udeeshan: The most comparable multiple is from the MSCI Frontier Index, which is currently at about 11 to 12 times. However, this index shows a wide variance: Pakistan is 6 times, Vietnam 14-15 times, and Bangladesh 10 times. The countries on the lower side, such as Pakistan, Bangladesh, and Kenya, face fundamental issues and haven’t yet recovered. On the other hand, countries that have emerged from problems and are showing macro stability tend to trade at higher multiples, closer to 12 to 14 times. Sri Lanka is heading in this direction.

If we look at 11 times earnings and average it to around 12 to 13 times, with an overall market earnings growth of about 12-13%, certain stocks will outperform the broader market. While the overall market might grow at 12-13%, accounting for abnormal items expected by December, there’s still about a 25% upside with a market multiple of 12.5 times and 12-13% earnings growth. Therefore, if Sri Lanka aligns with other frontier markets emerging from crises, we could see a 20-25% upside in the overall market.

What has Sri Lanka’s historic high PE been? Hasn’t it touched 20 times?

Bimanee: In 2009, just after the war, the market PE was around 10 times, almost as high as 25%. This period was marked by the war’s end, which led to a re-rating driven by positivity and optimism, significantly increasing the market.

A 25 times PE, but by discussing a potential historical PE of 12 times, are you being conservative?

Asanka: I think we are being conservative in our outlook, but it’s important to remember that in the select basket of stocks we track, corporate earnings tripled between FY09 and FY11. In such an environment, the market’s willingness to pay 20 times or more for earnings is entirely acceptable. However, we are being cautious in our predictions.

As I’ve been saying for the last 12 to 18 months, if Sri Lanka sticks to the IMF programme, fixed income rates will likely remain low, and equities should outperform. While returns might moderate over time, the longer Sri Lanka stays on this path, the more confidence foreign investors will have in the market. This would reduce the discount at which Sri Lanka trades compared to other countries in the MSCI Frontier Market Index. The market could re-rate by another 20%. Going into 2026, if we continue with the IMF programme, which we will, we should see increasing foreign investment and further PE expansion. Sri Lanka can reach those levels because the most stable countries in the Frontier Market Index trade around 13 to 14 times PE. Therefore, while being conservative, we also focus on a 12-month outlook.

For an investor looking at the market currently—and I’m not asking you to pick stocks—look where opportunity lies. How big is your universe of stocks that you would consider investable?

Bimanee: Our investable universe covers about 40 to 50 stocks. However, we typically take active positions in around 50% of those, translating to about 18 to 20 stocks.

What is the potential forecast earnings growth for the stocks you’re tracking?

Bimanee: We expect over 30% growth in the stocks we follow. Given the current macro strength, we anticipate this trend will continue. With import demand increasing and consumption increasing, we expect earnings to rebound enormously.

For an investor looking at the market, the averages can be misleading because, within the market, there will be a fair number of companies that can substantially outperform the average position. Where are these opportunities in equity?

Udeeshan: If you dissect the market, the finance sector is one area that still has room to grow. Banks have already adjusted upwards, but finance companies are just starting to see growth, especially as vehicle imports pick up. They perform well in a low-interest-rate environment because their margins are relatively high. Overall, the finance sector trades at an average of 0.6 to 0.7 times book value, indicating significant potential. However, as with any industry, there are both winners and losers.

Is that both banks and finance companies?

Udeeshan: No, just the finance companies. Banks within the banking sector are trading at around 0.7 times book value. We typically focus more on book value than price-to-earnings for financial institutions, and there is potential for this to rise to about 0.8 to 0.9 times book value. However, it’s not just about the upside; earnings growth also plays a crucial role. Some banks might not see a 20-25% upside when factoring in earnings growth. Sections like consumer durables and overall consumption-related products should perform well on the consumer front. With a payee reduction, a government sector salary increase, low interest rates, and credit starting to pick up, 2025 is expected to be a year of increased consumerism.

Additionally, this will be the first year without significant individual tax burdens, as the last few years have seen substantial tax hikes in areas like VAT, corporate tax, and personal income tax. This will allow earnings or personal income growth to convert more directly into consumption. Another sector to watch is conglomerates. Some of the key conglomerates are still trading well below book value. They haven’t performed as strongly as other counterparts in the industry, but there is still potential for solid returns, especially as earnings pick up.

