Accepted wisdom, that equities offer superior returns in the long run, sounds a little hollow right now, if long term is defined as three to four years. The All Share Index is up approximately 12% from levels four years ago.

Institutional investors know they cannot stay out of equity forever. In the last two years, high fixed income returns touching 12% risk free have been a safe harbour for portfolio funds. However, in the September quarter of 2016, listed company profits rose 24% compared to the same quarter a year ago. Some analysts forecast corporate earnings will rise around 20% in 2017.

Four equity analysts joined a roundtable discussion at Echelon to discuss equity strategy for 2017. We asked them if portfolio managers should start switching to equity from the guaranteed risk-free double-digit returns offered by bonds.

Joining the discussion were Softlogic Stockbrokers Chief Operating Officer & Head of Research Danushka Samarasinghe, Vice President at Frontier Research Travis Gomez, Assistant Vice President of Research at stockbrokerage NDBS Sidath Kalyanaratne and Head of Research at portfolio manager Lynear Wealth Asanka Herath.

What is the outlook for equity in 2017? Any broad themes?
Travis: We think 2017 could be a turnaround year for the stock market. The appointment of the current Central Bank governor was a positive catalyst. Add to that the improvement we saw in the earnings of many listed companies. The trend towards fiscal consolidation is also timely, although it will have a negative impact on sectors because of higher taxes. Given all that, we are positive.

We went as far as saying that, by the first quarter of 2017, the All Share Index will reach the 7,000 points level. However, now, given some external threats, we are revising that, particularly after the Trump win and uncertainty in Europe. There are too many moving pieces when it comes to Trump. If you consider what happened at Brexit, the initial thinking was that there will be an outflow from emerging markets, but actually there was an inflow. Investors thought the political situation is as volatile in developed markets as emerging markets, so we might as well put our money there. But with Trump, you are not really sure, it could go either way. Due to this, we’ve revised our thinking.

Were any of your forecasts for 2017 altered by the nationalist fervor sweeping the US and Europe?
Sidath: I would take a step back, and look at what Sri Lanka has gone through since independence. In the 1970s, there were two major trends impacting the economy – one, was the demographic surge, because the population at that time grew at 2.5-3% (currently, it grows at about 0.5%). At that time, we were dependent on rubber and tea exports, and those commodities were going through a cyclical decline. Then, partial economic liberalisation took place. On one side, there was the onset of the war. So we were very unlucky.

[pullquote]”I’m bullish about Tourism, healthcare and FMCG over all and in the long term, and Even housing and property, utilities, and telecom
– Danushka[/pullquote]

Despite all that, taking 2011 as the base and comparing with the region on GDP per capita adjusted for purchasing power parity, Sri Lanka has grown per capita income by five times over 1990-2015. Only two countries do better: India by 5.3 times and Vietnam by 6.2 times. No other country even came close. So out of the 25 years, for 18, we were at war. We have done well despite this drag. During 2014-15, there was an event risk element as well – two major elections, the presidential and general elections. Then there were the fed rate hikes. Now, those drags are in the past. The external factors are there, but if you look at the internal scenario from a macro point of view, I feel we are on a very strong footing, especially considering the commitment to fiscal consolidation.

Asanka: There is value in selected sectors. However, we need to be aware of fund outflows.Putting this in perspective, since Trump’s election win in November, we have witnessed five consecutive weeks of equity inflows into the US market (by 15 December 2016). There hasn’t been such a continuous streak since the middle of 2014. If this continues for another three weeks, it will be for the first time in eight years. So there clearly seems to be some strong momentum towards US equities. The week after Trump’s victory, bond outflows from emerging markets were the highest since 2013. I would expect these sentiments to persist at least until April or May 2017. By this time, investors will have some clarity on how the Trump government might operate.

At that point, a few things can happen. Investors might realise that Trump’s policies cannot be implemented to the extent that he professed. Second, they will discover that whatever has to be implemented will take a long time.

And third, they will realise that if the fiscal stimulus and infrastructure spending, which is fairly strong on Trump’s agenda and unlikely to be opposed by Democrats, is implemented, it will generate short-term market growth.

The US growing at a faster rate is generally a positive for emerging markets. So there is a possibility at that point for some kind of a fund flow reversion to happen.

