A 60% fall in June 2023 quarter earnings halted in its tracks the stock market’s rise. However, the market reaction to the earnings fall didn’t take everyone by surprise given the 80% correlation between a stock’s performance and the last quarter’s earnings, as pointed out by analysts at the investment bank CAL

Three of Sri Lanka’s top fund managers joined an Echelon round table to discuss the underlying value of stocks and what will drive their value up.

Fund managers from Sri Lanka’s three largest portfolio management firms, NDB Wealth Management Ltd.’s Vindhya Jayasekera, Kanishke Mannakkara from CAL Investments and Lynear Wealth Management’s Asanka Herath, joined the discussion.

The round table discussion was held in late August 2023. Excerpts follow:

Asanka Herath, what do you think are the forces that will shape equity valuations in the future?

Asanka: It’s kind of a general belief that equities will do well in the next 12 to 18 months. I expect that in the next month and a half, we might successfully conclude the bilateral debt restructure and the commercial debt restructure. The conclusion of these negotiations will be a major catalyst for both the economy and the markets. We will see a lot more confidence driving stock prices up, as foreign fund flows as well as local fund flows increase.

We also expect interest rates to fall further, by between 200-250 basis points by the end of the year. Then the decline in corporate earnings may have bottomed out and we expect earnings to start growing from this point onwards. So it’s a culmination of all three factors which will drive the stock markets forward in the near term.

In 2022 there were economic factors bearing down on equity valuations.  What were they and will those change in 2023 and beyond?

Vindhya: 2023 has been dominated by the high interest rates. We started the year with lower interest rates of about 8%. But there was a 700 basis point rate hike, and interest rates went up to about 23%. People had the opportunity to invest at a rate of over 30% returns.

Not everyone seized the opportunity to lock in those high rates for the long term. Now some of these investments are beginning to mature and interest rates today have declined. So, investors are going to be yield hungry and that will be a catalyst for investment flows to equity.

There is a tax-related story on why more money can flow into the market too.  Interest from fixed-income instruments will be taxed at the personal income tax brackets. So the highest personal income tax bracket is 36%. If you were investing in a 30% fixed-income instrument, your after-tax return is around 20%.

But at these rates’ after-tax returns are going to be 8-9%. So this is going to be one catalyst for investments to flow into the share market. Combined with the macroeconomic reforms, easing policy rates and the undervalued shares, I think there is a good case for the share market to perform over the next 12 to 18 months.

Kanishke if you were to add something to what has already been said about the forces that will drive the equity investing environment, what would those be?

Kanishke:  At the risk of repeating what my colleagues have already said, I also agree that there is a lot of upside. It is driven by two things that I always think about from an investment principles perspective. One is that, especially in frontier markets, you make the most amount of money when things go from terrible to bad. The market has gone up by 35% in 2023, but it’s still early days.

Expanding on that through a fact, adjusted for inflation, the ASPI today is lower than it was on the 9th of May 2009, which happens to be the day when the war ended with Prabhakaran’s demise. Consider that Sri Lanka today is a vastly different place. Sure the growth outlook is lower, but from an overall economy and productivity perspective it’s in a significantly better place. That the stock market has not gone up represents significant undervaluation. That catching up, that gap presents a significant upside in the very near term. For me, 12 months is near term.

The second fact is that bad times lead to good policy, and good times lead to bad policy, often at a national level, and even at a company level, sometimes. So the very bad times that we have gone through have led to, so far, good macro policy to lead us out of this. Provided there is policy continuity, there can then be a period of growth and prosperity beyond the 12- to 18-month horizon that we are talking about here and that could give further upside on equity. So for both of those reasons, I am also very bullish.

How do you make this distinction between terrible to bad and that we are still in a terrible state?

Kanishke: I think we have gone from terrible to bad, but I would argue that equity prices haven’t adjusted to that fully. The 35% market rise is insignificant in the grand scheme of things and how far we have fallen. Considering that inflation was 70%.

What are your GDP growth expectations and forecasts on interest rates over the next 12-18 months?

Asanka: We expect a one-year treasury bill rate of 11-12%, at the worst case by year-end, but it can be possibly lower. Next year’s GDP growth rate will be around 4%. But that should not deter from thinking that corporate earnings too will be low.

You have to remember the accounting profits of companies are denominated in nominal terms. Given the high level of inflation we had, I feel that if you take the non-financial sector companies, they will at least report 30% to 40% nominal earnings growth starting from this point and it might even be substantially higher.

