A MODEL EQUITY PORTFOLIO SOARS, RETURNS 17%
Listed equities gained a disappointing 1.25% in 2019, down from 2.6% the previous year. The market recovered in the last quarter after a dismal run due to policy uncertainty, an economic slowdown and the devastating Easter terror attacks. Equities had declined 16% over the last five years.
Six years ago, three fund managers built hypothetical stock portfolios valued at Rs10 million each for Echelon’s January 2013 edition in an exercise to understand how long-term portfolio investments worked. For the six years to end-November 2019, the Rs30 million combined portfolio has grown to Rs 48.5 million, up 6.2 million from last year. The combined annual average return was 8.3% over the last six years, compared to the All Share index’s 2.5% gain during this period.
Fund managers are restricted from buying and selling stocks during the year. The rules of this exercise also prevent them from manoeuvring funds to any other income assets for better returns as they would normally do for portfolios they manage in the real world. Only year-end allocations were allowed.
Ramesh Schaffter of Janashakthi Insurance, Sumith Perera of Guardian Acuity Asset Management, and Kanchana Karannagoda of Ceybank Asset Management manage these model portfolios. Ineka Dunuwille, a fund manager at Candor Asset Management, joined the exercise in 2018 submitting a model portfolio valued at Rs10 million. For this edition, Perera has stepped down to allow a CFA-award winning Senior Fund Manager at Guardian, Asanka Jayasekara, a shot at this exercise.
During the reference period for 2019, the benchmark All Share index gained 3.2% while three of the four model portfolio’s beat the market’s return— with one gaining an impressive 17%. We take a look at how each portfolio performed and the present reallocated portfolios, which will be reviewed next year.
BANK VALUATIONS DON’T MAKE SENSE
Executive Director, Janashakthi Insurance Plc
The portfolio returned 17% during the period under review, outperforming the market’s 3.2% gain. Access Engineering made the highest gain of 45% partly due to the political sensitivity of the stock. The share moved up in the run up to the presidential elections, and after. However, Access is fundamentally a sound exposure to the country’s construction
sector and property markets. It’s large enough to attract any foreign investor looking for some exposure to these sectors. There’s upside potential in terms of earnings with the construction and real estate sectors expected to grow in 2020. LB Finance gained 41% but the share is still way off from where it can go. Earnings were flat despite the challeng
ing conditions in the industry. Janashakthi Insurance returned 33% but it’s still undervalued and far below its peak just before a share buy-back two years ago. I will continue to hold Janashakthi because I believe the prospects are good as the share is tremendously undervalued in terms of price to book value relative to the rest of the industry. It’s the same logic that sees HNB Assurance in the portfolio.
This company has shown strong growth in both general and life insurance businesses. The insurance industry has potential to grow, particularly with non-general insurance penetration still at low levels. There are few stocks in this sector with attractive valuations. NDB Bank gained 7%, but it’s nowhere near where it ought to be, priced below 0.7 times its book value. This is what saddens me about the Sri Lankan equity market.
Valuations of most banks are less than their assets. This does not make sense. This tells you how sentiment has a bigger impact on market performance, rather than business fundamentals. Banks have taken a beating because governments very sadly see them as a source of income and are taxed exorbitantly. On top of that, IFRS-9 impairment provisioning and Basel III capital-strengthening will require more capital calls from banks. I will hold on to both banking stocks because I believe improving sentiment will unlock their fundamentals-led potential. Earnings should improve with bond yields reducing. The recent tax cuts should improve consumption and boost business confidence which should be positive on banks.
Bairaha Foods was the only other stock on the portfolio to decline, the other being Nations Trust Bank. I avoid investing in companies that are constantly pressured by excessive government interventions because it forces a greater risk to their business decisions. Bairaha, unfortunately, did not perform too well after taking a hit at two ends: restrictions on maize imports impacted chicken feed prices and retail price controls squeezed profitmargins. I’m exiting Bairaha for another company that’s in a tightly controlled sector: motor vehicles. Motor vehicle importers and dealers are subject to constant interventions from import duty hikes, imposing leasing limits and higher margins on letters of credit to protect foreign currency reserves. I’m allocating United Motors
because I believe the motor sector could get another lease of life as sentiment improves, the economy gains momentum and disposable incomes increase. If this happens, I believe United Motors is best positioned with its mid-range motor brands: Perodua and Mitsubishi cater to middle and upper-income segments which are the fastest growing. United Motors, again like most stocks, is undervalued in terms of price to book value.
IN 2020, I BELIEVE STOCKS WILL DO MUCH BETTER, ONLY BECAUSE IMPROVING SENTIMENT WILL RECOGNIZE THE STRONG FUNDAMENTALS THAT COMPANIES DEMONSTRATE.
In 2020, I believe stocks will do much better, only because improving sentiment will recognize the strong fundamentals that companies demonstrate. Stable government is necessary for consistent and predictable policy. Investors like nothing better.
