Is it time to break open the piggy bank?

Should savers get excited about equity investment opportunities in 2016? Four of Sri Lanka’s top equity analysts discuss market strategy

Listed company stock prices performed dismally in five quarters up to the March quarter of 2016. Last year’s (2015) uncertainty around economic policy and how the government was going to fund the vastly higher public spending damped sentiment and company profits.

Investors had few options in the capital market because interest rates were low and the outlook on stocks, weak. It made sense for investors to invest just in short-term instruments because inflation was low, until better opportunities presented themselves. Piggy banks full of savings will find the higher bond yields in 2016 attractive. But what about the other big asset class, equity? Can opportunities be found here for investors willing to make long-term investments? This was the primary question we posed to four top equity analysts during a roundtable discussion about the outlook for listed stocks. Chethana Ellepola, Head of Research at Acuity Stockbrokers; Purasisi Jinadasa, Chief Strategist at Capital Alliance Partners; Dimantha Mathew, Senior Manager of Research at First Capital Equities; and Kanishka Perera, Head of Research at Asia Securities joined the discussion. We started by discussing the economic outlook. Excerpts are as follows:

We’ve got an IMF package and there is reason for optimism for the second half of the year versus the first half, but what risks remain? Do Brexit and the Fed indicating a series of rate hikes pose risks?

Kanishka Perera: Even with the IMF package, the first risk with a country like Sri Lanka is the political one. Is there a will to actually go through with what the fund wants us to do?  We have two dominant political ideologies in government. The SLFP are socialist and the UNP are capitalist; and when you look at policy direction, the SLFP is more agricultural and rural focused, and the UNP is trade focused. They don’t tend to diverge in terms of their opinions. A good example is the VAT implementation. The UNP brought it forward, went through the cabinet, and a few weeks later, the president who is leader of the SLFP comes and says he doesn’t like it. This seems to be the problem. In fact, with some of the conditions of the IMF loan, we feel the government asked the fund to include them, as it looks better coming from the fund than from the government.

Kanisha-Perera

Kanishka Perera, Head of Research at Asia Securities feels there is still room for rates to pick up 50 to 75 basis points more during the rest of year

Chethana Ellepola: We have a lot more clarity now than we did at the start of the year when even the long-term economic plan the government put out looked quite hazy. The IMF loan is positive in that sense. I read an IMF working paper on the correlation between IMF-supported programmes and FDI flows, which showed a very strong link. A developing country with an IMF programme can get up to four times as much FDI than without fund support. That’s a pretty big deal. For Sri Lanka, private investment increases during an IMF programme, a study done by a major bank shows. So prospects look for the medium to long term. I am concerned about the short term, but not as much as I was at the beginning of the year.

To answer your question about Brexit and the Fed, I do think they will impact us. The UK is a big member of the EU. What happens if we get GSP, and the UK is not one of the countries abiding by it? I don’t think that’s something Sri Lankans have priced in. What the US Fed does with rates will definitely have an impact, but most of South Asia and Sri Lanka are pretty contained. We are not really that exposed to global markets, particularly because we have our own challenges, but that’s changing.

When you combine the two, you get a huge issue. I don’t think equity market players look at Fed rates, but I think they should. Why? If you look at emerging market fund flows, from March to May, there was a bit of a turnaround in terms of capital flows, even in Sri Lanka. If you look at inflows into government securities, it turned around as well. As soon as concerns emerged about Brexit and Fed rate hikes, funds began to flow out from Sri Lanka as well. I do think we are a little more sensitive now. If we do become more export oriented, the economy will become more exposed to these vulnerabilities.

Regarding Brexit, I think the UK is aligning itself with China, which provides us an opportunity to have a free trade agreement directly with the UK, which might benefit us more
Jinadasa

Purasisi Jinadasa: In the short to medium term, especially in the course of the next two years, I see significant shocks emerging that a lot of people may not have factored in. When you are studying the economy of Sri Lanka, it’s difficult to make sense of what’s happening and make forecasts because no one really abides by a set of principles. In order to forecast the economy, we’ve had to make a few assumptions. One is that there is going to be loose exchange controls, and the other is that the rupee will be allowed to adjust. If this happens, interest rates will probably win in the short to medium term, as people start to send capital out of the country. It’s going to be a free-fall. This is going to have an added impact on the exchange rate as the rupee depreciates further.

As policy certainty emerges, and if the government doesn’t panic and keeps policies stable, we’ll see fund outflows regressing. We’ll see foreigners and locals coming in because interest rates are high and there is policy certainty. So, in the short run, we see a significant rate upside in the horizon. In numbers, we expect interest rates to be about 10.4% on average this year, and probably reach 11.4% on average next year. So far, the average one-year T-bill for this year has been about 9.36%. It can average at 10.5% this year and 11.5% next year. In terms of the exchange rate, we expect the rupee to fall to 154 against the US dollar, and 161 next year.