Discussing the financial sector, don’t be surprised if the book values of the banks, even this year, rise 10% to 20% given the kind of bond positions they hold and the growth in the lending book.

If I can expand on this. We have only now seen off hyperinflation, which means the nominal prices of every product companies sell are much higher. That also means the nominal markup is higher. So, you don’t need to have business volumes recovering to pre-crisis levels to have substantial earnings growth.

Vindhya, what do you anticipate with GDP and interest rates?

Vindhya: Monetary easing started in June 2023. So, expect a marginal GDP decline for this year (2023), probably a contraction of 1% or so. But next year we do think the base effect will also come into play and the central bank will ease policy because they are very interested in growth.

Sri Lanka is struggling to achieve budget targets and part of the reason we are falling short of our revenue targets is due to our low economic growth, which fails to generate enough activity and tax collection. So, there will be substantial earnestness to promote economic activity. As a result, we anticipate a 250 to 300 basis points interest rate reduction over the next year. GDP growth will be about 3% in 2024.

Kanishke, do you agree that we have taken a U-turn in the direction of corporate profits?

Kanishke: Yes. We think annual average inflation this year will be 23% and we are expecting a 1% decline in real GDP this year, so nominal GDP is up 22% this year.

Next year we are expecting 5% inflation, and we are expecting about 5% real GDP growth, so nominal GDP growth of 10% next year. On interest rates, by year-end, the one-year T-bill should be in the range of 10-12%.

What is the forecast for earnings growth in 2023 and 2024?

Kanishke: June quarter 2023 earnings are out and they are very low. I think market earnings are in the 50-55 billion rupee range. If you multiply that by four, it is 220 billion rupees, the annual earnings trajectory at that level.

For context, cumulative market earnings in the 2021 calendar year was about 370 billion rupees. It’s important to bear in mind that we have had maybe 70% inflation since the end of 2021 to today.

So, as Asanka said, even if you take 30% higher than 2021 earnings, for next year, at a very macro level, you end up with a market PE of 6.5 times. At a time when interest rates are 10%, a market PE of 6.5 times looks extremely interesting and this is in a market where capital gains on equities are not taxed.

For context, the current market PE is?

Vindhya: The current market PE on the trailing four quarters is 5.8 times. 

Kanishke: But if you annualize the last quarter of profits, then the market PE comes at like 18 times.

Vindhya: Yes, that is correct. So, I think that’s because last quarter the earnings were down over 60%. Quarter-on-quarter earnings were down over 40%.

Asanka: Take this example, now they just allowed the importation of buses and trucks. The prices at which these will be imported will be materially higher than the pre-crisis prices. Let’s say the banks are to lend to import these vehicles. So, just imagine how big the increase in the working capital banks will require to finance the importation of these vehicles and extrapolate the net interest margins on it.

Though share prices of banks have risen substantially from the beginning of 2023, if you value them on forward earnings and forward book value, I think we are barely scratching the surface of the potential.

Kanishke: Let us talk about banks and the levels of impairments they have made. There will be two phases to this. The first is where those impairments taper off, you start making fewer impairments. Phase two will be the write backs of those impairments.

As a disclaimer here I want to add that we may have interest in the companies that we are talking about.

HNB’s net book value at the end of March 2023 was 190 billion rupees. They wrote off 92 billion rupees in the 12 months ending 31st of March 2023. I mean, this is a meaningful percentage of book value. If you start writing back some of these loans, because at 30% interest companies and people could not afford to service their debt, but at 10% or 12% they probably can. Also, 70% of Sri Lankan bank lending is backed by collateral. So when you start writing back, you are talking about a very significant book value growth.

HNB for instance, is trading at 0.5 times book?

Kanishke: Not any longer, now it’s like 0.7. But the book can grow so fast.

Asanka: I agree with Kanishke and I will urge any potential investor to do their modelling on the future book value. What we are trying to say is that right now, certain banks might be trading at around 0.7 times book value. But if you model the writebacks of the impairments and whether they have over-provisioned for ISB (international sovereign bonds) losses, the bond portfolios carried in their balance sheets and expected credit growth; I would say banks are substantially undervalued.

But once again, I will also state that as a company we may have positions or interest in those companies.