CONSTRUCTION BOLSTERS A BATTERED PORTFOLIO
Fund Manager, CeyBank Asset Management
In a period where an economic slowdown, political uncertainty and the unfortunate Easter attacks took their toll on listed equities, this portfolio returned 9.6%, three times more than the 3.2% All Share Index gain. Tokyo Cement returning 101% was the growth catalyst for the portfolio. The company posted good results during the period under review on lower raw material import costs, improving margins and higher prices. However, the share price only gained during the second half of the year due to improved investor sentiment in the market which also saw the return of the Employees’ Provident Fund.
Access Engineering gained 45% despite a disappointing performance in the first half of the year. Its construction, building materials and property segments underperformed due to the economic slump. Also, these segments were heavily taxed. The company’s automobile business didn’t do too well either. The post-election income tax reduction, VAT falling to 8% from 15% and removal of the Nation Building Tax eased pressure on margins of all its construction-related business segments. Also, the removal of the 15% VAT on apartments is positive for Access Engineering’s property businesses.
All these factored into the company’s share price gain in the last quarter. Teejay Lanka gained 39% as the company benefited from currency depreciation, capacity improvement and lower cotton prices while a dynamic product mix and improved internal processes and efficiencies bolstered the fabric manufacturer’s bottomline. Lanka Indian Oil Company (LIOC) reported a strong recovery after a tough lower half. Global oil prices fell and net finance costs decreased due to lower interest rates which improved LIOC’s profitability. However, the share price did not reflect these gains and declined by 18%. This is probably due to the previous administration’s fuel pricing formula and investors mainly focusing on construction and consumer-related stocks which would benefit the most from the recent tax cuts.
Softlogic Holdings fell 18% reflecting its negative financial performance. The company reported losses due to high finance costs and weak performances in its retail, finance and healthcare segments. I believe the stock will recover as the company’s fundamentals improve. Retail contributes 50% to group turnover and will benefit from rising disposable incomes, lower interest rates and credit growth in 2020. Finance costs which increased in the first half of 2019 will gradually ease. The portfolio’s banking stocks declined reflective of the challenging year, weak credit growth, rising non-performing loans and surge in taxation rates. New rules on loan impairments impacted earnings while banks engaged in capital building activities to comply with Basel III regulations. Banking valuations still look attractive and prospects are positive. The removal of a 2% Nation Building Tax and a 7% debt repayment levy will create some breathing space. Going forward, there are expectations for a surge in credit growth due to lower interest rates. Non-performing loans will ease as borrowers’ repayment capacities improve as overall economic activity picks up on rising disposable incomes and consumption. For this same reason, the portfolio will continue to hold diversified companies John Keells Holdings, Softlogic and Hemas which have considerable exposure to consumption.
Hemas, in particular, had a challenging year. Its businesses in consumer and leisure took a hit after the Easter bombings but are now recovering. The healthcare segment will also see benefits once the Morison pharmaceuticals
plant comes online. I believe the prevailing bullish sentiment on equities will continue and attract investors as the economy continues to rebound. Equity valuations are attractive as ever compared to other emerging and frontier markets. Corporate earnings potential will improve on the back of rising consumption and this will create upward momentum in share prices. Investors should find equities a compelling investment amidst a low-interest-rate environment. However, this remains a sentiment-driven market which is why political certainty and policy consistency are so critical.
WITH BANKS UNDERPERFORMING, DIVERSIFICATION PAID OFF
Guardian Fund Management, Senior Fund Manager
The portfolio’s heavyweights in finance companies, telecom, F&B and construction-related stocks made satisfactory gains which offset the underperformance of banking stocks which helped the portfolio return 9.4%, outperforming the market’s All Share Index by 6.2% in the same reference period. Banking prices fell for two reasons: The first was a cyclical factor where non-performing loans (NPLs) increased which is a part of the economic cycle. But this allows investors to understand how strong each institution’s lending & recovery procedures are and management attitudes towards transparency & governance.We need “on the ground research” to understand this. The second reason for the decline was due to a secular factor which affects banks’ valuations. Bank earnings declined on new regulatory requirements for capital and liquidity under Basel III, and higher loan loss provisioning and enhanced risk management procedures under IFRS-9. While these factors dampened returns on equity for banking stocks, the new regulations will make banks more robust going forward and less susceptible to cyclical factors because bankers are now compelled to act more prudently and be more transparent. Considering all these factors and combined with the current historically low multiples of banks, there is good upside potential. However, one needs to weigh-in the medium-term outlook.
The portfolio’s finance companies’ prices have performed better in the latter part of the year. These stocks tend to adjust faster to improving macroeconomic conditions. Both Central Finance and People’s Leasing & Finance experienced sharp declines in earnings earlier in the period due to rising NPLs which will see a reversal along with the recovering economy.
