THE CONTRARIAN BET OF THE DECADE

Will equity outperform other asset classes in the next couple of years?

INVESTORS IN SRI LANKAN listed companies are facing one of the longest losing streaks in recent stock market history. After a peak in early 2015, following an election that appointed a new president and government, stocks have slid more than 22%. In every year since, except 2017, Colombo Stock Exchange’s All Share index has declined (see chart 1). By late August 2019, stock prices are down three percent from levels in January 2019.

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Companies are also cheaper, compared to their underlying assets than at any point in the last five years. Market-wide price to book value (PBV) at 0.9 times by August 2019 is less than half the value it was in 2015 (see chart 2). In 2014 and 2015 PBV was 2.2 times and 2.0 times respectively.

 

 

Generally, with losing streaks, it’s impossible to tell when one is going to end. Sri Lanka’s stock market losing streaks are also long-drawn, observes Amal Sandaratne who has been analyzing listed companies and other investible assets for over two decades, has witnessed first-hand several market cycles. “It’s the experience; we usually have two good years and five negative years.”

Sri Lanka’s market is dominated by old world, asset-heavy firms like manufacturers and banks

The merits of using just the book value as a gauge of how much a company is worth are questionable. However, it is
more useful as a measure to appraise companies where much of their value is in fixed assets. But its a poor judge of companies where much of their competitive advantage is from intangible assets like brands, patents and process excellence.

Sri Lanka’s market is dominated by old world, asset-heavy firms like manufacturers and banks. At least compared to some other markets, the book value multiple as a measure is more relevant here.

In the equity investment world – those asset-heavy companies with a low price-to- book ratio are called value stocks. Accounting rules recognize in the books the assets of ‘value’ companies than those of ‘growth’ companies. Capital assets on books like factories and office buildings are easily valued. Accountants haven’t figured out reliable methods of valuing the intangible assets, like brands, knowhow and patents, that account for most of the success of growth firms.

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Asset heavy firms, like most of those listed at the Colombo stock market, suffer during downturns when those assets lie idle. Now, as demand has fallen, factories are not operated at full capacity, and there are not enough customers to serve in the service sector.

Of the 284 listed companies, 187 firms, or around two-thirds of all listed companies are trading below their book value in late August 2019. Investors in Sri Lankan listed companies have had a poor run in the last decade, except for a period in 2014 when the market rose 22% in the run-up to a watershed Presidential election (see Chart 3). In the year since October 2018, they’ve dealt with a constitutional standoff between the President and the government, a terrorist attack on Easter Sunday and an economy that was straining under fiscal and monetary instability. Research head at Bartleet Religare Securities Nikita Tissera forecasts the market has factored in the earnings hit from all the bad news, “I properly feel, we have hit bottom”. In fact, that market bottom was hit in mid-May 2019 when the stock index fell to 5,199 points. It has since risen 13% by late August 2019, to reach levels close to the 6,000 index points level of early 2019.

The constitutional crisis was a bigger attack on investor mindsets than the Easter Sunday terrorist attack

Tissera says the double whammy of a confidence hit and the weak economic outlook led to the market slide down during the last four years. Confidence erosion commenced when, in 2015, the government announced retrospective corporate income taxes. It’s estimated this resulted in additional liabilities of over Rs2 billion for listed companies. However, the reputational damage to Sri Lanka as a rule-based and predictable destination for investment far outweigh the one-off financial cost to companies.

The constitutional crisis was a much bigger attack on investor mindsets than the Easter Sunday terrorist attack, according to Tissera and other stock analysts who spoke to Echelon about the equity outlook. Just like in the run-up to the 2014 Presidential election, the expectation of a turnaround in sentiment accelerating should alter the equity allocation of a portfolio according to Amal Sandaratne. In theory, the value of a stock is equal to the future cash flows to investors, discounted at the appropriate rate. There are several practical problems to this theoretical approach to investing. First, no one knows for sure what those future cash flows are going to be. Second, forecasting an appropriate discount for the future also can be challenging. These two challenges relate to analyzing stocks based on fundamentals.

But fundamentals are only one half of the puzzle and cannot be solely relied on to forecast the direction of a market. That’s because theory cannot explain the sentiment that leads investors to speculate, a crucial driver of any market. The weak fundamental outlook of Sri Lankan listed companies aren’t forecast to change. However, sentiment has already shifted, and some are arguing this should lead investors to now consider reallocating more of their portfolio quickly to equity.