So, it is taken for granted that the fund management firms the three of you represent may have positions in the stocks that you are talking about here today. The audience must appreciate that context. Vindhya on banks and finance companies. We have talked about book values. What about price-to-earnings ratios?

Vindhya: For non-bank financial institutions (finance companies), and banks, we would take PBV (price to book value) as a measure where we evaluate, we would not look at PE so much.

But even for non-bank financial institution earnings, you will see that when interest rates fall, finance companies tend to perform better. Because they have long-term loans, but their deposit base reprices faster. So, there is NIM (net interest margin) expansion there with interest rates falling. As economic growth picks up and stability returns, the asset quality also keeps improving. For these, the finance sector looks attractive.

Asanka you said earnings will start rising 30 to 40% in 2024 excluding the financial sector. Why did you exclude the financial sector?

Asanka: Because you usually do not value the financial sector on earnings growth. You value the financial sector on book value growth. That is why I made the differentiation.

While underlying macro factors that drive financial sector earnings and non-financial sector earnings are the same, the actual business drivers are slightly different. So, professional investment managers try to separate the non-financial earnings growth and the financial services earnings growth.

I am trying to put the financial sector in the context of the entire market.  Financial sector listed companies’ share in the market isn’t as big as it used to be. Banks and financial institutions were 40% to 50% of the market cap. Are they likely to return to that relative market dominance?

Kanishke: There are two factors at play here. For sure, I think the financial sector has taken a hammering in terms of its market cap. We believe, quite strongly, that there will be a surge in market capitalization. Within this, it is important to note that the most valuable financial sector company in market capitalization terms is not one of the big banks. So, you need to adjust for those anomalies. I believe Commercial Bank and HNB are probably the most valuable financial sector institutions in this country, regardless of what the official market cap list says.

On the other hand, you have seen companies like Expo, market capitalizations have grown significantly. I don’t know whether the historical relationship of 40-50% of market cap is something that it will come back to. However, that does not change the investment thesis.

Asanka: I think that is important. The index weighting of the financial services does not necessarily change the investment thesis.

Financial services tend to be valued on book value. It is almost a cumulative profit. So, seasonality or cyclicality of earnings, which some of the other sectors face, should not impact the financial services market capitalization. It almost always tends to grow unless there is a massive economic crisis in the country. Now, we are beyond the economic crisis. So, to add to Kanishke’s point and your question, I think equity markets will grow.

Somebody out there may be thinking, what portion of a portfolio should be invested in the financial sector versus say consumer stocks or construction or others?

Vindhya: The financial sector is going to be one of them. You might also want to have consumer sector stocks. There is a pickup of activity in this area.

So companies like Cold Stores and Cargills will see top-line and bottom-line growth.

The financial sector including banks will benefit from declining interest rates. There are other companies that are highly leveraged that will benefit from falling interest rates.

In the tourism sector too, with the arrivals picking up, and interest rates declining these companies, will see growth and higher profitability.

I am just curious, if you look at the financial sector’s weight in the market, it’s about 25%. In the individual portfolios that you manage, how is the financial sector weighted?

Kanishke: We are overweight.

Can you give us a measure of how overweight you are in the financial sector?

Kanishke: I would rather not talk about exact percentages, but we are significantly over 25%.

Vindhya: We are also overweight.

Asanka: We are also overweight in the banking sector and overweight on consumer stocks. There’s a tactical approach we have to take. There are going to be two different types of fund flows. One is foreign the other is local. So when you allocate a portfolio, you should not just be considering the sector allocation. You should ensure you have substantial exposure to shares which will get re-rated based on foreign flows while at the same time, you need to have exposure to small- to mid-caps, which can give alpha on the back of local fund flows also.

So besides the financial and consumer stocks, are there any other sectors where you are notably overweight?

Kanishke: Overweight in tourism.

Asanka: We also have substantial exposure to tourism. But two things. One is that we do not necessarily try to build our portfolios to outperform the index in the short term. So are we overweight versus the index, is a question we do not think too much about.

Vindhya: Consumer sector, tourism and financial sector shares are where our exposure is greatest.

Kanishke: Another non-sectoral but interesting investment thesis, in my opinion, is the dividend yield. You are still seeing elevated levels of dividend yield at several companies, 10% plus at some. It is important to understand that this is a net return. So a 10% dividend yield adjusts for inflation, potentially if you assume you are investing in a stable business.