I’m saying this as a possibility, not a certainty. This will soon result in overall equity market valuation of US equities becoming relatively expensive compared with emerging markets. So at some point, when the disparity gets larger, some fund flow reversion could happen. Until that happens, I would say it’s very difficult to see the overall equity market in Sri Lanka performing strongly.

Any robust performance of the overall market in Sri Lanka may happen in the second half. We need to be weary of the French presidential election scheduled for April or May, and the German federal election, which might happen August or October.Our equity market for next year is likely to be driven by foreign fund flows simply because interest rates may have peaked. We don’t know if they will come down. It may be an extended plateau. So until interest rates decline in Sri Lanka significantly, retail investor participation in equity will be weak, and we will have to depend on foreign fund flows.

Assume a fund manager senses an opportunity in 2017 and he needs to start switching his assets to equity. Should he be doing so now?
Danushka: A fund manager having to decide between equity or bonds is a domestic question. It’s the local fund manager who will shift between these classes. As long as Sri Lankan interest rates remain at these levels, it will be very hard for us to attract funds out of fixed income into equity from local fund managers, because they are comfortable with these rates. But we have to be mindful that it’s not domestic fund managers that have created the trend and set the pace, it’s always been foreigners in Sri Lanka. Domestic fund managers have always followed. Globally, Brexit and the US elections will matter less in a Sri Lankan context, because fund management is divided into developed, emerging and frontier markets. Frontier market funds will not invest back in the US or the EU. The question is how fast frontier market funds will grow, whether the propensity or momentum of attracting investments into those fund pools will continue or not. That will slow down because people will be more confident with developed markets, so they will allocate money to those funds. But that doesn’t mean there will be massive redemptions on frontier market funds; that has already happened. Now it’s fairly balanced.

In that context, I’m not very concerned about how global politics will play a role in attracting frontier fund money to Sri Lanka.

The question is Fed rate increases. What happens here is not necessarily money flowing directly out of Sri Lankan equities back to the US: no. It will be a step-by-step process. First, it will be bond money that will flow back to the US or developed markets. That will create pressure on Sri Lanka’s fiscal situation because raising money overseas will become costlier. Then, the government might have to go to domestic markets to bridge their short-term funding requirements. That will create additional pressure on local interest rates. Then, of course, there will be an outflow from local investors in equities to the fixed income market. That is my take. Right now, we are experiencing a buyer’s market. The question is, how long will this buyer’s market last?

Sidath highlighted Sri Lanka’s resilience. We are forgetting about the difficulties in 2008-09 at the last stages of the war. We didn’t even have reserves for three weeks of imports. However, all that time, there was foreign inflow to the market. I recall back then, in the first quarter of 2009, foreign activity in the stock market was more than 65%; foreigners kept the market ticking. Foreigners won’t be concerned about the global scenario when it comes to a market like Sri Lanka. They will be watching growth rates, corporate earnings and what is happening locally. The budget deficit narrowing is great. But there is backtracking on a lot issues and disconnect between the overall long-term, five-year strategy and the short-term 2017 budget.

Other concerns are disruptions due to riots or strikes; because, in a global investor’s eyes, that is disturbing, not politics per se. That’s one reason we are not seeing high FDI flows. Some proper FDIs will highlight Sri Lanka’s place in the investment map and equity markets will rebound. We are encouraged by the appointment of Dr Coomaraswamy to the Central Bank governorship. I think all of us are bullish because of that. But now we see the finance ministry trying to claw back some of the areas under the Central Bank. Those actions will be viewed negatively. We are facing short-term hurdles. Otherwise, we are in a buyer’s market – it’s a period to buy and people are positive, because in the September 2016 quarter, earnings grew at about 24% YoY.

Nothing was given to the corporate sector from the previous year’s budget. Despite this, their earnings grew. Now, we might see a slowdown in consumer spending and we see a slowing of job creation below expected levels, so disposable income would contract.

But with all this, corporate profit growth will remain at around 18% (in 2017). With that, the buyer’s market argument is valid. The headwinds will be how much interest rates will rise by? Because towards the first half of 2017, there will be pressure on interest rates.

Since Danushka gave an earnings forecast, what do you think is forecasted earnings growth rate for 2017?
Sidath: We are forecasting 20% earnings growth for 2017. Travis: I don’t have an overall figure.