In the short run, we’ll see private sector credit growth falling – this year will average at 19%, and next year will average around 12.7%. Private sector credit growth will improve to 18% around 2018, when consumption picks up.

About the Fed and Brexit, I don’t think the Fed rate hike is a big concern for two reasons. For one thing, they have to consider what China will do. If the Fed increases rates, China will see an outflow of money, the budget deficit will increase, and treasury bonds and bills issuance will be significant. Rates will go down again, so it won’t make a difference to the US. Regarding Brexit, I think the UK is aligning itself with China, which provides us an opportunity to have a free trade agreement directly with the UK, which might benefit us more. We currently have an ECTA with India, and we are planning an FTA with China in 2017; so if the UK exits, it will be an interesting situation for us. We can actually become that transport hub and financial centre we always talk about, where all the funds flow through Sri Lanka. So I don’t necessarily see Brexit as a challenge.

What are those major assumptions around economic growth, interest rates and the exchange rate?

Dimantha Mathew: I’ll start off with the political risk Kanishka was talking about. Political risk was very high at the start of this regime. When two major parties get together, there is always risk because none of them has a majority. This is why the IMF is important. The prime minister will present a policy statement for the next four years, which he hasn’t done for the last one and a half years. What we are looking at here is the buildup of more certainty, even from a foreign investor’s point of view.

When the IMF came in with a three-year plan in 2009, the economy was better off the following two years or so. This time round, the IMF has stricter guidelines, which will bring down political risk. Limits and specific targets have been set and reviewed every three months. A huge amount of restructuring of the economy has to get done over the next six months. Some may say this will bring chaos, but the government will have to see it through to keep the fund engaged. If this happens, the economy will be in better shape in the next two years.

Interest rate-wise, the one-year T-bill exceeded 10.5% – our peak target for this year was 10%. I feel, at these levels, interest rates will start to peak and won’t come down drastically anytime soon. Liquidity is low, but when foreign funds come in, it will improve. Inflation is a factor to watch. Inflation is around 4.8% and we think it will rise from June to August. It will peak at around 6% due to the tax hike, floods and higher food prices. So over the next six months, we think interest rates will ease by 100 basis points or so. Our target is 9% for the one-year T-bill. Out of that, 25% or less will come through during the third quarter. A bulk of it will start to come in towards the fourth quarter; that’s when inflation will peak and start to come down.

There will be many positives in the fiscal front. Inflows to the government will improve. There is usually a revenue surplus in the second half of the year, with 66% of spending happening in the first half. If you look at maturity of government securities during the second half of this year, it’s just one-third compared to the first half at Rs650 billion, so the government’s domestic borrowing requirement is low. We will also see foreign funds coming in, further reducing the government’s borrowing requirement. I feel the government will look at more foreign borrowing in the next half of the year.

You’ll find more institutional and foreign investors seeing bargain opportunities right now, but from a local perspective, interest rates are quite attractive to be honest
Perera

Perera: To a certain extent, I disagree. If you take Sri Lanka’s external debt, it’s roughly 54% of total borrowings. So if the US decides to increase their rate, which they will do before the November election to say their economy is fine, our rates will go up and we will see all our money flowing out of the country. I feel there is still room for rates to pick up 50 to 75 basis points more during the rest of year driven by the reality that the US will raise their rates and that our foreign currency reserves are falling fairly significantly.

The government’s only option is to let the rupee depreciate or raise interest rates. I don’t think the government will let the rupee fall, so it’s more likely they will raise rates more than anything else.

The government did say exchange controls will be relaxed, but what I understand is that this will likely be included into the monetary act or other laws. I expect GDP growth at 4.5-5% mainly due to high inflation and interest rates. In terms of inflation, I expect roughly around 5-5.5% due to the VAT increase and the impact of the floods. There is also a slight pick-up in terms of oil prices here, so you are going to see that impact coming into inflation by the end of this year. It’s not going to be too much above the IMF’s targets for inflation. As such, if we reach the upper limit, the fund will have discussions with the government about what happened, and if we reach the outer limit, they will hold back the funds until the government can clearly explain what happened and what they are going to do to contain inflation. I also expect the rupee to hit 150 against the US dollar by the end of this year, and go down a bit more by next year, maybe to 154.

Chethana-Ellepola

A developing country with an IMF programme can get up to four times as much FDI than without fund support. That’s a pretty big deal, says Chethana Ellepola, Head of Research at Acuity Stockbrokers

Ellepola: I’m in line with what Kanishka says. We can expect another increase in policy rates: we expect about 25-50 basis points more, and market rates already have about a 50-75 basis points premium on top of that. Excess liquidity is declining as private credit growth is high. Part of the reason is that people are frontloading on that. We spoke to quite a few banks and a lot of them said that people expect rates to go higher, so appetite for private credit is partly so high because of that. Of course there is also a significant lag between the policy rate change and the reaction in the market.

In terms of GDP, my estimate is about 5-5.1%. Last year was a consumption-driven year, and we are not going to see that this year. We are not going to see it coming from government spending either. Post-war GDP was propped up by government spending and consumption.