Distilleries remains on the portfolio because of its robust business model being the market leader with a two-thirds share of the hard liquor market, an unmatched distribution network and sourcing power. The ban on advertising liquor is a huge barrier for entry and market-share grabbing. This helps them to have sustainable topline. Growth potential is only tampered by bootlegging, taxation policy, and price movements in soft-liquors like beer. Distilleries’ bottom line is exposed to volatile imported ethanol prices, a prime raw material. The company is shifting to local suppliers where margins are also high. Distilleries’ price to earnings multiple of 14 times and its dividend yield of 5-6% are too good to pass-off.
Hemas Holdings has successfully navigated through perhaps the worst period in its history. Muted consumption growth, massive currency devaluations, price controls on pharmaceuticals and the Easter Sunday attacks impacted its key businesses all at once. Hemas has exposure to several growth sectors in the economy including FMCG, healthcare, logistic & shipping, and leisure. The group’s FMCG business has the potential to grow through brand extensions both vertically via premiumization of its existing portfolio, and horizontally by introducing new products and categories to both local and export markets.
Challenges include growing competition from emerging local producers and multinationals. Similarly, Hemas’ healthcare business has great growth potential but it’s highly vulnerable to policy shifts. Therefore, Hemas is a medium-term pick as current prices are not way off from its intrinsic value. My other allocations including Cargills, Cold stores and Tokyo Cement are all trading around fair value though the underlying business sectors have significant growth potential.
Given the potential growth in consumption and construction activities in the short term, I expect these companies will see a boost in earnings which will drive up their share prices. Overall, I believe the market has more upside potential with strong fundamentals, historically low valuations and improving investor sentiment.
KEEPING THE FAITH IN BANKING STOCKS
Fund Manager, Candor Asset Management
The portfolio’s heavy tilt towards banking saw it underperform the market, returning 2% against the All Share’s 3.2% gain. The banking sector underwent a challenging year, to say the least. Weak economic growth and restrictions imposed by the government on several industries led to a slowdown in credit growth while rising impairment costs and steep taxes hurt banking profitability. In addition, the sector underwent capital raising exercises to comply with BASL III requirements. While Commercial Bank and Sampath Bank declined in value in the portfolio, a sharper drop was seen in Sampath due to a heavily discounted rights issue price.
This brought down the share price sharply in May 2019. Commercial Bank underperformed the market by 18% during the period under evaluation largely due to the expected capital infusion in 2020. The share prices in the banking sector have dropped to levels that currently do not justify their long-term earnings potential. I expect the fundamentals of the sector to improve on the back of improved economic activity and remain confident that Commercial Bank and Sampath will perform well in the next few years. I have revised their allocations in the portfolio and included Hatton National Bank as well.
The notable winners in the portfolio have been Lion Brewery and TeeJay Lanka. TeeJay Lanka gained 39%. The fabric manufacturer had an excellent financial year in 2018/19 with the topline growing by 29% and net profit up 16%. A full order book, growth in volumes across all brands and stabilizing cotton prices towards the end of the financial year helped the company perform well and the share price reflected this performance. I will continue to hold the share and remain positive on the counter as it enters its next growth phase. Soft cotton prices will help margins due to the still unresolved US-China trade war, while volume growth from new brands in the portfolio is expected to contribute to topline growth. Lion Brewery had appreciated 17%. The brewer’s topline grew in the second quarter of 2019 aided by price revisions from an excise duty hike and volume growth. Profitability had improved on lower finance costs.
Anticipating a consumption boom I will continue to hold Cargills and Hemas Holdings and have added Ceylon Cold Stores as a new pick. I am confident in modern trade’s long-term potential, and both Cargills and Ceylon Cold Stores are set to expand their operations. Manufacturing is expected to recover in 2020 which is why I allocated ACL Cables. Commodity analysts forecast a bearish year for metal prices as global trade tensions are yet to ease and demand remains weak. For ACL Cables, this is likely to translate to margin expansion while its newest acquisition of Cable Solutions will enhance its export presence.
Access Engineering also makes an entry into the portfolio as a longer-term investment with new projects helping to boost margins in the years ahead. The company has diversified its operations into the office and residential spaces, whilst not losing sight of its core strengths: large-scale state and privately funded infrastructure projects. The halving of taxes will also be a significant boost to Access Engineering’s bottomline in the coming year. I’ve included Dialog Axiata because the latest tax cuts will likely be passed on to consumers which will increase both voice and data usage. Capital expenditure will taper down from 2021 as it completes its 4G coverage. Overall, I believe market participation will improve with local and foreign institutional activity after the 2020 general elections when clear macroeconomic policies are articulated and established.
For the long-term investor, Sri Lankan market valuations look appealing with a PE ratio at 10.7 times in comparison to the MSCI Frontier Market PE ratio of 13.1 times at end November 2019. Even in the Asian region, Sri Lankan equities are trading cheaper than India at 22 times, Vietnam at 16 times, Thailand at 14 times, Indonesia at 16 times and Malaysia at 17 times PE. Furthermore, the current low-interest rate environment is likely to prompt local investors to look at the equity market as an alternate form of investment.