“It’s our favourite asset class for allocation in the near term. We think this asset class will do the best, and that’s because it’s currently cheap,” says Amal Sandaratne who until recently was advising

“It’s our favourite asset class for allocation in the near term. We think this asset class will do the best, and that’s because it’s currently cheap,” says Amal Sandaratne who until recently was advising investors to be in fixed income, where the returns have been good.

He forecasts stock prices will rise 20%, maybe 30% in the first year, and maybe 10% later in a two to three year period. A change of 40% from the bottom. This forecast rise has already started, he points out.

Stock analysts’ expect a confidence boost following a Presidential election due in late 2019. Stock brokerage, Asia Securities head of research Kavinda Perera argues that the discount on equity due to political uncertainty will go away after the presidential election. But any discount due to weak fundamentals will not.

Perera does not get drawn into a market rebound forecast but suggests the turnaround that commenced in May 2019 will continue. This is despite the earnings continuing to fall. Despite a 12% rise so far in 2019, stocks are still around 35% off their February 2011 peak of 7,700 on the index. Sandaratne expects the market to close this gap in the next few years.

Analysts who spoke to Echelon were unwilling to forecast the extent of the earnings impact from the 2019 Easter Sunday terrorist attacks. So far it has been brutal on listed hotels, banks, consumer goods companies and some diversified firms. Construction and automobile firms were facing headwinds even before the easter attacks. The earnings reports during the next six months for key sectors are going to be very poor, suggests Sandaratne. “Everyone knows it, that’s factored into the stock prices.”

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Four analysts who spoke to Echelon all agree the market will get re-rated upwards. A re-rating is when overall prices rise or fall based on a change in the outlook. In Sri Lanka’s case, the political stability after the presidential elections is forecast to deliver un upward re-rating.

“We may like some and dislike other new policies, but we’ll have better visibility and stability, “suggests Sandaratne about the likelihood that the upcoming presidential election will bring political and economic stability. But anyone getting into equity now shouldn’t buy only for the next few months because of elections.”

“As a result, market rating needs to move up, it might happen over the next two months, or 12 months, but it has to happen.”

There are at least two ways the elections can be catalytic. First is the uncertainty about who will be the winner. Second is the speculation about the policies and outcomes in the years following.

Sri Lankan stocks are relatively cheaper than those in the region. However, value investing is dammed strategy in Sri Lanka. Analysts suggest the approach of buying value stocks (ones with a low price to book multiple) and being patient, won’t lead to superior rewards here generally.

Another way stock prices can be compared is the price to earnings ratio (PER), which measures the underlying profit for a share. Sri Lanka’s forecast PER for 2019 is 9.2 times according to stock brokerage CT CLSA estimates. Compared to 2019 estimates from other Asian markets compiled by Bloomberg, Sri Lankan stocks appear cheap (see Chart 4).

Low net asset PER multiples suggests there is potential for re-rating. However, none of the analysts is suggesting the fundamental macroeconomic reasons for the weakness are expected to alter fast. In essence, the problem will not go away for a stock rally. It will only become less acute. Greater confidence about future political stability can achieve that.

To a lesser degree but essential nonetheless, an expectation that interest rates should decline during the short term, improving the profitability of companies. Most analysts expect interest rates to pick up in late 2020 or 2021.

Fixed income has been the most favored investment asset class during the last few years. Those used to successfully picking real estate investments, where returns are now reduced and the market illiquid, had switched to fixed income. Yield hungry investors will find slightly tighter conditions in fixed income during the next year than at any time in the last five years.

Benjamin Graham – considered the father of value investing – said, “price is a creature of the market’s mood, he wrote. In booms, it is set by the greediest buyer; in busts by the most fearful seller. A stock’s value, in contrast, is enduring. It is anchored by the worth of a firm’s assets. The enterprising investor can profit from finding stocks that sell for much less than their value.”

A lousy run such as the last four years can breed doubt. Those doubts may have been confounded by Sri Lanka’s old economy companies seemingly having few intangible assets that may transform value company into their antithesis; growth companies. However, the rise of technology, ubiquitous data and sophisticated consumers has edged the
most conservative ones ever forward. Not all two-thirds of listed companies at the Colombo Stock Exchange, trading below their book values will have growth investment deserving characteristics. To bet that stocks will rebound isn’t contrarian anymore. Listed company shares are up 13% from their post easter attack slump. Investors are confounded by the dilemma if equity will return a risk premium adequate to justify an overweight position on their portfolio. Some expecting stability in the next couple of years will conclude that indeed, equity will return a premium significant enough.