Vindhya: We were talking about yield-hungry investors, for after-tax returns. If you invest at a dividend yield of 15%, it can beat what you get on fixed income. Of course, you are taking on higher risk because share prices can be volatile and is something investors can look at as an alternative.

Kanishke: I take pains to explain this to clients because people sometimes equate the dividend yield of good stocks to a fixed deposit and it is not. You need to understand you are taking a risk, but if you have the stomach for it, I think it will be an interesting story.

Asanka: To add to Kanishke’s point. When the market is deeply undervalued, it is that much safer to take that exposure to dividend yield, because there are much less downside risks on the shares. Buying stocks for dividend yield alone is risky, but at times like this, it is probably less risky than most other times.

Kanishke, we started talking about consumer stocks, an area that you as a fund manager are overweight on, meaning that you have a larger allocation to it than reflected in the market. What is the thesis here? 

Kanishke: It is along multiple dimensions. One is a return to normalcy and people’s spending power increasing once again. The other key thing to bear in mind is that a crisis is great for incumbency, and the stock market is a club of incumbents. In a difficult economic situation, smaller companies might shut down or their market share might decline. But you have the dominant players expanding their market share.

Asanka: Consider the December quarter results or the September quarter results (2022) of large consumer companies. They were primarily driven by higher markups on products, but also because larger guys can withstand logistic stress and balance sheet challenges. Given the kind of crisis we have been through, some of the smaller players may not come back to the market in the same way for the next 6 to 12 months.

All three of you suggested, Vindhya, that tourism is a sector that you don’t mind currently advising clients to have exposure to. Tourism has had a very poor run for several years and they are burdened with loans that and many of these might have to be restructured. But do you see a different side of the sector?

Vindhya: We don’t look at a sector but at individual companies. We also don’t look at a short-term thesis. We want to get in when a stock is fairly undervalued or the prices are more reasonable. So, we will look at a longer-term hold where we might lose out on shorter-term returns.

But yes, I do agree with what you are saying. You are seeing all of these different problems that the tourism sector is grappling with. But, some of these companies will have exposure outside of Sri Lanka as well.

Does that mean you prefer the hotel holding companies, like Aitken Spence and John Keells Holdings, which by their structure have very direct and significant exposure to tourism?

Vindhya: We are looking at the individual stocks plus the holding company as well. Because the holding company has an additional thesis, right? Because at the holding company level, you are still looking at the diversification and the exposure to that economic growth.

Fund managers don’t like conglomerates. The logic is that the manager would rather allocate the capital to sectors instead of allowing the company to do so. Asanka, in the portfolios you manage, where the allocation is public knowledge, why do we see a large allocation to John Keells Holdings?

Asanka: It’s always a question of value. Why don’t fund managers like conglomerates? It’s due to the conglomerate discount. Companies with direct exposure with very simple structures are valued higher by markets.  There are two things here. If the conglomerate discount is more substantial than in the past, then there has to be a reversion to mean. In a country like Sri Lanka, conglomerates offer foreign funds the ability to get exposure to the country directly. So, if you’re expecting foreign flows to come back, and we expect a mean reversion on the conglomerate discount, then there should be substantial upside.

Vidhya: What you said is completely true, like in terms of a fund manager preferring to pick the stocks instead of having a conglomerate allocate it for you. But it also depends on the timing of the investment. Sometimes a broad asset allocation to the entire market makes sense. If you’re expecting a broad economic recovery, then it makes sense to look at the conglomerates.

Does the fact that foreign investors will return to Sri Lanka at some point, probably after the foreign currency commercial debt restructuring is finalized, lead you to think that conglomerates may be additionally attractive?

Vindhya: It’s not entirely based on that. But that is certainly an investment rationale as well. There have to be reasons for how you unlock value. Foreigners returning to the market is one way that you can unlock the value. Like Asanka was saying, deep discounts in conglomerates can just remain that, a deep discount if nobody buys it.

Kanishke: The only thing I can add is that fund managers may dislike conglomerates, but we love liquidity.

Asanka, you are bullish on tourism. What’s the thesis?

Asanka: We feel by about December, our tourist arrival run rate may be at, or slightly above the pre-Easter levels. What we need to be mindful of is that since Easter, global outbound tourism has actually grown. So, going back to pre-Easter tourist arrival figures is not an achievement in itself. But that is indicative of the potential upside. On the tourism-related investment thesis, there are two things I want to say.

