FIXED INCOME AND FIVE STOCKS STRATEGY

Three capital market analysts addressed the challenge of rebalancing a portfolio for 2019

Some rebalancing prevents a portfolio from becoming risker or safer than the investment objectives desire. When stock markets are drifting but inflation is somehow low, bond yields might appear attractive and a usual 50-50 split along the asset classes can quickly become 30-70. We invited the capital market research team of stockbrokerage Capital Alliance Securities to discuss opportunities across the asset classes. They discussed the outlook for stocks, bonds and real estate. In the decade to 2018, stocks have outperformed other asset classes, according to a simple analysis, mainly on the back of the boom during the years after the war’s end. However, during the last five years, equity returns lagged both real estate, in the first place, and fixed income. In 2019, they forecast that fixed income may become the top asset class.

Vice President of Research of Capital Alliance Securities Udeeshan Jonas was joined by two analysts from the company, Amila Perera and Mahesh Udugampala, for the discussion. Excerpts from the interview are as follows:

What are the economic trends to watch for when doing a top down investment?
Jonas: We’ve had two years of low growth. This year will end at about 3.7%, which is way below our historical average growth rate of 5.5-6 percent. Low growth is due to the government’s fiscal consolidation. Taxes were also increased for more revenue, which hit or hurt consumption spending over 2016-2018. These are the main reasons for the slowdown. In the first six months of 2018, fast moving consumer goods sales volumes fell about 6% year on year.

Listed companies like CTC, Nestlé and Singer are all seeing falling volumes during 2018. Adverse weather during 2016 and 2017 affected agricultural sector growth, but in 2018, conditions were better and there was an output recovery.

The entire benefit hasn’t materialized yet. The output recovery started in September, and November was pretty good. Based on good rainfall, we think the January-February harvest season will be pretty good. So you’re looking at roughly a 50% increase in rice output. This will boost the agriculture component of GDP and cause a turnaround on the agriculture segment. Even though agriculture accounts for only 8% of GDP, 28% of the population is dependent on it.

Irrespective of whichever government is in power, it will focus on the election at end-2019, so there’s going to be a fiscal easing. So lower taxes and lower fuel prices can be anticipated.

What a government may focus on within the year is putting money into the hands of the people rather than investing in three- or four-year projects. So current spending will increase compared to capital spending. Capital spending was low even in 2018.

Perera: One of the biggest problems with the economy has been the about Rs250 million in payments that the government owes the construction sector, as well as banks. That has caused the number of non-performing loans (NPL) to increase at banks. NPLs are around 3% of loans. For instance, at Sampath Bank, NPL have risen from 1.8% to about 4%.

This is because the government is withholding payments?
Perera: Yes. It’s not just affecting construction companies directly. It’s affecting everyone involved in the sector, like truck drivers and other people who depend on it. Banks suggest that about 70% of the new NPLs are related to these unsettled government payments.

IRRESPECTIVE OF WHICH GOVERNMENT IS IN POWER, IT WILL FOCUS ON THE ELECTION AT END-2019, SO THERE’S GOING TO BE A FISCAL EASING”

How do you come up with this Rs250 billion estimate?
Perera: Banks quote this figure: of about Rs200 billion from the construction industry and the rest from pharmaceuticals and some from an interest subsidy due for a one percent additional savings interest rate for senior citizens. The government has not compensated them for that additional interest payment over the last 12 months or so. All this put together roughly makes up around Rs250 billion, which has to be settled by the government.

Jonas: They also keep delaying without paying because the government’s budget is calculated on a cashflow basis and not an actual basis. Even though the construction companies have done the work, they don’t pay them so as to not reflect it as an expense in the government’s budget, thereby keeping budget deficit figures low for the year. Rs250 billion is roughly 1.5% of GDP.

So there is an unaccounted 1.5% deficit the government is rolling?
Jonas: The government has always been delaying payments, but now, the quantum is larger and they have been delaying it for a longer time.

Perera: It’s also affecting construction subcontractors now.

What other factors will impact GDP growth?
Jonas: We won’t see expected FDIs soon. Until there is political certainty, you’ll see all foreign investors taking a ‘wait and see’ approach.