Asanka: I also don’t have an overall earnings forecast.

Since the stock market is a barometer for economic health, do you feel the market is pricing in potential earnings growth for 2017? Are we fair valued, undervalued or overvalued?
Sidath: It’s not necessarily the barometer in Sri Lanka. In Sri Lanka, the market represents about 30% of the economy. Having said that, I would say some stocks are still fairly cheap.

Danushka: The 18% growth in earnings is not bad, but again, Sri Lanka’s track record shows we are not a market that has been focused on earnings growth. There are factors like politics and policy that seem to matter more than earnings growth.

Asanka: Danushka highlights an important point. If we can show some momentum in FDIs and free trade deals, or positive direction towards those, that will give confidence to foreign investors. Currently, to put things into perspective, Sri Lanka has never breached the 2% of GDP equivalent on annual FDI. I take Danushka’s point that foreign investors rather than domestic portfolio managers set the market pace here. However, if a local portfolio manager figures equity, as an asset class, is going to outperform in 2017, should he start switching now?

Danushka: If you want to be bold, 2017 is a year for switching. You might see interest rates at these levels, or a tad bit higher, towards the first half or the third quarter of 2017. Why I said a tad bit higher is because it depends on the Fed rates. Higher Fed rates might pressure us also to raise rates, given liquidity issues in the domestic market. What will happen during that period is, if interest rates remain at these levels or move up, equity will become cheaper. That will be a clear indication that this is the turning point.

When we started the discussion, we said there is a limit we can go down from where we are. If the government wants to extend their term beyond 2020, they have to put something on the ground this year. Otherwise, it will be very difficult for them. Them being seasoned politicians, will understand this. I personally think things will start moving soon. The FTA, if not with India, then first with Singapore, if it comes through by the first half of next year, will be a clear signal for some FDIs to come in. For a Sri Lankan portfolio manager facing an asset allocation dilemma, do you switch to equity starting now or continue in bonds? I guess it depends on your view about interest rates.

[pullquote]”What equity fund managers want to see is direction, policy consistency, economic’s ability and currency stability.”
– Sidath[/pullquote]

Danushka: Interest rates might increase in 2017, but the final quarter will be the turning point, when we might see dipping. I’m saying that because I’m expecting FDIs to come in and some government policy implementation to take place, and some direction from the long-term plan.

Travis: By end-2017, we expect rates to decline from current levels. We think 12-month T-bills will be 8.8%. The 10-year bond is to come to 11%. If you are a domestic investor, that’s when you are looking to make that switch from fixed income to equity. At the same time, what also lends us confidence is that we don’t think there will be a big cut from the Central Bank side, as they will not rush to cut interest rates. This governor raised rates in his first month in office. His focus has been on bringing down private credit growth. It was 25% in September 2016, and their target is to bring it to 20% by end-2016. At the same time, he doesn’t want to kill growth that much, so he is cautious. That lends some stability in terms of us escaping from this cycle. In a context where there is more stability, earnings can improve and, as a result, there might be a shift towards equity.

Sidath: Trump is adamant about fiscal expansion, so it’s unlikely the US Fed will increase rates again in 2017. That will really ease some pressure on emerging markets, and give us some leeway. I also feel interest rates are at a peak. But it might take fund managers awhile to rebalance. But rebalancing is a function of your risk, not necessarily the return. So it depends on the fund manager.

I’m going to nudge you for a short answer. You have a local portfolio; you have to choose between these asset classes. Is now the time to start thinking about switching?
Sidath: I would start switching straightaway, from the first quarter of 2017. Equity is a long-term investment, so I’ll take a long-term view. Our macroeconomic vibes are very positive; and as long as we can get something going on the ground, we will see the tides turning fast.

Asanka: If you are an institutional equity investor, especially in a frontier market, you need to have a 3-4 year horizon with regard to the economy, as well as the companies that you are convinced of, and you should be ready to deploy when you get them at attractive valuations. The kind of outflows you’ve seen since November 2016, and in the next 5-6 months, will present you opportunities to slowly build a position. There is a saying that you have to buy when there is blood in the street, and you should be ready to do that.