We don’t have a large enough rich middle class to support long-term growth led by consumption, so it will have to come from private investment, exports and FDI. For those reasons, I don’t think consumption will improve drastically this year because you don’t see a significant push from government spending, so I keep growth at 5% this year. It will gradually improve.

In terms of the rupee, I expect it to be about 148 to the US dollar by the end of the year. I wouldn’t say the depreciation is a free-fall. That was last year. Depreciation to-date is about 1.5%, so it’s stabilising with inflows coming from the IMF. We will get about $2.2 billion in total – $1.5 billion from the IMF, and the rest from the World Bank and ADB, but it’s not enough. An IMF tranche is $168 million, and we have external debt repayments of $181 million each month till the end of the year; but it’s the sentiment that is boosted. I thought it was interesting to see the link between FDI flows into the country and IMF support.

 Does fixed income offer such a grand opportunity that equities may have to take to the sidelines in a portfolio?

Perera: You are getting an 11.5-12% return for doing nothing. Why would anyone bother with a relatively illiquid market at the moment? In the short term, I don’t see anyone being too bullish. You’ll find more institutional and foreign investors seeing bargain opportunities right now, but from a local perspective, interest rates are quite attractive to be honest.

Ellepola: There is just no impetus. We still get conflicting messages about the capital gains tax and this is having a huge impact. When Fitch downgraded Sri Lanka, the index lost about 113 points. When the prime minister gave his speech a few days after about tax increases, the index lost another 194 points. When the government submitted the Cabinet paper on the capital gains tax, the index dropped by 82 points. You can see by this that the tax impact is huge, more so than what’s happening on the macro front. Having said that, once the IMF loan came in, we saw the market running up. Once they confirm what assets are going to be affected by the capital gains tax, and if we have that clarity, people can move on and make plans. But right now, it’s all up in the air. That kind of policy clarity has to come through to favourably impact equity markets.

Jinadasa: I think the equity market is used inappropriately in Sri Lanka. A majority of people just trade, but I don’t think the market is mature enough to trade consistently and make supernormal returns. So what we advise our clients to do is to pick stocks carefully and invest for the long run. There will always be market cycles. The market is bottoming out. So if you invest now for the next three years, you will get returns of about 20% annually. But it depends on the stocks you pick. You have to be consistent and invest diligently in the market. Hopping in to quick money-making trades will not work. There is significant opportunity in the equity market if stocks are picked right.

The market is bottoming out. So if you invest now for the next three years, you will get returns of about 20% annually
Jinadasa

Ellepola: I agree with Purasisi. Now is the time to get into it.

Perera: To add to that, that’s what some of the local institutions are thinking now. But when we speak with our foreign clientele, they say it’s a fantastic time for them. I totally agree with Purasisi on this. You need to pick your stocks right. For the near term, you are going to see people waiting on fixed income, especially if you have balance funds, but it’s not the death of equity as such.

Mathew: Now we have one-year T-bills at 10.5%, and FDI is going at 12.5-14%. Our expected return in the equity market is 18.5%, and we have an 8% risk premium. So if you are not going to get at least 18% in the current interest rate environment, it’s actually not worth staying in the equity market.

My view is that GDP will grow by around 5% this year – we had 5.5% in the first quarter. Growth will slow down in the second and third quarters, mainly due to lower consumption, with negative liquidity levels and private sector credit likely to crash.

Towards the second half of the year, we will start to see construction-led GDP growth, similar to what we saw in the last regime. That has actually been a cycle in Sri Lanka, where a credit boom is followed by construction-led GDP growth. Towards the latter part of the third quarter, or more so in the fourth quarter, construction-led GDP growth will take over, and because of that, investors should get into construction-led equity counters right now. I am not saying buy into the whole equity market. It’s a tough period and most investors are happy with current interest rates, especially high-net-worth investors bent towards fixed income debt instruments that offer good returns. This is worrying the equity market. You should pick stocks for the medium to long term, and include something related to construction.

Our debt-to-GDP was 71% in 2014 and it’s estimated to go up to 78% this year, so we are back at high levels.

There are three things we feel need to happen beyond this year for interest rates to stay low. One, government revenue has to meet the IMF target. Also, RAMIS (Revenue Administration Management Information System) needs to come online by October, linking 26 government institutions with each other and the public through digital IDs. The deployment of RAMIS is expected to increase government revenue by targeting professionals and others. Overall, we are looking at a revenue increase beyond this year from income taxes, including the capital gains tax.

The second and third things relate to IMF conditions on debt. The government has already spoken about a debt-to-equity conversion. Either that or something else related to debt reduction has to happen. If you go through the IMF agreement, there is so much related to restructuring state-owned enterprises. For example, the government has until September to decide whether to sell off, privatise or enter into a joint agreement to manage SriLankan Airlines. Then we have until December to implement policy to improve revenue and bring down debt. If we meet these targets, it will have a positive impact on the economy and market. At the moment, we are bullish only on construction-related stocks. How we select other stocks will depend on interest rates and progress in meeting IMF targets.