What does this mean for the various investment asset classes?
Jonas: The government’s foreign debt repayments in 2019 are at $4.3 billion. In January, a $1 billion repayment is due. With forecasted fiscal easing, that component too will need to be borrowed. Our dependence on local (Rupee) borrowings will increase as we settle foreign loans, as we can’t go ‘in a big way’ to global capital markets. So borrowing pressure will be high in 2019. Last year, Sri Lanka’s sovereign bonds were trading at around 6% in the markets. Today, a 9-year bond is trading about 8.3-8.4%. If they go to market now to raise a 10-year bond, our rates will be 250 basis points (2.5%) higher than they were last year. If the political situation here settles, risk premiums may fall slightly. However, the two challenges – refinancing risks and higher borrowing requirements – will push rates up. Plus, if the government wants to settle this Rs250 billion worth of outstanding payments to suppliers, it will have to be borrowed or printed. During the first half of 2019, we expect interest rates to remain on the higher side.

How do we approach asset allocation in this environment?
Jonas: Fixed income investment is the way to go at the moment because a five-year rupee government bond yields close to 12%. Banks now offer 11-12% on a 1-year fixed deposit, and investment-grade credit-rated finance companies offer rates of 12.5-13%. The only reason they can’t offer a higher rate is because of a rate ceiling, and that ceiling may have to be raised over the next two or three months. In the short-term, fixed income will outperform equities.

Leveraged the buying of bonds to lock in rates now may be an option. But, if the investment horizon is more than a year, we would recommend investing in listed equities. The stock market has fallen from a high of 7800 in February 2011 to about 6000 index points. On price-to-earnings multiples, it’s trading at 8.7-9 times.

That is a historical multiple?
Jonas: Yes, adjusted for one year. Next year, there are a few things that will affect company profitability , so you should factor that into account; you are looking at somewhere close to 9 times in terms of price-to-earnings multiples.

Nine times is a forward multiple?
Jonas: Yes. If you look at peer countries, the average is about 15-17 PE. Valuations are cheap. Sectors like banking and finance are trading at around 0.8 times of assets.

Perera: We don’t anticipate that banks will grow loans. We forecast private sector credit growth at 12-14% in 2019 because of low investor confidence due to political turmoil. Additionally, with increasing impairments, banks are more conservative.

The economy is also currently under capacity. There is plenty of spare capacity for expansion, and there is no need to borrow for expansion. Bank net interest margins (NIMs) will improve if high interest continues in 2019. Those with higher CASA (current accounts & savings accounts) bases can improve their NIMs, as around 70% of loans are at a floating rate. Their CASA bases won’t adjust at the same rate, or might not adjust at all. How it works is that, if interest rates are rising, bank margins will come down; but for those with higher CASA, although interest rates rise, your current account is still at zero percent and savings account at 4%. They don’t change, and for many banks, the CASA base is 35-40% of their total funding. So you’re increasing loan rates when interest climbs, but 40% of your funding cost is constant. The margin gap is increasing, but this is only happening for the top three banks – Commercial Bank, HNB and Sampath Bank – which have high CASA.

Are the big banks good long-term investments at the current prices?
Jonas: During the last two years, bank earnings grew 20-30%, but share prices didn’t adjust. So historical PE multiples have fallen for the large banks, Commercial Bank, HNB and Sampath Bank. They are all trading below net asset values. Sampath is at 0.7 times net assets and HNB at 0.8 times.

Perera: Commercial Bank is slightly above 1x, but this is a bank that used to trade at 2x the price-tobook multiple. In any other country, the largest banks trade at net asset, a huge premium to the rest, and the remaining banks of any size trade at about 1.3-1.5x assets. If Sri Lankan banking stock prices recover to book value or net asset value, you’re looking at a 20-30% share price gain. But this year, we are not very positive about bank bottomline growth for a couple of reasons. One is that private sector credit growth is subdued, and the second is a debt repayment levy of 7%.

What’s a debt repayment levy?
Perera: The 7% debt repayment levy was implemented effective from October 2018. This is basically a VAT on financial services, increasing the current rate from 15% to 22%. It will have a huge impact on the banking sector. On average, it will cost about Rs4 billion for the larger banks and about Rs2 billion for smaller ones.

Jonas: This is unless they get together and pass on the tax to customers. The government insists that it can’t be passed on. But if they get together, they can pass on a portion of it through interest rate hikes. But it is unlikely that they can pass the entire thing.