Let’s move on to equity. If the only available asset class is equity, what are the opportunities?
Sidath: FMCG is one sector, because with the 2016 budget, there was a lot of consumption power with the population, which got reflected in FMCG. If you take a longer term view, why I say FMCG is important is because it’s about 20% of the economy. When you look at employment, it’s about 18-19% in the sector. So overall, it’s a vital sector for the country. There are four things that can drive FMCG in any country: population growth, per capita income growth, reduction in income disparity and the foreign effect which is tourism.

In Sri Lanka, what has been driving the FMCG sector has been per capita income growth. Our income disparity is one of the highest in the region, and we don’t see that coming down significantly. Population growth is one of the lowest in the region, 0.5% or less. But tourism is improving as well, but there are certain issues with the segment of tourists we attract. Despite all of this, I feel the FMCG sector has quite a lot of potential.

Asanka: If you look at data coming from consumer expenditure, and divide the last nine years and compare it with the last three years, you will see that the personal care segment is one where the growth rate has accelerated. The last-three-years growth rate is greater than the last-nine-years growth rate. So it’s evident that the FMCG sector has a lot more potential.

Sidath: As we move up the personal income ladder, we tend to change our habits and go for more FMCG. F&B is an essential, but FMCG contains other items as well.

Having said that, if you are a new player, you might initially struggle because the ones who are consolidating will have an upper hand. Those who have the ability to purchase through their income will go to the established players. So if you are someone new, you might struggle for the first five years. But if you are like Cargills, Ceylon Cold Stores or Arpico, they have the brands and the retail network.

Everything is relative. What are the opportunities relative to stock prices?
Travis: The one thing driving segments like FMCG and healthcare is demographics. Recently, the UNFPA and the Department of Census and Statistics did a study and found a unique thing happening – since about the mid-1990s to 2012, compared with most other countries, Sri Lanka’s fertility rate has been rising and people have been getting married at younger ages. As a result, there is a lot of potential for population growth. Initial estimates were that population growth would be flat, and would be 22 million by 2040. But the revised forecast says it will be about 25-27 million by 2040, almost an additional 5 million.

This has implications on a lot of sectors. By 2040, about 25% of the population will be elderly. That has implications in terms of sectors like healthcare. You will want to invest in treatment of non-communicable diseases, as there is a bigger segment of the population that’s willing to spend. So when I’m picking stocks, I like those with long-term sustainability in terms of their earnings growth potential, rather than going after sectors receiving tax benefits, which can always be withdrawn.

Sidath: Three things drive healthcare. One is NCDs (non-communicable diseases). In most countries, NCDs are increasing rapidly. Out of deaths in Sri Lanka, 75% are NCD related. NCD incidence is higher because we are eliminating communicable diseases and people live longer. Second, not factoring the demographics surge that Travis talked about, the average person’s age in 2040 is about 35 years (it’s about 32 years currently). Therefore, we are looking at an ageing population. Third, is affordability.

These three points will drive the healthcare sector. The thing to consider is that 54% of total healthcare expenditure is bourne by the private sector. In a developed country, more than 50% is managed by the government. In Sri Lanka, the private sector accounts for most of the spend. As a sector, you need to be watchful, because there are a lot of opportunities.

Asanka: Since we are on the topic of older age groups, it’s not just the percentage of the population belonging to the older age increasing, but YoY there seems to be a sharper increase in the absolute number in older age groups. That will have implications for healthcare.

Sidath: Geadiatric care, or looking after the elderly, is a segment that has not picked up in Sri Lanka. I’m sure most listed companies are looking at this because the government doesn’t have the space to support this. We are talking about universal healthcare, but it can’t come at the expense of the government.

Travis: That type of assisted living, especially when it comes to housing, there is potential. At the moment, 60-70% of the elderly are dependent on their children. If there is going to be a social shift, housing will have potential, providing affordable housing with assisted living. Even fundamental things like fiscal policy are affected by ageing. If you have a tax structure that is moving towards indirect tax, that has severe implications. If you depend on a fixed income, changes in taxes can have implications.

Sidath: Talking about economic implications, an ageing population basically means you can’t look at labour augmentation to drive your GDP.

Asanka: And increasing the tax burden on the decreasing number of working people.