What is GDP growth going to be like in 2017? How does that translate to earnings growth?

Jinadasa: We expect GDP growth to be 5.4% next year, and that’s likely to be above my estimate of 5.3% for this year. In terms of earnings growth, that is a little tough to estimate. Talking about our selections, we don’t look at the short term; we look at the long term. We are looking at EPS CAGR (compounded annual growth rate) of over 30% for most of them (8 companies) over the next four years.

Perera: We are pretty much in line with what Purasisi said. We expect GDP growth at around 5.5% next year. In terms of earnings growth, it is a bit of a tough call to make. If we take the universe (7-8 names), we are looking at a 25% plus CAGR, but if you look at the broader market earnings growth, maybe about 1.5x or 1.4x GDP growth at best this time around.

Jinadasa: I’ll say earnings growth between 7% and 9%.

Ellepola: My GDP forecast for 2017 is 5.5%. In terms of corporate earnings, it’s hard to say, but I would say about 10-12%.

Mathew: GDP growth for this year is roughly 5%, and 5.5% for 2017. If you take the December 2016-March 2017 financial year, we are looking at overall market earnings coming down drastically to around 4-5%, which is on the lower side. We feel December 2017-March 2018 GDP growth will be at 5.5%, with market earnings improving to about 11-12%.

In terms of sectors, I will only look at construction-related counters. We are interested in Access Engineering and Tokyo
Cement
Mathew

Do we anticipate consumption kicking in next year, or not?

Mathew: This depends on the success of meeting the IMF conditions on government revenue and debt, but not immediately. Once consumption slows down, there is a lag before it picks up again.

Ellepola: Just to give some context, last year was a pretty bad year for us. Market earnings still grew about 15.3%, if you look at the cumulative. So I think, even during difficult times, you can see some kind of growth coming from corporates. In case you were wondering, this is in context of 5.5% GDP growth.

 If pickings are so lean next year, where are the opportunities?

Perera: We’ve been bullish on construction since November, and we continue to be so. If you look at the projects coming up like highways, expressways and bridges, there are around Rs300 billion worth of projects over the next three years, and another Rs100 billion in terms of water-related projects. That alone is going to give enough business for construction companies to keep growing. In addition to that, we see housing coming in; despite rates picking up to relatively high levels now, they are still cheaper than four or five years ago. High interest rates tend to depreciate land prices, so you are going to see the affordability factor coming in to an extent as well.

We really like the healthcare sector, as people spend on healthcare regardless of what’s going to happen. The government proposing to remove the 15% VAT on diagnostics and dialysis is positive. VAT will still apply for other things, but removing diagnostics is quite positive because that’s where the government has a problem catering to demand, whereas the private sector can.

We can look at a three-year investment horizon. If we are looking at exposure to the financial sector, we should look at larger banks because what happens with any IMF programme is that the fiscal situation improves, and banks always react very well to an improved fiscal status. So we are somewhat bullish on selected counters on the banking side.

Ellepola: If it’s for the short term, I would go with non-cyclical sectors like healthcare and banking. Like Kanishka very accurately pointed out, people are not going to spend less on healthcare just because VAT is higher. If you look at companies that have higher exposure to diagnostics, their margins are much higher for that very reason.

In terms of banks, even when rates are rising, assets re-price faster than liabilities, so they can continue to make money. I will also look at certain manufacturing stocks. Manufacturing is such a large sector that it’s difficult to be bullish, but you can pick and choose, particularly the ones with higher exposure to commodities, because we are still coming out from the bottom and you are not going to see commodity prices going up drastically. I would also look at construction. Many construction projects are coming back on-track, but if I look at the actual numbers, I am concerned that construction and diversified earnings have come down year-on-year and quarter-on-quarter. These sectors are leading indicators of the overall economy, so earnings coming down doesn’t surprise me at all. I don’t see the push coming from construction right now, not in the next six months anyway, but definitely in the longer term.

Mathew: In terms of sectors, I will only look at construction-related counters. We are interested in Access Engineering and Tokyo Cement, because they are directly linked to infrastructure development, and probably MTD Walkers, but not yet because of its valuations. We are also looking at the whole Royal Ceramics group. We are also bullish on the cable and aluminum sectors – basically everything related to construction.

We also look at banking stocks selectively based on the asset liability within the deposit side, which takes time to re-price. We more or less pick non-construction related stocks based on net asset values. Sampath Bank and NTB are our picks for banks, and we are bullish on Seylan Bank as well. For all other banks, we are on hold or sell. We are beginning to look at diversified counters and have a positive view on JKH and Vallibel One.

If you look at Sri Lanka’s mobile penetration, it’s at about 116% now. We feel Dialog is going to grow by adding subscribers more than anything else
Perera

 Is anyone concerned about Access Engineering’s and RCL Group’s implications – Access’ government projects are declining rapidly and RCL’s protectionist tariff. Does this make these two a little risky and difficult to make a call on?