Udeeshan discusses several categories: banks, finance companies, consumer goods companies, and conglomerates. As fund managers, most of you have many of these companies in your portfolios. This is where you see 30% or higher earnings growth in 2025. What are valuations like now, and what do you think will happen in these companies?

Asanka: In the construction, construction materials, and specific discretionary consumer sectors, forward PEs could be as low as about 5.5 to 6 times. This is because many of these businesses experience significant operating leverage. As demand increases and revenues rise, operating profit will grow exponentially due to a fixed cost base. This is happening in an environment where interest costs are also coming down. I’m seeing around 50 to 60% earnings growth for specific companies, meaning their multiples could currently be trading at about 5 to 6 times forward earnings, indicating significant potential.

Asanka brought in another potential group of stocks: construction and construction materials. I’m sure you agree with what Udeeshan is saying, but he is talking about valuations on banks, finance companies, consumer goods companies, and conglomerates, possibly companies you have already invested in. What do you see as likely outcomes in the next year?

Bimanee: To revisit our expectations, we anticipate about 30 to 40% earnings growth in the universe we’re tracking. Given this, these stocks, especially the banks, will be key drivers for the index. Banks trading at about 0.8 times price-to-book have historically shown a strong correlation between their return on equity (ROE) and price-to-book value. The higher the ROE, the higher the price-to-book multiple they can command. In the past, top-tier banks traded at 2-3 times price-to-book when their ROEs were above 17%. With bank ROEs improving from around 10% to 15-17%, we expect banks to trade at about 1 to 1.2 times price-to-book. However, because of the implementation of Basel III regulations, which introduce more risk mitigation, banks may not be able to command the exact high multiples as in the past. Still, there is room for a re-rating, with a potential upside of about 25% from current valuations, driven by improving ROEs.

Asanka: To add to what Udeeshan and Bimani mentioned, the MSCI Frontier Market Index includes certain countries, and from time to time, some of these countries may be promoted to emerging market status. When this happens, certain fund managers must exit those markets and look for other frontier markets in which to invest. Over the next 12 to 18 months, there is potential for this transition to occur. When foreign investors enter a market, they typically focus on large-cap stocks, particularly in sectors like banks and conglomerates. This influx of foreign funds can drive up valuations for these large-cap stocks, including banks and conglomerates, further boosting their market value.

If banks are trading at approximately 0.8 times price-to-book, what do you think a market re-rating will take them to in terms of price-to-book?

Asanka: At this point, you cannot rule out it crossing 01 time.

Does that take into account the earnings?

Asanka: When you talk about re-rating, you’re referring to the movement of the multiple. We can’t rule out the possibility of the price-to-book ratio moving from 0.8 to 1, or even 1.1 times, which implies a roughly 25% increase in valuations. Historically, bank book values have grown by around 12-15% annually. Considering lower credit provisioning this year, let’s assume bank book values grow by 15%. So, factoring in the 20-25% re-rating and the 15% growth in book value, the total upside could be around 30-35% or even more.

Bimanee: To add to that, the EDR (Economic Debt Restructuring) just concluded, and some reversals are also expected for the banks. These reversals will likely increase the NAVs (Net Asset Values) of the banks, which is another factor that could contribute to the re-rating. This potential upside in NAVs further supports the case for a valuation increase in the banking sector.

EDR is external debt restructuring. Has that hit the books of the banks yet?

Bimanee: Some of it has already been addressed through management provisions, which have seen reversals. However, with the external debt restructuring, further reversals are expected. These are likely to materialize when we see the 31st December numbers, which should reflect the impact of these reversals.

Is the external debt restructuring and the potential reversal of bank provisions likely to be concluded by December 31st 2024?

Asanka: The formal swap of the old bonds with the new ones was concluded on December 24th. Banks will carry the new bonds by December 31st, and all provisioning must be finalized by then. Therefore, we expect to see the full impact of the provision reversal as of December 31st. While the reversal is not likely to be substantial, it will be reflected in the financials.

Bimanee: So far, most banks have provided about 54% so there will be some reversals comeing through. As Asanka mentioned, there is also a need for clarity regarding the deferred tax asset reversal, which is crucial to consider when finalizing the financials. But broadly, it will be positive for the banks because they’ve substantially provided over the years. The reversals will likely boost their financials, benefiting their valuations.

And not all banks are equally exposed to these restructured sovereign bonds.

Which banks have prominent positions?