So, healthcare, the ageing population and FMCG are opportunities. Anything else in the same broad terms?
Sidath: The banking sector for me still has opportunities, especially banks that have exposure towards SMEs and links towards consumers. Looking at our classification, SME contributes about 52% of GDP. In terms of employment, it contributes about 30-35%, so it’s a significant sector. It will become even more significant if we can clinch FDIs and FTAs. In Sri Lanka, SMEs contribute to about 20% of exports, which is low. As a sector, it’s not reviving.

Within the value chain, anyone linked to the SME value chain will benefit. Basically, banks are right in the middle. It need not be microfinance or SME finance. For example, I’ll highlight two banks, Seylan Bank and Sampath Bank – even HNB has huge exposure to SMEs, more than 50%. They will benefit if the sector becomes more active.

Therefore, I’m very bullish on the banking sector, but you have to look at the pricing. For example, Seylan Bank and Sampath Bank’s price to book value is around 1 times, while the sector’s is about 1.5 times. It’s definitely cheaper, but there are certain other elements to consider as well. For example, Sampath Bank has some pressure on tier one capital, so they might have to raise funds soon. But if you look at the fundamentals, those two banks are well positioned.

[pullquote]”If we can show some momentum in FDIs and free trade deals, or positive direction towards those, that will give confidence to foreign investors.”
– Asanka[/pullquote]

Travis: The other sector that has already been highlighted, but I am also confident on, is tourism. Even though it may not be so positive for listed companies, overall, tourism has a lot of potential in Sri Lanka.

At the same time, we need to be mindful of the environment, because of the way we are positioning Sri Lanka. We should consider the experience of countries that have become over dependent on the beach like in the Caribbean – in the 80s, they invested so much in beach resorts; as a result, they completely destroyed the environment, and tourist arrivals never returned to previous levels. In Sri Lanka, we could head into a similar situation. Because of that, we should push for developing more activities in the city itself, tying into what we are doing with the Megapolis and developing museums and improving the shopping experience and the cultural side of things; that’s more sustainable. Countries like Singapore and Hong Kong don’t even have natural resources, but their tourism contribution to GDP is much higher.

Danushka: Tourism, healthcare and FMCG are sectors I’m also bullish about. But this is overall and in the long term. Even housing and property, utilities, and telecom are ones to be bullish about because of the state of our country. If you narrow it down to a one-year horizon, it depends more on the budget and what is available in the listed space. I am negative about the hotels sector because of the proposed corporate tax increase from 12%, which will supposedly go up to 28%.

In healthcare and FCMG, revenue is growing, but business profitability and margins are narrowing, because input costs are rising. In healthcare especially, input costs have risen significantly with dollar appreciation. But the growth rate of demand will also slow with VAT being added. Affordability is an issue, and I think it will shrink next year due to tax-driven inflation.

There is reason to be bullish about banking, but it’s still unclear with the budget proposal with regard to the 0.5% transaction levy. The finance ministry says banks will have to pay. This will be a cost on the income statement, which will narrow margins. Right now, if the sector is trading at 1.5x book, it will rise to around 1.65x book, on a rough calculation. So it becomes expensive. Profitability margins for the corporate sector are under pressure because of these tax implications.

There has been an advantage with regard to personal income taxation – the tax threshold has been increased. But all the fringe benefits will also be taxed. So, for a person paying the payee, the net impact might become zero, but overall, it’s a good move by the government to increase the tax fee threshold and convince employers to pay more.

Sidath: It’s a regressive tax regime. You have to tax through direct taxes and not through indirect. Those uncertainties only bring about opportunities for equity investors. That’s why funds have exposure to emerging and frontier markets. The red tape, indiscipline and policy indirection all create opportunities if you are a sophisticated investor. Therefore, it’s important that you come with a proper diversification approach, within the equity space. But it’s important that you come now, when there is uncertainty.

Asanka: I would like to add a couple more sectors into the mix. There are reasons to be bearish and bullish about construction. If we start off after the first couple of months in 2015, there were misgivings about the construction sector as a contributor to GDP. Listed construction companies’ earnings have all shown strong growth, mostly funded by retail construction and private sector projects. In 2017, there is a possibility for some of the larger projects to break ground. Given the sheer size, what could it mean for the construction space? Are there opportunities there, or has the price appreciation run its course during the last 12-15 months. As an investor, that is fairly intriguing.