Perera: Regarding Access, out of all the projects in their books, the only thing that disappeared was the airport, an $80 million project. If you look at what they have on their books now, they have three more flyovers, a water supply project and a housing project for the Urban Development Authority.

A concern for investors with regard to the housing project is cash flow: can they generate inflows to finance the workflow? What they are doing is selling housing units to government-sector employees. The money goes into an escrow account and is paid to the developer first before compensating the government for the land—they are becoming a little more savvy in how they sort issues like that now.

Access has strong foreign connections and a stable order book – even the new flyovers initially came into conception in 2014. In terms of the government changing, there certainly was an impact initially, but they have since sorted out their order book quite well. Currently, their order book is worth about Rs28-30 billion.

Jinadasa: Our view on Access is not the lack of government infrastructure projects—there are so many out there and only a few local construction companies that are able to absorb that pressure. Our concern is with the margins of these projects. Over the past three years, there has been a significant decline in gross profit margins. I don’t have a number for margins, but it has fallen from more than 30% to about 18%. I think this is because the government is moving towards a more transparent bidding process or giving more realistic margins on projects. I think the question is, will the projects in its order book help Access maintain profitable growth?

Perera: I would disagree slightly, because if you look at Access’ construction order book, margins have actually improved. They are taking margin hits mostly on the materials side. Looking at their core business, the construction order book is weighted towards water infrastructure projects, which have much better margins. I think the order book is almost 54% water infrastructure projects technically not government funded. The only purely government-funded project is partly financed by the UDA as a public-private partnership.

Mathew: We began taking a bullish view on Access once the government commenced infrastructure projects late last year. It’s been a tough year-and-a-half for the construction sector, particularly in the March quarter, but Access’ numbers look reasonably good. Its order book looks very attractive now and Access is starting to turnaround.

Margins have come down significantly, but will improve from here onwards, especially with Access taking on the northern expressway project. Once they start utilising those assets, margins will start to come down, probably from the third quarter. We also feel smaller players in the market will start to see money flowing to them as well.

The banking and finance companies sector has seen a significant increase in non-performing loans, especially in motor vehicle leasing.

Regarding Royal Ceramics’ protectionist status, I think there are risks there. So they’ve taken the initiative from Lanka Walltiles, who was the only exporter in Sri Lanka for tiles, and are now setting up operations and starting to export, exploring new markets in Bangladesh, Australia and the US. The risk of lower import taxes for tiles is there, but the government also needs revenue and now is probably not the time for them to bring import duties down. We think the government needs to get its finances in order right now. That will give Royal Ceramics time to adjust their export and domestic sales; only then will they be able to mitigate risks of lower import tariffs in the future.

Hemas has high growth in very good markets, but valuations are too expensive. The company has a pile of cash, and before I can be bullish on the stock, I’d like to see Hemas invest that cash
Mathew

Ellepola: I think the risk is there particularly because of the IMF, which wants us to do certain reforms in trade and investment. That obviously entails being more open and not having protectionist policies. The risk is on the domestic side if tile consumption is driven by households; this is where Royal Ceramics will take a hit. The company’s corporate side, which pitches higher-grade tiles for high-rise buildings for example, will be able to mitigate that risk a little. They are also diversifying. Sri Lanka’s per capita tile consumption is very low and raw material costs are falling. So I think the market dynamics are there to mitigate risks to some extent and positive enough to maintain margins.

Telcos – two of you think Dialog is a buy, and the data boom is not fully priced in. Give us some insight.

Jinadasa: I feel data is driving growth in the telco sector. Data is very much under penetrated. Even if you look at Dialog’s subscriber base, you are looking at 15-16% penetration on full data usage, so there is significant room for growth. Additional margins and new subscribers are significantly up. That is where growth is going to come from. Lots of people say voice minutes are coming down, RPUs (revenue per user) are coming down, but not VAT. My counter argument is that user dynamics are changing. More people, especially the younger generation, are using data plans for voice calls and so on. Because of that, we don’t see a significant fall in profitability growth over the course of the next five years or so. Our EPS CAGR for Dialog for 2020 is 46%, and a majority of that is coming from data growth and cost savings over the next two years amounting to Rs1.8 billion based on lower frequency fees and the Bay of Bengal gateway where they don’t have to pay a rental fee to Sri Lanka Telecom.

Perera: I’m pretty much in line with what Purasisi says about Dialog. For us, I don’t think voice tariffs are coming off anytime soon. If you look at Sri Lanka’s mobile penetration, it’s at about 116% now. We feel Dialog is going to grow by adding subscribers more than anything else. When we look at some of the regional peers Malaysia, Thailand, India, the Philippines and Vietnam, when we were moving upwards in mobile penetration, they roughly add about five percentage points a year. In fact, when we were looking at telcos, we were forecasting mobile penetration at 117% last December, but it came at 116%. We don’t think the voice story is coming to an end either. As long as we have the data side picking up, revenue will grow 5-8% year-on-year, but margins are what’s going to be driving it.