Udeeshan: So, it’s the large banks like Commercial Bank, HNB, and Sampath that have substantial positions. If you look at it, the actual NPV (Net Present Value) loss was 37%, but the provision made was 54%. This means they provided more than required, and this excess provision will likely be reversed by December. When an external debt restructuring is concluded, they must recognize the reversal immediately, which means we can expect a slight uptick in net asset value and earnings in the December quarter. However, this is subject to the treatment of deferred taxes and the discount rates they are using.

A sector that the market has ignored is the other finance companies, which, as you mentioned, have much more substantial credit growth. Banks are expected to grow at 15% credit growth in 2025; finance companies may see double that or more. I don’t know how many have finance companies in your portfolio. Are those companies in the universe of stocks you track?

Asannka: Yes. While it’s uncertain whether finance companies will experience double banks’ credit growth, there is potential for around 20% over the next 12 to 18 months. However, investors must be cautious when selecting finance companies, as not all vehicle loan imports are allowed. Historically, certain finance companies specialized in leasing commercial vehicles, trishaws, motorbikes, or personal vehicles. Since some categories are no longer allowed to be imported, choosing the finance companies positioned to benefit from the permitted imports will be crucial. Overall, though, the entire sector has the potential to perform well.

What are valuations like broadly? Udeeshan just touched on finance companies. Can I ask the two of you also? What are the net asset valuations of finance companies? Where do you think earnings will be?

Bimanee: Currently, finance companies are trading at about 0.7 times their book value, generally higher than banks. With loan growth expected to be around 30% for finance companies, these companies can see a significant re-rating, potentially reaching a one-time price-to-book valuation. Additionally, after about five years without fresh demand, finance companies will see a resurgence starting from February 1st. This demand and higher vehicle prices will drive top-line growth for finance companies. Moreover, to achieve nearly Rs5 trillion in revenue, there may be an increase in border taxes or import taxes, further enhancing the value for these companies as the larger vehicle ticket sizes will result in more significant revenue potential.

When you say Rs5 trillion in revenue, you refer to the government budget, right? What percentage of the budget will likely be financed by vehicle import taxation? Can it be as high as 5 or 10%?

Udeeshan: As we’ve seen in the past, a substantial portion of the incremental revenue, potentially more than 5% of the budget, is possible. This could translate to around Rs300 billion out of roughly Rs500 billion, contributing significantly to the overall financial growth.

Asanka: As we look into 2025, the IMF programme details suggest that we need to achieve a primary surplus of 2.3%, and it’s widely agreed that this target is achievable. Incremental revenue growth from 2024 to 2025 will be crucial to reach this. Vehicle imports will likely be a major contributor to this revenue increase. However, it’s important to note that the government and the central bank will prioritize external stability over raising government revenues. If the external environment becomes destabilized, simply increasing government revenues will not be adequate. Therefore, while higher taxes might be used to boost government revenues, there will likely be a focus on managing vehicle import volumes based on the foreign reserve targets for the end of next year.

Udeeshan: The process will likely be more phased out than it may initially seem. In addition to focusing on incremental revenue from vehicle imports, we also need to work towards building a current account surplus to reach the target of $15 billion in foreign reserves. The immediate goal is to achieve around $7 billion in reserves, which takes precedence over allowing more vehicles into the system. Ensuring external stability is crucial, the government will prioritize measures supporting long-term foreign reserve growth rather than just focusing on short-term revenue from increased vehicle imports.

Vehicle imports are the primary driver of net new taxation, essential for hitting the primary deficit target, which is part of the IMF programme.

Bimanee: Exactly, broadening the tax net will likely be a key strategy for the government. Instead of increasing the tax burden on existing taxpayers, the focus will be on bringing more people into the tax system. This approach can generate additional revenue without overwhelming those already paying taxes. The growth in the economy will also contribute to increased tax collection. Hence, as the economy expands, it will support the government’s revenue goals without necessarily needing to raise tax rates. Expanding the tax base and improving compliance will likely be crucial to the government’s fiscal strategy.

Broadening the tax net has been talked about in this country for 30 years.

Bimanee: With the marginal tax rates high—30% for corporate taxes and 36% for personal income taxes—the government will likely focus on optimizing the tax system. As GDP growth contributes to increased revenue, the next step will be to broaden the tax base and improve tax compliance. This will allow for more sustainable revenue growth. Expanding the tax net enables the government to gradually reduce reliance on high tax rates while ensuring sufficient revenue for fiscal targets.