In the telecom industry, there are two competing views. The predominant view is that telcos historically have been value destructive. With technology evolving fast, capex cycles are shorter and you don’t have sufficient time to monetise. The voice to data switchover is going to lead to loss of revenue or margin compression. The emerging view is that newer tech like 4G is making it possible for telco players to sell data for a variety of users than anticipated 4-5 years ago – when this worry about switchover from voice to date came, people thought data would replace voice calls. But now, telco operators have a possibility to sell data for video streaming/downloading, web connectivity and enterprise solutions like cloud computing. Also, smartphone manufacturers have seen ROI slowing down after the initial good years of 2007-12 or so. If you look at the handset evolution, tech evolution and network evolution have slowed down. This means the technology evolution is going to be a little slower, so operators have a lot more time to monetise.

Sidath: Two things I want to add to what Asanka said. One is that we have five telco players, so that itself says we need some consolidation within a 20 million community.

The second point is this evolution. Certain companies like Dialog or Mobitel are looking at about a 1% increase in smartphone penetration every month. When you switch from 3G to 4G, your data use increases about 2.6 times or 260% – that is through video streaming and downloading. That’s a huge opportunity. Coupled with the slowdown in the tech evolution, the two major players are bound to benefit.

Travis: Construction is not just about large-scale infrastructure. Last year, the sentiments with the companies were that, after the election, there would be a lot of moratorium and reassessment. Even then, households drove a lot of growth. Since 2010, the Colombo household construction index has been continuously improving, and it’s more towards larger houses, over 2,000 sq.ft. There is also a mismatch between demand and supply, because a lot of the supply is concentrated towards the high end, where there is a lot of expectation that expats and foreigners would buy holiday apartments here. What we are seeing is that the take up in terms of re-sales have been slowing down. Even companies like Overseas Realty have delayed further phases of Havelock City because they are seeing a slowdown.

You think Overseas Realty will outperform? What are the reasons?
Travis: In terms of pricing, it’s still attractively priced. I think a lot of negative sentiment was over Havelock City, as growth has not come through from that. There is a change in their accounting policy, as they will switch to a completed contract method, so revenue will take time to be recognised. They have fully recognised up to phase 2, which they have completed. Phase 3 is supposed to be completed in 2019, so there won’t be any return from that immediately.

In terms of office space in general, I think there hasn’t been much focus on that, it’s only been on the apartments and the hotels. They are still in a premium position to continue to improve on that. One good metric is the rental yield – in 2011, it was 5%, in 2016, it’s 8.4%. This is despite the value of the property going up; there’s been this continuous improvement in rental yield. In 2016, the rental rate increased about 11% overall, even though occupancy fell; still, their ability to renegotiate at higher rates at WTC is good.

Let’s go to Teejay, the fabric firm. What is your opinion?
Sidath: Apparel and garments is the only sector in Sri Lanka that has got the connection to global value chains. Hayleys Fabric and Textured Jersey (Teejay Lanka) have been resilient through the loss of GSP+, because they cater to a different market, especially Teejay. Their European mix is 40%, another 40% to the US and the remaining 20% to the rest of the world. They are cotton heavy, so GSP was never a major concern for them, as their clientele is high end. They have the reach and the quality, and they don’t compete with countries like Bangladesh and Vietnam, because they are better positioned.

Recently, we also saw inorganic growth when Teejay moved to India and bought OCI (Ocean India); now, their total capacity is about 50 metric tons, about 1.5 times larger than Hayleys Fabric. These guys are looking at end-to-end value creation for their clients. They don’t have much competition within the region, and if you look at pricing, there is still significant potential, and I’m not taking into consideration GSP+ becoming available again.

Travis: I’m cautious because of the pricing compared to the value that it’s generating. In terms of operations and turnaround it’s achieving with its investment in Ocean India, it’s still very good story.

I’m cautious for two reasons. One, the brands they’ve been acquiring and the segments that have been showing this growth have been more towards the retail side – more price sensitive. In the face of this global volatility, I feel they are more exposed as a result of that. At the same time, I also feel the market has not priced in the full implications of what’s going on in Europe, in terms of Brexit. The even bigger story is the potential break up in the EU, with the shift to the far right. Even if you take Britain alone, their inflation picked up in November, the highest in 4-5 years; pretty much because of this imported inflation, their currency depreciated and that has implications. Particularly in Sri Lanka, which is exposed to the EU market, those risks have not been fully factored in. That’s why I’m a bit cautious.