SLT is a fantastic proposition because they got the national backbone with them. The problem with SLT is they are following a wired business model, pulling cables to houses to deliver broadband. They will need to spend about Rs7 million per km of fibre input on average, and to break even, you need roughly a household density of 190 per sq.km (Sri Lanka is at 80-something). There are very few places SLT can go with their model. The other thing is, for the typical SLT mobile user, their RPUs are relatively lower than Dialog’s, and mobile users seem to be more sensitive to the VAT hike than Dialog users. It’s essentially going to be a question of free cash flow. When SLT initially came out with the fibre cable, they were offering it at Rs25,000. Now they have brought it down to Rs7,500, but they are aggressively acquiring as many subscribers as they can because they see the threat of the Bay of Bengal cable. Other players we spoke to say they don’t mind going to the Bay of Bengal cable rather than using SLT’s infrastructure.

Dimantha-Mathew

For Dimantha Mathew, Senior Manager of Research at First Capital Equities, the economy is on recovery mode and things will take a bit more time to settle

Mathew: In terms of Dialog, I completely agree with Purasisi and Kanishka, but we are not bullish on telcos for several reasons. Mobile broadband subscriber growth will slow down from here onwards. The internet subscriber base is more towards the 19-20% mark at the moment. Mobile broadband penetration is closing around this range, so we feel there will be a slowdown. Will existing users drive data growth? Probably, but I think growth will be below expectation.

Internet usage over the last couple of years has reached 27% for desktops and 73% for smartphones. Over the next three years, growth in internet usage will slow down in line with the affordability factor and the increase in internet penetration overall. Our call on telcos is hold. They will take a small hit with the tax on ‘minutes of usage’ despite growth in data usage. Telcos will have some growth, but valuations are not attractive to put it on a buy. Earnings growth will be flat this year, but grow 39% next year and 29% the following year; but if you consider interest rates and expected returns at 11-12%  including dividends, it gives a total return of 14%, in our view.

I feel Sampath is able to take on higher risks in lending out money, and still keep their NPLs low
Jinadasa

You discussed healthcare and the advantages you see with companies that have a significant diagnostics business. Can you break it down for us?

Ellepola: The market leader is obviously Asiri Hospital group, they have about 45% of the diagnostics market; the next two are Nawaloka and Lanka Hospitals. I think Lanka Hospitals is an opportunity. They are aggressively going into the diagnostics space unlike any other hospital. They haven’t really outdone themselves in terms of capex and their debt levels are pretty good. The downside of that is trying to cater to increasing demand when they don’t have the capacity that Asiri or Nawaloka has. This is why the diagnostics space is going to drive significant growth for Lanka Hospitals. They are expanding the tests they offer and plan on getting accreditation to help promote their product.

What happens in the country in terms of demographics and disease patterns will affect the sector as a whole, but I chose Lanka Hospitals because they have created a niche in the kidney and fertility space, and are working towards consolidating that position, which is a good way to capture market share. The private healthcare space is extremely competitive, and although gross profit margins are good, when you come to EBIT and EBITDA margin levels, pretty much every hospital has high capex costs because they need to upgrade their facilities and increase bed capacity, which pushes down margins. Lanka Hospitals’ strategy of focusing on its niche is for us a positive factor.

Lanka Hospitals is also benefitting from medical tourism, which is a fairly new phenomenon globally. There isn’t a lot of data, but available information points to medical tourism being a growth sector, so there is a lot of potential. Healthcare in the west is very expensive. There are good alternatives particularly in emerging Asian countries like Hong Kong, Thailand or Singapore. India is also really good for medical tourism. The fact that Lanka Hospitals was more or less a pioneer in this area here gives them an edge. They also have links to India’s Apollo Group and the Maldivian health ministry. Most of our medical tourists come from the Maldives and India for kidney-related medical needs. Last year, 15% of the hospital’s revenue came from medical tourism, and 5% of that was from Indian tourists. Foreign ministry regulation is a risk factor. These are the reasons for me to pick Lanka Hospitals. Asiri’s coverage is good too, so I’m bullish on both stocks.

Perera: In healthcare, we had two slightly different ones. I agree with Chethana about Asiri, and we are bullish on that. Asiri has the diagnostics side of the business and also about 10% market share in terms of private hospital beds. Its focus is mostly on tertiary care. If you look at Asiri’s patient breakdown, apart from its Matara hospital, 65% are in-patients who generate the most revenue for any hospital. The company’s strategy is to build on this strength by hiring more in-house doctors rather than visiting consultants. In-house doctors cost more, but EPS (earnings per share) will grow faster than its peers. If you look at the trailing 12-month average EBIT margin, Asiri’s is about 10-12 percentage points higher than the rest. Essentially, the focus towards tertiary care seems to be driving margins and profitability for this company.