Perera: Banks are lobbying. Their effective tax rate is close to 50%. Whatever money they make, 50% is directly given to the government. That is affecting the banking sector’s return on equity. Also, with IFRS 9, bank loan impairment provisioning will increase by 30% to 50% for smaller banks. For big banks, impairments will rise by around 50%. However, this will not go through their income statement.

Jonas: How it works is, in the previous methodology, you started providing for impairments when you see signs of a default. Let’s say an installment missed and after looking at the profile, you say that this person can’t repay, so you make a provision for the credit loss. Under the new methodology, you are basically advancing that provision. From the point a loan is granted, you look at historical events. Normally, if I lend to an SME in a particular sector, there is a percentage of loans that always goes bad. So banks have to recognise impairments well ahead of the actual event.

What will happen is a huge increase in impairment charges immediately, but it might settle down over a period of years. Ideally, this should have been charged to the income statement, but in order to not give a bad bleak picture to investors, on 31st December, they’ve allowed to adjust the balance sheet by taking this impact out of the equity base. So you won’t see it in the company’s profit and loss statement, but your balance sheet equity component will reduce by roughly about 4 percent.

Perera: The equity hit will be around Rs6 billion for the three big banks.

Is capital adequacy impacted?
Perera: Yes. There is a 50-70 basis point reduction in their tier 1 ratios. However, there won’t be an immediate capital raising need as banks have adequate tier 1 ratios to absorb this.

Jonas: Banks have known this, and when they did their rights issues, they covered for this anticipated impact. So banks don’t have a problem, but finance companies do. Because for finance companies, it’s not only IFRS 9. They are moving from BASEL 2 to something that is not completely BASEL 3, but an interim measure.

This will result in a huge capital adequacy requirement. Their capital adequacy calculation methods have changed. Tier 1 and 2 requirements have gone up, so finance companies will have a huge capital raising challenge. The big ones like People’s Leasing, Central Finance and LB finance won’t have a problem, but the medium-to-smaller companies will have to either do a rights issue or merge.

Perera: Finance company core capital needs are to go up to Rs2.5 billion by 2021 and Rs1.5 billion by 2019.

Let’s roll back to asset classes. If fixed income, equity and real estate were the options, how do their outlooks compare against each other?
Udugampala: In real estate, the question is if the great rental yields and capital appreciation will continue in the coming years. Demand has declined because the market is hitting an affordability snag. There is now a fall in rental yields. Transactions have also declined, but that’s true in many investible asset classes. Even in motor vehicles, there is a fall in new and registered sales. The major trend driving the property market is traffic growth. Since Colombo’s property prices are high, families can only afford apartments. But then again, about 50% of the apartments are either high-end or luxury, something most employed professionals can’t afford.

If you apply this to real estate as an investible asset class, based on what you’re saying, is there an opportunity?
Udugampala: Expensive apartments aren’t liquid as an investment asset class. If liquidity matters, mid- and lower-priced apartments will work better.

However, from a combined capital appreciation and rental yields point of view, we predict that real estate yields will be equivalent to what you see in fixed income.

How has real estate compared to fixed income in the past?
Udugampala: It’s been better than fixed income. But it’s slowing down now.

Another factor is VAT on apartments effective April 2019. Your average apartment price will go up by 8% because of this. It’s only 8% because they can pass some of the input VAT costs, so the effective impact is about 8%. All this is going to dampen the real estate market. But we don’t see a crash because 90% of apartments purchased are with owners’ equity and not borrowed money. A fundamental problem with affordability is Sri Lanka’s high financing costs. For an apartment worth Rs20 million, your monthly installment on a 20-year mortgage works out to about Rs200,000. If you look at the household income survey of 2016 and adjust it for inflation, the top 10% of the urban population in Sri Lanka earns about Rs190,000.

How does the outlook for the two asset classes compare, fixed income versus real estate?
Jonas: We don’t think investment will flow into real estate at all. We are seeing signs of it happening now itself. We also see prices being adjusted: moving from dollar-based pricing to a rupee-based and changing payment methodology like delaying the completion of apartments. They aren’t reducing prices, but changing the methodology, which is an indirect price reduction. On the supply side, about 15,000 apartments will be completed over the next two to three years. It’s almost doubling the existing apartment capacity. We don’t think there is enough demand to absorb this, which means price appreciation is going to be limited.

From a returns perspective, fixed income bonds yield about 12%, and if you expect rates to decline, you might end up making more than a 20% return.
Udugampala: Historically, apartments have returned about 1-3% higher than fixed income. But going forward, this may not be the case, because of slower real estate capital appreciation.