Any view on Aitken Spence?
Travis: Aitken Spence’s exposure is very much to hotels, where revenue is 50% from Aitken Spence Hotel Holdings and PAT is 70-75%. I don’t understand the Aitken Spence strategy where they’ve expanded greatly domestically; I feel there is an oversupply. I don’t think they can maintain occupancy levels. At the same time, it’s very strange that they went into more overseas expansions – in India Oman, etc. Previously, they’ve had bad experience with it when they had a footprint in India and the Andaman islands, and they exited from that because they couldn’t manage it. Now they’ve gone back to that. I feel they’ve over-extended themselves.

[pullquote]”When picking stocks, I like those with long-term sustainability in terms of their earnings growth potential, rather than sectors receiving tax benefits.
– Travis[/pullquote]

Any particular stocks that you like?
Danushka: I’m bullish on JKH. The negative stories are what are they going to do with Cinnamon Life with no casino, have they over-extended the investment into that, and what is going to happen with interest rates rising? Foreign borrowing funds it.

My argument on JKH is a bit different. I believe all the negative news is already factored in. The warrants are out of the picture. It’s in the past and won’t bother the stock price further. JKH right now is trading at one of its lowest multiples in the last two decades. This stock was once considered a proxy to the Sri Lankan economy. It may not be anymore, Commercial Bank may be a better proxy right now, but it’s still the largest listed company. So if there is foreign interest coming into Sri Lanka, given the lower liquidity risk, JKH is one of the first bets. On valuation, there is a premium for JKH because of liquidity and size, and the company’s ability to manage through difficult times and continue to grow.

They might not have grown as fast as expected. But at this junction, valuation wise, it’s looking attractive. And their consumer side has turned around and is showing double-digit growth. The only lag I see right now is not the property segment, but the hotels segment because of increased taxation, nothing else. Otherwise, the operating margins of Keells Hotels have improved drastically, and now it’s better than Aitken Spence Hotels, who was the leader in the industry. They have somehow got their act together, but unfortunately the tax rate has whacked them. But other than for the hotel sector dragging them down, all other sectors are doing well. City hotels have done quite remarkably over the past quarter. This will be an opportunity, because of new five stars coming in, but it may not have the diverse offering in terms of the restaurants and space at Cinnamon Grand. They can compete in price. If price floors are removed for city hotels, again, Cinnamon Grand and Lakeside will tend to benefit. If they have Cinnamon Red management fees coming in, which has occupancy north of 85%, that is good as well. Then the property segment negatives are priced in. Next year, if the economy starts to revive and the macro situation improves, you will see sales increasing. Right now, it’s a difficult period for high-end condos. If there are isolated projects like Altair and Colombo City Center by Abans at the same price range, as JKH is a reputed company, their sales would be better.

Then comes what they are going to do with the transport segment – the east container port terminal. If they are awarded it, that’s a game changer, and it will transform their logistics segment. Right now, they are competing with LIOC in the bunkering business, where there is severe price competition, but they seem to be improving profitability. There is a turnaround in that operation. SAGT is at full capacity, but with shipping transshipment going down, we may not see growth because of capacity constraints.

Anyone else has a view on JKH?
Travis: Not JKH, but in terms of logistics. One of the reasons we have been cautious of the logistics segment in diversified companies is the activity and declining freight rates. For Aitken Spence, logistics was one of their biggest segment, and now the contribution is declining because of falling freight rates. Even for Hayleys, in terms of bottom-line contributions, logistics was the biggest segment. But now it’s showing slow growth. There aren’t any positive catalysts to see a freight rates turnaround.

Sidath: On a very broad level, Sri Lanka’s position is a key positive for the country. About 70% of the global oil trade and global container traffic pass through the Indian Ocean close to Sri Lanka every year. Logistics is key, there is no doubt about that. We should also tap the Chinese-led ‘one belt, road trade’ trade revitalization strategy – which even the Maldives is looking to tap into by working closely with China on a new port and its airport expansion. Our relationship with China is good. We’ve had some differences in the past two years, but that’s behind us. We also have excellent relationships with capital surplus countries in the region. If we can tap into those resources, along with our position, logistics itself can be a game changer for the entire country.