First, when you’re selecting tourism-related earnings upside, just be mindful of companies whose balance sheets may not be strong enough to withstand refurbishment or servicing their debt.

The second; when it comes to tourism-related investment consider the value chain.  To build an investment thesis based on tourism, you don’t necessarily have to buy hotel stocks. In that value chain of servicing the tourism industry, you will see companies which will see substantial upside.

What kind of stocks are you referring to?

Asanka: When tourism picks up, greater pickup for food and beverage. That could be one sector. Also just be mindful that even in this fairly dire consumer environment, the Southern belt consumption is picking up because tourism is picking up. So, that pickup in tourism can actually transform into a pickup in consumption, which will also benefit consumer stocks.

Kanishke: I don’t think you can generalize. If you’re talking about Sri Lanka as a whole, obviously apparel is a big segment. It looks like it’s slow going for the industry until the end of this year because the orders have been slow.

I’m coming from an apparel industry background. I can tell you, I won’t be surprised if next year you don’t see a bounce back. Globally, it doesn’t look like major economies will dip into an out-and-out recession. So there will be a pickup in consumer spending and more importantly, it will lead to lower stock levels at retailers. So you probably will see a pickup in orders in the apparel sector next year. But by the time that translates into earnings here, we’re talking 12 months at least.

Something that I think about as a fund manager is that I can have my long-term investment thesis, but my first job, I think, is to make money for my clients. We see an 80% correlation between stock prices and the last quarter’s earnings. Essentially, our market prices move according to the last published earnings. We do take a position when we think a company will do well in four quarters. But that position is likely to be smaller as a percentage of my total portfolio than a company whose I think the next quarter’s earnings growth is going to be dramatically higher. So we do time my investments in that way.

Asanka: Kanishke brings up a very important point about portfolio construction. Given the market liquidity versus portfolio size, given the differences in the investment mandates of different clients, you may decide to take long-term positions or short-term positions.

If you are so large that it takes time for you to build a position, you’ll probably carry a lot more for shares likely to start giving you returns 12 months from now, as opposed to another portfolio where the portfolio size is smaller.

Also the client’s investment mandate matters. Certain clients’ outperformance is based on a longer horizon, while other clients’ are short-term. So I think it’s very important as fund managers, that we recognize the needs of each client and deliver what the client needs.

Vindhya: If you look at unit trusts you get evaluated on an almost monthly basis whether you like it or not. Versus if you look at larger clients, they would be happier looking at a longer-term build-up of a portfolio. It depends on who you are catering to.

Let’s wrap this up. Take a couple of minutes, any final thoughts?

Kanishke: Under normal circumstances, I would be worried when everybody around the table says the same thing. But maybe this is not a normal circumstance, it’s a relatively extraordinary circumstance.

I do think that there is value. Yes, we all see it, but the market has not yet adjusted. A lot of institutional money has already come into the market. But I think there is a long way to go in terms of foreign money, in terms of high net-worth individual money and in terms of retail money, yet to come.

As we discussed, the Colombo stock market reacts strongly to quarterly earnings. It appears highly likely that quarterly earnings numbers will grow very fast, with very high percentages over the upcoming quarters. So all of this lends to a fairly robust hypothesis in favour of increasing exposure to equities. That’s what we have already done for our clients and it’s what we are advising clients to do.

Asanka: Essentially the similar themes. We started building our positions beginning in May this year and increased recently when fixed-income yields dropped. The point is that when the market is substantially undervalued as this, in the initial rally it moves up very fast. This 35% move doesn’t capture the market’s full potential.

We discussed certain catalytic events which will happen over the next few months. For an investor who is staying out of the market, the biggest risk is that if they wait until those catalytic events materialize, the market will be another 15-20% up before they can enter. I don’t want to run the risk of repeating what Kanishke said, but we are seeing substantial foreign interest but some of the foreign interest is not materialising due to a lack of liquidity. At some point they are going to say, heck, we’ll pay 5% up or 10% up to build the position. So I would say we are probably at the beginning of a 12-18 month, very strong performance in equity markets.

Vindhya: I agree with my two colleagues in terms of where we believe the equity market is going to go. But I don’t think we want to leave a story, where we say, everything is going to be a full bull run. You have to be aware of certain risks building up. The biggest one may be the forecast drought, which might have negative effects on all our GDP forecasts and lead to food security issues, exchange rates, interest rates etc. I agree that we will see a re-rating of the market.