I assume you have Rs100-200 million real estate portfolio. What’s the approach? Should you switch now?
Jonas: It’s difficult to sell at this time, but you’re also not going to see the abnormal returns that you saw over the last two or three years.

So real estate historically has outperformed fixed income by 1-3% annually over the last few years?
Udugampala: Fixed deposit rates have returned around 10-11% over 5 years. Luxury apartments have returned about 12-14%.

On apartments, you are combining rental yields with capital appreciation. What about listed stocks?
Jonas: We looked at Iceland and Monarch (apartments) since they were built. What kind of rental yields and capital appreciation they’ve offered compared to equity and fixed income over that period. On that basis, equity has returned 9% over a 10-year period. T-Bills have averaged 9.7% and fixed deposits about 11%. Iceland and Monarch (condos) have given 12-14% returns.

Udugampala: Stocks had about a zero percent return over the last five years.

Jonas: Earnings growth is about 15% annually. It’s mainly from the banking and financial sector, which is about 60% of market earnings now, although only 40% of market cap.

If you were investing 5-year money, where would you put it?
Jonas: One asset class within fixed income is debentures. Debentures now return 13-14%. Good quality issuers like banks pay 13-13.5% rates, which is decent for a five-year horizon. You are also locking in rates during a high interest rate environment. If you accept slightly lower credit quality, say that of a solid finance company, you will get a 14-14.5% return. This is pretty good compared to what you can get from other asset classes. Even with equities, a 20% annualised return is what you can expect over a 5-year horizon.

Udugampala: That is from selected stocks. Debenture investments make sense from a risk-reward sense. You might not get this opportunity in six months. But to invest in equity, you need to pick stocks. We don’t think you are going to make abnormal returns by investing in the overall market.

Can we talk about listed real estate companies. Are there any that are directly affected by what’s happening in the sector?
Perera: Access Engineering has some real estate exposure with Capital Heights and Marina Square condo projects. However, with SLFRS 15 (accounting standard), they cannot recognise their revenues and profits now. Most of the revenue and profits will come after they complete the project and hand the keys over to customers. That will happen after 2021, and then there will be a big earnings jump. In the short to medium term, due to the construction slowdown, earnings growth won’t be so good. Capital Heights has sold about 60% an Marina Square, which is about 900 apartments, has sold about 30%. They’re struggling with Marina Square sales at the moment.

The price points of the two projects are different, right?
Jonas: It’s not the size of the apartment that matters anymore, but the time of travel to the central business district. The smallest Marina Square apartments are around 500 square feet. Their positioning is right. They are targeting port workers and catering to Chinese demand. Of the 30% sold, it’s mainly to China Harbour investors.

Let’s discuss banking stocks. I want you to reconcile this. Is the outlook good or bad with all these new taxes? At the same time, you point out attractive valuations. All banks are not the same. What’s the strategy here?
Perera: We are bullish on Sampath Bank and HNB. If I start with HNB, it’s a very conservative bank and a safe investment. It’s trading at around 0.8 times the book value. We expect HNB will track private sector trading growth of around 12-14 percent. Also, HNB has a microfinance capability. Although there is a cap on microfinance lending rates, growth here of over 25% has been exponential over the last few years. They also have around 32% lending exposure to SMEs currently and plan to grow this to 40% by 2020. SMEs are a high-margin business. One other factor is the prevailing high interest rates, that will also improve NIMs.

Jonas: We were expecting a re-rating of baningk stocks in 2018. If more foreign funds return to emerging markets, we will see the first investments targeting banks. If you take a 2- or 3-year horizon, banks will outperform the remaining sectors. Among the banks, we are more bullish about the three large private banks because of their capital base, first-mover advantage and low-cost funding, which will help them outperform the smaller ones.

BANKS ARE LOBBYING. THEIR EFFECTIVE TAX RATE IS C LOSE TO 50%. WHATEVER MONEY THEY MAKE, 50% IS DIRECTLY GIVEN TO THE GOVERNMENT”

Any thoughts about the future of the financial sector in general?
Jonas: The tax and the new IFRS standard on provisioning will impact smaller banks mostly because they are the ones who will be challenged to raise capital. Funding costs of smaller banks are also higher. They offer higher deposit rates and yet don’t have high enough CASA.