Travis: That’s why we need to focus on FTAs; getting it done should be a high priority.

Any final thoughts?
Sidath: Logistics is something we should focus on as a country. The second point is our relationship with India, something we tend to ignore sometimes. We are about 20 miles from the world’s fastest growing large economy. That’s not something we can take lightly. We talk a lot about China, but we really need to look at this Indian relationship and monetise it fast. Third, is fiscal consolidation. We have to go forward with that regardless of our different political and economic views. We have to go through fiscal consolidation, looking at our issues within that framework, and trying to reduce at least the debt and focus on exports to address key structures within the economy; we are basically restructuring our economy following a similar model to what Vietnam did: export growth by attracting related FDI.

If you have those three things going for you, it will give a positive vibe for the country. I’m looking beyond one year for the macro economy. People will then look at the country differently and so will equity fund managers. What they want to see is direction, policy consistency, economic stability and currency stability. If you have the three points I mentioned in place, especially fiscal consolidation, which has been the key source of instability in the current system, you then have a proper ground level framework for an equity investor to come in. A little bit of uncertainty is good for an equity investor. It affords an opportunity to use circumstances created by others who cannot hold and don’t have the risk appetite, and are unsophisticated. This will be the time to increase your exposure.

Travis: We have all these global risks, but that has got to be taken as given. What foreign investors will look for in Sri Lanka is mainly policy consistency – even if we are not making dramatic reforms, if we are heading in the right direction even incrementally in terms of fiscal reforms and getting monetary expansion under control, they would continue to look at Sri Lanka favourably. From there, if we drill down further in terms of sectors, I would say to look at sectors where you see sustainable growth prospects, whether it be tourism, FMCG or logistics – through these FTAs and exports. I would focus on those sectors, and within those, given that there is this negative sentiment over the market as a whole, that’s a buying opportunity into stocks that are relatively cheap.

Sidath: I don’t know whether any of you read the Standard Chartered Bank’s 2017 Equity Focus report. The theme was ‘Welcome to the jungle’. Not just in Sri Lanka, but the world over, investors are moving out of the institutional sphere and looking at other avenues. It’s all a mess, in politics and economics. In the US, the report discussed in length, how things are shifting from one end to the other. The EU is the same. A couple of EU countries are facing critical elections in 2017. The Asian region is more or less alright comparatively because investors aren’t surprised by some level of uncertainty.

Asanka: Compared to the year ago, I’m positive on the long-term equity outlook, as well as about Sri Lanka’s economy. We have seen slow but steady improvements, and we’ve been able to slowly address some of the structural weaknesses in the economy. Given how the recent budget proposal got passed compared to the previous year, it looks as if incrementally, those improvements would continue. But it doesn’t mean it’s going to be a steady run in the next 6-9 months because of global uncertainty. If you are an equity investor, you have to look beyond that uncertainty and treat it as an opportunity to build your position on selected stocks, and believe on the stronger macroeconomic foundations we are currently building.

Danushka: I think 2017 is going to be a turning point for equity markets, so it’s time to shift. I expect it to be better than last year. Again, I’m not expecting miracles, but I expect it to be better – maybe around 4-5% growth in the All Share index. But all that could vary because of what’s happening on the ground, and not necessarily globally.

I hope three things continue. One, Central Bank stability. There is high respect for the current governor. Limited interference in the Central Bank will be key. Investors will look at that closely. wThen on FTAs, I would love to see a Singaporean FTA happening fast. We have to acknowledge that what mcame out in the discussion was our importance as a logistics hub. We will definitely play second fiddle to Singapore, because they are decades ahead of us. But we have to participate in their value chains rather than try to compete with them. It’s better to join them soon and try to benefit through that, especially with the Chinese involvement. There are significant Chinese investments in Singapore and amicable relationships politically. Now, hopefully, the Hambantota harbor will be managed by the Chinese, and there are Chinese investments happening here. If we can sign the FTA with Singapore, we might get some FDIs focused on developing Trinco and some logistical businesses from Singapore, which will be a clear indication for equity markets to rally here.

Then comes political cohesion and policy implementation without backtracking. It need not be drastic, but just implementing what was said. The government should also, maybe not this year, move firmly on tax reforms. Those are the three elements I sincerely hope the government will do for everybody’s betterment. Then, the equity market should grow.