Shifting slightly away from healthcare, the other stock we are slightly bullish about is Hemas. People associate Hemas with FMCG, but when you look at the revenue breakdown, healthcare is about 43%, followed by FMCG at 38%, with leisure and transport making up the rest. Out of healthcare, 70% of revenue comes from pharmaceuticals, 20% from hospitals and 10% from retail merchants, which is technically pharmaceuticals. Hemas provides you with exposure to the FMCG side on a selected number of items. Hemas’ entry into Bangladesh’s personal care market is a positive move. Bangladesh has a population of about 160 million and per capita income is significantly behind Sri Lanka, so there is potential for growth. This is what we like so much about Hemas, its focused exposure to growth areas.

Honestly speaking, we have a hold on JKH at the moment, because they have all their eggs in one basket. What we like about JKH is their consumer business and cold stores, but its asset-heavy tourism and leisure segment is a bit of a problem. Its Cinnamon properties are all old and newcomers Shangri-La and ITC will easily attract more guests. What JKH will do with an asset-heavy portfolio is something to keep an eye on. The other main problem is the Waterfront property. They are facing construction difficulties. They first said they will complete construction early 2018, now it’s pushed to 2019. You won’t be able to put a casino in there without the government getting voted out of office.

Jinadasa: Just adding to that, even their transport side is seeing significant issues. Their container volumes for last year have fallen by 5.7% and their margins are coming down. So both their leisure and transport sectors are suffering. What they have left is pretty much only Ceylon Cold Stores.

The flipside is once the building is ready and the casino does turn up there, the east terminal is about to be offered, and there is synergy there for JKH to take over.

Perera: There are so many what-ifs with JKH. If you look at what is visible, there are issues. Logistics is their main cash generator, and that segment is also having problems.

Mathew: Hemas has high growth in very good markets, but valuations are too expensive. The company has a pile of cash, and before I can be bullish on the stock, I’d like to see Hemas invest that cash and generate returns.

JKH is going through another phase like it did with SAGT, then the leisure sector, and now the retail and consumer sectors. JKH has its phases very three or four years. I think next is the property sector. Valuations have come down significantly from peak levels and are starting to look attractive. With Hemas, however, valuations are too expensive.

We briefly discussed bank and interest rates rising, and the repricing advantages they will have. On the flip side, many have large portfolios and mark-to-market losses. Is anyone bullish or bearish on this sector?

Perera: This is a sector for the relatively long-term investor. Looking at some of the banks, the main risk will be from Basel III, with tighter capital adequacy requirements and leverage ratios that look at all contingency liabilities that most of these banks have. State banks are already reaching Basel III requirements on the leverage ratio anyway, especially when you take contingency liabilities that are the main problem.

Our main pick is Commercial Bank, for the moment. The bank has adequate capital and a targeted plan of how much capital they are going to raise and when, which is something lacking in several other banks. They have about a 40-42% market share in SME loans.

The Ministry of Finance estimates SMEs contribute 52% to GDP in 2015. So having a 40% market share in SMEs, a significant part of growth, places Commercial Bank in a strong position.

Then the question arises, how can they fund SME lending? The bank’s Tier I capital ratio is at around 10 plus. The only question mark is over Commercial Bank’s investment in government bonds and bills. Fortunately, they’ve classified Rs40 billion worth of long-term government securities as held to maturity. You still have other bills and bonds that will tend to show some losses over the next few quarters with rates picking up, but not to the extent we saw in the last quarter. At first glance, first quarter results look pretty good because ROE was at 19%, but what happened was that they had losses in equities. That is the only risk.

At the beginning of this year, I was a lot more nervous than I am now. Having said that, I think a bit more clarity would be good
Ellepola

Ellepola: I agree with Kanishka, including the risk. The one thing you didn’t mention that we like is the Bangladesh operations, which have been doing well. It’s a small part of Commercial Bank’s revenue, but if you look at margins, it’s pretty high. The market there has good prospects. When we spoke to the bank, they said they are looking at other markets in the region like Myanmar.

Mathew: We are a bit cautious with the banking sector because, when interest rates move up, there is a perceived negative correlation where NPLs also start moving up. Again, credit demand is likely to come down in the coming quarters, so margins will start to improve, and this is the only advantage banks have. So we’ll see lower volumes and higher margins, so we pick our stocks carefully. Commercial Bank has still not come to our buy level. At the current interest rates, we believe the bank’s stocks will go below Rs128. The share is hovering at this range. We are bullish on NTB because of their fee income component from the card business and a significant decline in their price to around Rs77. Seylan is another stock where NPLs are starting to decline significantly after the bank had to be restructured in 2009-10. Things are starting to get back to normal for the bank. Seylan Bank is heavily exposed to the construction sector, and they have a huge overdraft facility, which is about 35% of the loan book, which are re-priced faster. All three banks are trading very closer to their book values. That’s why we would pick these three stocks, more so NTB and Seylan.