Sampath Bank is our top pick of the banks. We essentially have two picks. One is a growth pick, which is Sampath Bank, and a value pick, which is HNB, basically because it’s cheap. Why we say Sampath Bank is a growth company is because, historically, they have been aggressive in terms of lending. When the industry is growing at 15%, their loan growth is 20% They are also well ahead of the curve in terms of innovation. All this will convert into better cost-to-income ratios.

In the future, the industry is unlikely to add branches. It’s going to be digital branches that come into play and the staff requirement will gradually reduce.

Is there scope for consolidating?
Jonas: Not in the banking sector. It’s only Pan Asia Bank that will have issues in terms of capital. Even banks like NTB with profit growth will be able to meet requirements set by 2021, so we don’t expect consolidation to happen in the banking sector. But in the finance companies sector, certainly yes.

Let’s discuss consumer stocks. What’s the outlook? You said there was a 6% volume drop in the first 6 months of 2018, according to research agencies.
Udugampala: People had less money to spend and private sector credit growth was also low. Consumers stocks like Ceylon Cold Stores were impacted by the sugar tax. Their volumes fell more than 30% and their prices increased by about 33%. This was in an environment where people were becoming more health conscious and reducing their sugar consumption. Even if the government takes this sugar tax out, the stocks won’t revert back to the levels they were previously trading at because people have now adjusted to a new consumption pattern.

CTC’s tax per stick increased by Rs3.8 in August, and with that, their prices increased by about Rs5. Even though their revenue grew due to the price increase, their volumes fell drastically. For the last quarter, volumes were down 14%. Consumer durables stocks like Singer have been slowing down too due to lower private sector credit growth. Singer’s revenue growth and private sector revenue growth values correlate more than 90%. If you can predict private sector credit growth, you can predict Singer’s revenue growth.

If we observe Singer during a run up to elections, their sewing machine sales increase drastically. Maybe politicians are buying and distributing these? Anyhow, consumer products and consumer stocks have performed well during election periods primarily because of fiscal easing.

Growth we witnessed was due to the 2015 public sector salary increase and the following credit-driven consumption. The effect of that was felt in the latter part of 2016/2017, and again in 2018. It’s likely that the government will implement more such populist measures, and there is a good chance the public will again start spending on consumer durables and even on more FMCG products.

A damper is the rupee depreciation and imports becoming expensive for consumers. Additionally, new regulations like LC 100% cash margin requirements for even items like refrigerators and air conditioners introduced will increase costs and working capital requirements for importers. Therefore, prices may go up, based on both these new regulations coming in and rupee depreciation. Basically, about 80-90% of consumer products are imported.

Monetary policy adjustments may not be reflected immediately in the economy because there is a 12-18 month policy transition lag. So whatever they do now will have an impact on private sector credit growth only in another 12-18 months.

Jonas: But fiscal easing comes at a cost. You had to tax someone more. The most likely candidates to be taxed more are breweries and CTC. So companies selling products with inelastic demand like CTC and Lion Brewery may not see much growth. Normally, in an improving cycle, the first segment to benefit are food and beverage companies. Thereafter, you’ll see it moving into consumer durables. Then vehicles and things like that. We think that the first layer of food and beverage might see an improvement in 2019. That’s where growth will probably come from.

This is a general comment. Are there investment opportunities you see in the financial sector?
Jonas: Not really. For instance, Ceylon Cold Stores is valued at a 20x multiple.

How big is the stock universe that you analyse?
Jonas: We cover about 35 companies.

Are the ones listed here the ones you have strong opinions about?
Jonas: Actually, we only recommend about five companies, out of the 35, for investment. Of banking stocks, it’s Sampath Bank and HNB, and People’s Leasing from the financial sector. TJL is a textile manufacturer, and Dialog and Expo Lanka. That’s it. If the government goes through the fiscal easing, we may include a few more consumer sticks like Bairaha Farms.

Do you have a view on Lion Brewery’s valuation?
Jonas: We had a buy recommendation when the tax was reduced. We have been cautious because that’s the first thing they’ll tax. It’s easy to raise revenue by taxing distilleries and breweries. Given that both political parties will look at fiscal easing, they have to fund this, and most likely by raising taxes.

Any reason Singer is not here?
Udugampala: Singer may turn around based on election-related spending. But I don’t think there will be significant growth. There are opportunities mostly because of Hayleys’ acquisition and to expand their furniture business. There may be synergies between the two companies as Hayleys is strong in logistics and Singer has been looking at growing furniture exports.