Assume that they are not as successful in broadening the tax net. But from what you see on the ground, in terms of meeting the targets given by the IMF programme, which can keep the programme on track, is Sri Lanka comfortable for 2025, given the macroeconomic situation?

Bimanee: The IMF target for government revenue in 2025-2026 is about Rs5 trillion, while expenditure is expected to reach Rs6 trillion. Historically, governments have often reduced capital expenditure to meet budget deficit targets. However, this year, there’s been such a backlog in capital spending that it’s crucial to continue investment in infrastructure and capital projects. This spending will benefit sectors like construction and manufacturing as increased demand will arise. At the same time, import taxes will play a significant role in bridging the budget deficit and supporting overall fiscal stability.

Where do you think interest rates will be one year from now, the end of 2025, and what is the likely economic growth you anticipate in that year?

Udeeshan: From a treasury perspective, the treasury bill rate, currently around 9%, is expected to decrease to about 8%, reflecting a decline of approximately 1 to 1.5%. As the government continues to raise less than what is maturing, interest rates should continue to come down. However, the yield curve might steepen slightly, with short-term rates at 8% and long-term rates possibly around 10%.

A 4% growth rate for 2025 seems achievable on the economic growth front. This is based on expectations of decent consumption levels and a potential rebound in capital expenditure (CapEx). Construction, a key sector of the GDP, has been underperforming, but if it recovers even 50% of its losses, it could help drive GDP growth towards the 4% target for the year.

I have two questions for you, Asanka: interest rates and economic growth.

Asanka: The one-year treasury bill rate could increase by 100 to 150 basis points by the end of next year. This isn’t due to a crisis or destabilizing policies but because we expect economic growth to increase. This growth will drive higher demand for private credit. For example, vehicle imports require a 70% loan-to-value (LTV) ratio, meaning buyers can finance up to 70% of the vehicle’s value. Significantly, all cars will be taxed at least twice the CIF (Cost, Insurance, and Freight) value, and that tax must be paid at the point of import. This will be financed through credit, with the consumer borrowing up to 70% LTV. This kind of increase in economic activity can lead to greater demand for private credit, which, in turn, could drive up treasury bill rates. Along with other sectors of the economy growing, banks may need to offer higher yields on one-year Treasury bills and may need to pay depositors slightly higher rates. This would represent a natural recovery in interest rates, not something that would destabilize the economy or equity markets.

What do you think economic growth will be?

Asanka: We will be closer to 4.5%. We’re more bullish than most multilateral agencies. The key sectors driving growth—tourism, construction, and trade—all show signs of recovery. Trade, in particular, is a significant part of our economy. Given these factors, we are more likely to see growth closer to 4.5% rather than 4%.

What do you anticipate in terms of interest rates?

Bimanee: In the immediate short term, we expect rates to decrease. However, looking further ahead, towards the end of 2025, we anticipate the one-year rate to reach around 10% to 10.5%, with the long end at about 12% to 12.5%. This is in line with historical averages, given that economic growth is picking up, imports are expected to rise, and credit growth will increase, leading to some crowding out. Additionally, we can’t forget that there are significant government borrowing requirements. For example, in the first quarter alone, the government has substantial debt repayments planned, around Rs900 billion in January, Rs800 billion in February, and similarly in March. While the macroeconomic outlook is positive, these debt obligations will likely limit significant adjustments to interest rates, especially regarding rupee-denominated debt.

Asanka: To clarify further, we expect rates to come down slightly towards the end of February and March, but after that, we anticipate a gradual increase.

When you anticipate higher rates, you’re talking about the government bills and bonds here.  You also anticipate the central bank will respond to higher credit by slightly tightening rates towards the end of 2025. Is that, by extension, what you’re saying?

Asanka: No, we are not saying the central bank will follow a tightening policy unless, of course, they feel that the demand for the dollar becomes uncontrollable and growth picks up to unsustainable levels. We are merely stating that the economy will require more credit, more borrowers will seek loans from the banks, and as a result, banks will face liquidity tightening. They will likely raise more money from the market to address this.

So, this is an entirely market reaction.

Udeeshan: That’s right. The central bank is unlikely to increase rates because credit has not overheated. For instance, if they’re lending Rs80 billion a month, the current run rate, it’s important to note that Rs80 billion today is not the same as two years ago. Ideally, the economy would need to reach a monthly lending average of Rs100 to Rs150 billion before the central bank considers the economy overheating. Our credit-to-GDP ratio has fallen significantly, indicating that the system has room to grow before it becomes a concern.