Jinadasa: I agree with Kanishka. I think growth is going to come from SMEs, and from borrowers, but I disagree with his pick. If you reclassify SME loans to a lower base where you actually see value addition from the people taking those loans, Sampath Bank has greater exposure to that market. Commercial Bank is more into corporate lending, even if you classify the loan book. I feel Sampath is able to take on higher risks in lending out money, and still keep their NPLs low. So they are lending to the right people who are able to add value to the economy as well. But the risk with Sampath is they might have to go for a rights issue to prop up their capital adequacy ratios, but this might be the case for most banks. In terms of NTB, NPLs may rise slightly and fee-based income will fall over the next 20 months while consumption falls. So we are not overly bullish on them. In the long term, Commercial Bank is good.

Perera: To just counter one thing, we honesty like Sampath Bank. We think they are an aggressive and dynamic bank compared to the rest of them. But to us, the main concern is capital and Sampath comes in at relatively low levels. To be honest, I don’t think it will be looked at negatively by investors at all because Sampath has shown what they can do. Management continuity is also a concern. Several key executives are retiring soon. Succession planning is not something we are too comfortable with at the moment. When it comes to banks, people make a big difference. If they can answer those two questions on capital and succession, I will also be more bullish on Sampath.

Are there any other stocks you want to highlight?

Perera: Out of the sectors, when you look at manufacturing, we feel exports are going to do well. But what you need is an export company that is not affected by Sri Lanka being Sri Lanka, and Textured Jersey is one company that can do that without much problems. They import their raw material, add value, and export or sell within the country. What we really like is that their revenue is in dollars, so they are not too exposed to exchange rate fluctuations. The other thing is you are looking at significant growth potential. Sri Lanka’s apparel sector sources only 40% of their requirements from within the country, the rest is imported. So Textured Jersey, with their expansion into India, which enables them to cater to Brandix’s clients and several others, opens up a fair bit of capacity and growth that can come into play in the near term. In terms of gross margins, they are one of the stronger ones in the textile industry globally, at around 20%. They also have very strong dividend yield, around 50%.

Jinadasa: One risky pick we have is Softlogic. A lot of people question us on that. What we see in that company is there is probably going to be really high returns from its core operations in retail. If you believe in the country’s growth story with the port city and Shangri-La coming up, the type of tourist you are going to attract who will spend much more, and people’s incomes increasing even at 5-6% GDP growth over the next five years is compelling enough reason for us to see this stock as a good pick. The only risk we see is its debt burden. But many investors have put a discount on the management’s ability to manoeuvre through this risk over the past five years. This is a three-year play, our EPS CAGR is at 60%.

Perera: Softlogic is a question of when we are going to hit the $6,000 per capita GDP, and how much debt the company can keep taking. With group subsidiary Asiri Hospitals providing the cash, they should be able to, but it’s a relatively risky play. On the other hand, what we do like about Softlogic is that they have an asset that is easily cashable, which is Asiri. If they see a pickup in retail, they can sell off Asiri and settle the debt, and focus just on retail. That’s an option. That’s why most banks continue lending to Softlogic. Over the longer term, if they see the retail side growing, they might put it on the table, because it’s an asset with a readymade buy.

Purasisi-Jinadasa

The market is bottoming out, says Purasisi Jinadasa, Chief Strategist at Capital Alliance Partners. Investing now for the next three years can bring 20% annual returns

Any final thoughts?

Mathew: The economy is on recovery mode and things will take a bit more time to settle. The fourth quarter is going to be critical. With the budget coming in November or December, we hope there will be more clarity on policy direction. We will have to take it from there. For now, the way things are going and the way the government is doing things, I’d rather be more positive than negative. I’ll start collecting in the equity market, focusing on construction-related counters, which I believe have a lower risk.

Ellepola: I would say I’m cautiously optimistic too. At the beginning of this year, I was a lot more nervous than I am now. Having said that, I think a bit more clarity would be good. I think we really need to get some idea on where we stand in terms of taxes, because obviously it has an impact. If you can sort that, and once interest rate changes are priced in and the Central Bank decides what to do with that, then you will see a turnaround. But I’m definitely more positive in the longer term. I think policies are in place. We are perceived in a more positive light.

Perera: This is the year for tightening. Key points people should be looking out for is on the political front: will there be more coordination in terms of the policy message the UNP and SLFP give out and will they implement policies. We will have elections in 2020 and Sri Lanka has a reputation for creating higher fiscal deficits in election years, so this is a long-term concern we need to be mindful of. Now is the time to start shopping for selected stocks. When I say shopping, I don’t mean putting all your eggs in one basket: a healthy mix of construction and export-related stocks, maybe an equal allocation on the healthcare side, and a slightly lower allocation of banking stocks sounds good.

Jinadasa: I think the macro volatility we have is more of an opportunity to buy. The market is starting to bottom out, so it’s probably the time to start buying selected counters. The equity market can be a very powerful tool if used properly to achieve your financial goals. But you have to know what you are investing in and invest for the long term.