They were considering expanding store sizes by 50% to accommodate more furniture. But this hasn’t materialised. After the acquisition, there has been a slowdown. Of course the impact from the 100% cash margins for LC’s and rupee appreciation have had a significant impact on Singer.

HISTORICALLY, APARTMENTS HAVE RETURNED ABOUT 1-3% HIGHER THAN FIXED INCOME. BUT GOING FORWARD, THIS MAY NOT BE THE CASE”

What’s attractive about People’s Leasing?
Jonas: People’s Leasing is going through a consolidation phase. The bigger leasing players are well positioned, and the smaller players will have to either merge or find capital if they want to continue growing their business. People’s Leasing recognised impairment charges way ahead of IFRS-9 and made provisions ahead of any finance company. Increased impairment charges won’t continue to 2019. Impairment costs will decline over the next 12 months, and you’ll see a huge bottomline improvement. Their return on equity is about 18%, good for a finance company. Also, exposure to the private vehicle segment is limited. They lend for commercial vehicles, which are less impacted by tax hikes. If you pick one company out of the finance sector, it would have to be People’s Leasing because its valuation is about 0.7 times book and they pay dividends of about Rs1.25, which means their yield is about 7-8% and low impairment charges will drive bottom lines.

What about Expo Lanka?
Jonas: Expo Lanka is a beneficiary of the rupee depreciation because 100% of their revenue is in dollars, so the entire gross profit benefits from depreciation. Globally, freight forwarding margins are tightening. Yields are under pressure. So they will also see similar pressure, but the rupee depreciation will help them.

Their main trade lane, which is the North American trade lane, accounts for 60% of their business and they have a niche focus on the apparel sector. With a US economy pickup, they should see volume growth. Last year, they acquired a company in the US to expand operations there. The last financial year’s bottomline was impacted by that investment, but this year, that acquisition is starting to reap benefits.

Perera: So the stock is cheap and the share price has fallen by about 40%.

You mentioned Teejay Lanka is attractive. What’s the story there?
Jonas: With Teejay Lanka (formerly Textured Jersey), a couple of things matter. They are a beneficiary of the 17% rupee depreciation in 2018. Around 100% of their top line is in dollars, while only 70% of the cost is in dollars. Also, their Indian capacity expansion two years ago is now fully utilised. Plus, they’ve partnered with a new company, and now have about 8-10 companies and brands like Marks and Spencer, Victoria’s Secret, Intimissimi and a few other large apparel brands.

Recently, they partnered Uniqlo, a Japanese brand, which might change the game for them in time. Now, if you consider apparel dynamics globally, retail growth is moving from American to Asian countries. Uniqlo is well positioned to cater to this market. If they get even 5% of Uniqlo’s orders, it’s about 50-60% of growth for TJL’s business. Normally, this process of acquiring a client takes about two years. They are at one and a half years of this life cycle and have shown sample materials. Now it’s gone to the testing phase. That means commercial production can start in another six months. Also, cotton prices have stabilised, which is good for them because they use cotton to produce fabrics. Stable cotton prices will allow them to improve margin as well.

What about Dialog? The weaker rupee must be hurting them. What’s the story here for optimism?
Perera: Dialog is in one of the strongest growth services, but the rupee depreciation is hitting them hard. During the last quarter. they had about Rs1.8 billion foreign translation losses as their borrowings are mostly foreign currency. They have about Rs181 billion value loans in dollars. When the rupee depreciates, they have to realise that in their balance sheet and there is a translation due to that. So that will continue.

How does one account for this: rupee revenue, dollar loans and a 17% rupee depreciation?
Perera: The loan value increases as the accounts are in rupee terms. So you increase the loan value and that loss comes into your income statement. For the last quarter alone, they recognised around Rs1.8 billion, which is a significant part of their quarterly earnings.

We expect rupee weakness in the next quarter as well. But we don’t expect the trend to continue to 2019. So their growth story can continue.

Data has been the key growth driver for Dialog. In fact, data revenues will surpass their voice revenues in this quarter of 2019, that is Q4 2018. Data revenues have been growing at a faster pace, owing to a few factors. One being smartphone penetration. Out of Dialog’s own base, about 54% are smartphone users. Also, 4G adoption at end last quarter was 32% versus 23% a year ago. When a user shifts from 3G to 4G, what Dialog has seen is that data consumption increases, for a prepaid customer, by 50%.