Do you have a number at the top of your head?

Udeeshan: I don’t, but there’s a substantial reduction in where it was versus what it is right now.

Asanka: Based on this discussion, I’d like to offer some practical advice to the audience. We’ve been discussing a one-year outlook on rates, and 12 months can be a reasonably long time. We all agree that equity returns will likely be strong in the coming year. If anyone is concerned about a potential rate increase later in the year, there’s no need to rush into decisions right now. Observing how the situation unfolds and evaluating the economic indicators throughout the year is better. You can react accordingly as the year progresses, giving yourself more time to assess the broader macroeconomic environment.

We’ve discussed the financial sector, but many other industries, many of which you’ve highlighted, have growth potential. One is consumer growth. Slightly lower taxation means that people are likely to spend that money. What companies are well placed to unlock the consumer potential broadly?

Asanka: The discretionary consumer space holds significant potential. When discussing the discretionary consumer sector, I would include personal financial services, such as finance and construction material companies, in this mix. These sectors are well-positioned to benefit from the broader economic recovery, especially with the expected uptick in consumer spending, lower rates, and economic growth.

Companies like Hemas, Sunshine Holdings, Cargills, Tokyo Cement and Royal Ceramics, and finance companies cater to consumers and personal  vehicles. What are the broad valuations in this sector currently, and what will this pickup translate to regarding earnings growth? Does this sector have the capacity to meet the new demand, or will it have to reinvest new money?

Asanka: certain stocks can deliver returns over 50% to 60%. What I want the audience to focus on is that 2025 will be our first full “normal” year since late 2018. If you analyze the data from Customs, the Central Bank, and industry volume figures, you’ll notice that many sectors have not even reached the volume levels seen in 2018. In hindsight, 2018 was a relatively uneventful year, characterized by low growth. Despite that, current volumes are still lagging behind those levels. Given this context, specific companies are well-positioned to generate substantial growth, with potential returns of 50% to 60%.

For somebody with an individual portfolio, some will look more attractive than even banks at some point next year because there’s more to go in consumer stock growth than potentially banks. How would you weigh a portfolio between the sectors, consumer, banks and construction or construction services, assuming you have equities? What’s the approximate weight now, and how will that likely change?

Bimanee: The market has seen a 45% growth this year, but when we look at the top banks, while they’ve performed better than the overall market, their returns haven’t reached the 90-100% range seen in some smaller companies. Given this, we remain very bullish on the consumer sector. However, maintaining about a 20% allocation to banks in the portfolio will continue to provide positive returns. Similarly, having a balanced weight in industries like consumer durables and finance will contribute significantly to overall portfolio growth, benefiting investors profoundly.

That’s not an entire portfolio; it’s 20 plus 20. So, what should the weight be if you’re considering equity only as an asset class? Is it 50% for the financial sector and 50% for the consumer?

Bimanee: Banks and the finance sector comprise around 25% of the portfolio, consumer goods and consumer durables, construction, approximately 20-25%, and export counters, which are expected to benefit from improving market conditions. Overall, a 95% equity allocation capitalizes on the positive outlook for the market.

Udeeshan: For a pure equity mandate, I’d reduce the allocation to banks from the previous 40-50% to about 20%, increase finance companies to 10-15%, and increase the consumer sector to around 30% because this sector is expected to benefit from discretionary spending and 30% to construction with expectations of growth driven by discretionary spending in the construction sector.

Asanka: My advice is for portfolio management to manage your positions actively, depending on the size of your portfolio. With a smaller portfolio and position size relative to the market, you can react quickly to changes in share prices. Monitor expected returns across about 40 stocks and adjust your allocations to optimize your returns. This allows flexibility to reallocate based on price movements and market conditions.  Market liquidity becomes crucial for more extensive portfolios like those in billions. Planning and building positions strategically when market interest is low is essential, ensuring you have the time and flexibility to react to market changes. Large orders can move the market, so consider spreading out your purchases and selecting stocks with better liquidity to avoid significant slippage. Look for catalysts within the next 3-6 months that could drive sectors or stocks, allowing for better positioning.

One sector we haven’t talked about is what we call conglomerates. John Keells is a big stock here, but the stock hasn’t moved much. I’m not asking you to look at conglomerates, but it’s challenging to avoid the fact that John Keells dominates that sector, and it’s about 6-7% of the market. It’s one of the most extensive stocks, if not the largest listed company, right now. Any thoughts?

Bimanee: Sri Lanka’s market attractiveness for foreign investors centres around key factors. Large, well-established companies like John Keells are often the top choice for foreign investors due to their strong market presence and liquidity. These companies’ depth of coverage and transparency make them a preferred option. The view on the Sri Lankan rupee is crucial for foreign investors. The currency has appreciated by about 11% year-to-date, and the future direction of the currency will heavily influence investment decisions. If the currency remains strong, it could draw more foreign investment, but concerns about its stability will make investors cautious. Sri Lanka was previously in a default state, which restricted foreign investment due to lacking an investment-grade rating. However, recent developments may free up space for foreign investors, especially as the country moves towards a more stable fiscal situation. As the MSCI Index recalibrates, there could be more opportunities for foreign capital to flow into Sri Lanka. However, large-scale investments will still depend on a firm outlook on currency and market valuations. There has been a net foreign outflow of around $9 billion for the year, but this doesn’t mean the trend will continue into 2025. While interest from foreign investors is increasing, their final decision will depend mainly on how the Sri Lankan rupee performs and how foreign investors view the country’s currency and market in the upcoming year.

When you give us this forecast, I haven’t asked you for a market where the index will be forecast, but do you anticipate large foreign inflows to start in 2025?

Bimanee: There is a general expectation that foreign inflows will increase, but the exact magnitude is uncertain. This will depend on several factors, including economic growth, currency performance, and investor confidence in Sri Lanka’s fiscal policies. The Sri Lankan rupee has appreciated by around 11% in the past year. While this has positively impacted investor sentiment, the future direction of the currency will remain a key determinant of foreign investment flows. As Sri Lanka’s GDP grows and imports begin to pick up, this could significantly impact the economy and the flow of foreign capital. Strong economic performance could attract more foreign investments. Before the domestic debt restructuring, foreign holdings in Sri Lanka’s treasury bills and bonds were approximately Rs169 billion. This figure has decreased to around Rs66 billion, reflecting outflows from foreign investors. Despite this, there is still potential for inflows, as Sri Lanka’s macroeconomic outlook improves. The Sri Lankan stock market has seen around Rs9 billion in net outflows. However, with recent positive developments in December, the sentiment around Sri Lanka as an investment destination could change, potentially leading to future foreign inflows.

You mentioned the levels of foreign holdings in several stocks. How long will it take for Sri Lanka to become stable or attractive enough in the eyes of foreign investors before stock holdings in companies can revert to those levels?

Asanka: I don’t view the foreign outflows we’ve seen in 2024 from the equity markets as unfavourable. One key factor to consider is that foreign investors who entered Sri Lankan equities in 2022, particularly between March and April, were primarily attracted when the currency was around 3.30, 3.40, and 3.60. These investors were explicitly looking at Sri Lanka as a distressed country, much like those who invested in our domestic debt during its distressed phase. Those investors will likely move out now that the distressed discount is diminishing.

With the rating upgrade, we will see more long-term investors considering Sri Lanka. The rating upgrade was announced on December 24th, and with Western markets closed during that period, we expect foreign flows to start picking up around mid-January and continue thereafter. As we hit various milestones, different groups of foreign investors will gain confidence, increasing allocations. We may also see new foreign investors entering the market.

However, it’s possible that until 2028, we won’t fully regain the level of foreign investment we had in 2014 and 2015. This is because some foreign investors will wait to see if we can successfully implement the IMF programme and demonstrate structural growth leading up to 2030. After 2030, our debt service requirements will increase, so some investors will prefer to wait for that clarity. This journey has already begun, and we expect foreign inflows to increase next year, continuing to rise if we stay on track with the programme.

Udeeshan: Investor confidence is one aspect, but another important point is the size of frontier market funds, which has shrunk substantially. Many funds that had significant allocations to Sri Lanka in 2014-15 have moved towards emerging markets or closed down their frontier market funds altogether. The allocation to frontier markets now is likely just one-third of what it was back then. For example, funds like Janus and Matthews, which had significant exposures to Sri Lanka, no longer exist. The funds currently in the market are relatively minor but will gradually return. We will see an improvement in foreign inflows, but it won’t reach the same level we saw before. There is also some scepticism regarding whether Sri Lanka is indeed on the right track or if this is just a temporary blip. These investors take a long-term view, typically with a five-year horizon, and wait for the longer-term trajectory. While foreign inflows will improve, they won’t be as substantial as before. Foreign turnover accounted for about 40% of market turnover, which is unlikely to be the case now. The pace of improvement in Sri Lanka will determine how much allocation is shifted back into frontier markets.