Video consumption is also increasing. Currently, about 50% of Internet consumption countrywide and basically even globally is video. Both YouTube and Facebook are contributing to this. If you take the period when Facebook introduced the ‘explorer’ feed in February 2018, Dialog’s revenues were affected because people were not watching those videos on their own ‘newsfeed’. Then Facebook discontinued this and we saw the recovery in terms of data usage.

DVD quality is about 480p, but there is a significant increase in data consumption when that moves to 1080p maybe another 10 times more data is consumed from 1080p to 4K. Dialog is investing heavily on 4G coverage with a target of completing it in one to two years. Once that is complete, capex might slow down. 5G expansion might not be immediate, but the challenge with that is infrastructure as a whole new equipment set will be necessary to run that.

Dialog’s earnings have been growing steadily, as has their subscriber base. The rupee depreciation and foreign exchange losses they faced didn’t only impact their mobile segment but Dialog TV as well. Dialog TV is the only major segment that makes losses for them right now, and losses expanded mostly due to these foreign exchange losses.

We are forecasting that their business is likely to breakeven in 2021 on the broadband side (their data business). Their subscriber base grew 57% year on year, significant but from a low base. Dialog’s share price is a factor, having dropped from Rs14.6 to Rs10.5, or lower. When the government removed floor pricing, it didn’t have a major impact because that anticipated price war didn’t exactly happen. Average revenue per user of Dialog for mobile is around Rs411. The new packages they introduced after the removal of the price floor was slightly higher.

For data, they are secure because the TRC has said that you can’t price anything below cost. What we saw was a market overreaction to floor pricing. Therefore, Dialog stock has become very cheap right now.

John Keells Holdings is very diverse. Which parts are attractive?
Udugampala: JKH pricing is attractive right now where they’ve been trading in the lowest levels in terms of their recurring PER after the war. Their current recurring PER is at about 11 times, while it used to be 25 times in 2010/2011.

There are positive stories and negative ones. A positive is recognition of Cinnamon Life apartment sales. The accounting standard requires it to be recognised mostly after its completion in 2021. We don’t think this has been factored to the PER multiple right now and that may be an incremental revenue of Rs43 billion. That recognition will come. The structure of Cinnamon Life indicates that they have kept provisions for a casino; if they are able to secure that casino license, that may add another Rs60 billion to their top line. It’s a maybe scenario. A casino will also add Rs20 billion to their enterprise value.

They also have underperforming assets in their hotels. If they sell some of these, that too may add to their fixed income. If you take the Asian Hotels ROE, that’s around 5.5%, but the one-year term yield is around 10.4% itself.

The negatives for JKH are mostly in the consumer segment. CCS isn’t doing well. On the leisure side, low occupancies are troubling them and the informal sector is encroaching hotels in general. So their group revenues are coming down because of that. From the logistics side, South Asian Gateway Terminals (SAGT) has reached its full capacity.

Insurance sector corporate taxes are now 28%, and this will have an impact, and on banking, the 7% debt repayment levy will impact NTB. Falling luxury apartment demand may also impact the Cinnamon Life project in the future.

WE WON’T SEE EXPECTED FDIS SOON. UNTIL THERE IS POLITICAL CERTAINTY, YOU’LL SEE ALL FOREIGN INVESTORS TAKING A ‘WAIT AND SEE’ APPROACH”

Jonas: They’ve sold about 50-55% of the apartments. Everyone in the business is changing their payment terms to accommodate higher sales.

Udugampala: If the 15% VAT goes through in April 2019 for apartment sales, that will also have an impact on Cinnamon Life sales.

Any closing thoughts?
Jonas: On asset classes, I would say fixed income in the short term and equity if you are taking a one-year plus horizon. Equity is now cheap compared to our historical multiples, as well as the region, but we would be more cautious and more stock specific rather than picking the market or sectors. Avoid industries like plantations, motor and finance companies.

Look at solid companies for immediate short-term benefits like Teejay Lanka and Expo Lanka, because of the rupee depreciation. Dialog Axiata on a one-year horizon when earnings improve and there are no forex losses. If there is a consumer turnaround, we can look at companies like Bairaha Farms and Keells Food Products; and if incomes increase, we could look at companies like Singer Sri Lanka. But for the moment, those are not short-term plays.