Additionally, the U.S. interest rate trajectory will also play a role. If U.S. rates remain low, investors will look for alpha returns, which could make frontier markets more attractive again. Due to currency issues, the last couple of years have challenged U.S. investors in frontier markets, not just Sri Lanka but also countries like Pakistan, Bangladesh, and Kenya. This negative experience leads to a more cautious “wait and see” approach rather than a full return to frontier markets.

Asanka: In 2015 and 2016, we saw robust foreign inflows because those were also strong years for frontier markets. During that time, the funds investing in frontier markets were much larger, and they had more confidence in the markets. However, the key takeaway here is that the path forward matters. Given the current market valuations, it will be more challenging for foreign investors to build significant positions without paying a premium price. For example, when Commercial Bank was trading around Rs105/110, the stock had significant foreign interest. However, there was a lack of willing sellers, and some of those funds may have purchased at higher levels, around Rs125/130. So, while it will take time for foreign investors to re-enter the market, the gradual process is not necessarily harmful to market returns.

Is there still more on this current euphoric run to continue?  We’ve seen much of the gain of 2024 happened in the last two months of the year. Would somebody looking at January to March count on this euphoria continuing? Because markets never settle at equilibrium. It’s always either overshooting or under, right? Can the market overshoot? What do you think?  

Asanka: There are specific characteristics of markets that tend to overshoot. For example, when leverage investments are at all-time highs, and the underlying collateral loses value, corporate earnings often don’t grow significantly. However, none of this applies to the current market. From what I’ve gathered, broker credit levels in the industry are still about 20-25% lower than in December 2021. More importantly, the collateral backing these credits primarily comprises large-cap stocks, expected to grow earnings by at least 30-40%. This means collateral values will likely increase, enabling more borrowing on the same collateral.

Furthermore, the total amount borrowed is still 20-25% lower than in December 2021, indicating that the market is not showing signs of overheating. As we discussed earlier, the index has the potential to see substantial earnings growth, and a select basket of stocks could experience even higher growth. Over the last two years, the nominal value of fixed-income holdings in the Sri Lankan economy has grown significantly. Even if these institutions continue to allocate the same percentage to equities, the amount of money flowing into the equity market should increase. While some are being cautious because the market has already run up, it’s only a matter of time before they invest. Equity returns will ultimately outpace fixed-income returns. So, this is not a euphoric or speculative run, although, like any market rally, there is some speculative element. But we are far from it.

I would like to ask each of you to share some final thoughts.

Bimanee: So, the base for 2025 will be the strong fiscal pillar and the solid macro fundamentals. With the political stability also coming through, we are not relying on temporary measures to boost consumption or growth. Instead, it’s more of a controlled growth, which is quite positive. This positivity will carry into 2025, and investors will likely assign a premium due to the macro strength and stability we are seeing. One critical milestone for the new government will be the budget, which is scheduled for February 17th. This will be a key catalyst for defining the policy direction for the next few years. Given this positivity, we remain optimistic about equities, and equity will be a strong asset class heading into 2025.

Regarding our fixed-income outlook, rates could come down in the short term. However, gradually, they will trend higher towards the end of the year, mainly because growth will pick up. This will lead to crowding out, and rates will likely rise. So, 2025 will be a good year for equities.

Asanka: To recap, a select basket of stocks can generate around 50-60% equity returns over the next 12 months. This will be driven partly by valuation re-rating and, in part, by corporate earnings growth. Therefore, this is an equity year where fixed-income yields will also outperform. This is not speculative or euphoric; we’re beginning a strong market run. My advice to investors is to stay ahead of the market. Do your analysis and build your positions before the market catches on because that is likely the easiest and least risky way to generate strong equity returns.

Udeeshan: As long as macro stability prevails and interest rates remain almost single-digit, the equity market can maintain a multiple of around 12.5 to 13 times. However, it’s essential to remember that FOMO (fear of missing out) could drive speculation in certain stocks, leading them to overshoot. That said, focus on strong fundamentals and look for companies with robust earnings growth that can outperform the market. Allocate your portfolio more towards these companies to ensure a solid trajectory. Aim to align your investments with the country’s GDP growth, which will likely yield positive long-term returns.