TWO MODEL PORTFOLIOS DECLINE, ONE GAINS
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Listed equities declined 6% in the year to end-November 2018, reversing a modest gain of 3% the previous year. The market has declined 18% over the last four years, weighed down by policy uncertainty, mute business confidence, low consumer spending, sharp rupee depreciation and a seven-week constitutional crisis with two claimants to the premiership, which has since been resolved, but the government is shaky. The All Share Index (ASPI) declined 6% during the reference period, and two of the model portfolios gave negative returns of 3% and 16%, while the third gained a phenomenal 7.6%. Fund managers are restricted from buying and selling stocks during the year. The rules of this exercise also prevent them from maneuvering funds to any other income assets for better returns as they would normally do for portfolios they manage in the real world. Only year-end allocations were allowed. Five years ago, three top fund managers built hypothetical stock portfolios valued at Rs10 million each for Echelon’s January 2013 edition in an exercise to understand how long-term portfolio investments worked. Ramesh Schaffter of Janashakthi Insurance, Sumith Perera of Guardian Acuity Asset Management and Kanchana Karannagoda of Ceybank Asset Management manage these model portfolios. By end-2018, the Rs30 million combined portfolio has grown to Rs42.3 million, down 2.7 million from last year. We take a look at how each portfolio performed and the present reallocated portfolios, which will be reviewed next year. Ineka Dunuwille, a fund manager at Candor Asset Management, has joined the exercise submitting a model portfolio valued at Rs10 million.
Equities the world-over has had a turbulent year. Globally, trade war fears and the US Fed tightening rates triggered currency pressures and capital outflows from emerging markets. Net foreign selling in the Colombo Stock Exchange accelerated, while local investors were hesitant stepping into the market as foreigners exited. Sentiment in equities is lukewarm because the economy was sluggish due to policy uncertainty, external debt repayments and rising interest rates. The constitutional crisis, which was triggered in October, only exacerbated investor sentiment and eroded their confidence further.
Market valuations remain attractive and are becoming even more so as share prices decline. For any serious investor with an eye for long-term gains, valuations are now very compelling and hard to ignore. However, it’s not clear for how long the prolonged market slump will continue, and this may be a major deterrent to some investors. Based on valuations, a huge upside correction is due and investors with staying power will make significant gains. Over the last five years, we’ve seen earnings growth in fundamentally sound companies despite their share prices falling or stagnating just because sentiment is weak. Earnings growth in the portfolio I have submitted is 12% annually, while the price performance of these companies have been only a collective 6.2% annual increase.
Th e gap between share price and valuations is widening. What this leads to is a bigger upside correction if anyone is willing to wait it out. Eventually, the market will recover and those who moved in first will benefit the most. You need to look at stocks from a fundamental perspective and identify sustainable growth prospects, while understanding the competitive strengths of each company. When the economy eventually recovers, these companies will be able to participate in that growth. As a long-term investor, I am very confident that these shares may give returns, but you need to be patient in the current environment.
One of the key picks that I continue to hold is HNB. Earnings have met expectations, loan growth is strong and cost rationalisation strategies continue to bear results. Non-performing loans are higher, which is not unusual during an economic slump, but net interest margins have improved because of interest rates raising. What’s really interesting about the bank is that the stock is trading at a significant discount of 0.8x book value despite its strong balance sheet with capital raising. Th e valuations are very compelling compared to historical numbers. Sampath Bank, which has
similar performance trends, is trading at 0.6x book value and also cannot be ignored. I added Hemas Holdings because of exciting sectors the company is exposed to like consumer retail, healthcare and logistics. Hemas’ consumer segment has seen moderate volume growth despite the overall FMCG sector witnessing a volume drop due to sluggish consumer sentiment that prevailed since the latter part of 2017. Its re-pricing strategies have paid off with margins improving.
The share price increased rapidly before a sharp decline to the point that is now quite attractive. I feel Hemas is a good pick for the long term, as it will gain faster when the economy starts recovering.
It’s not easy picking stocks because a lot of the businesses are challenged in this environment, so you need to identify those companies that have the potential to grow, have management experience and balance sheet strength to withstand challenges.
Inclusions: Ceylinco Insurance, Hemas Holdings, Distilleries, Tokyo Cement Exclusions: Cargills, Aitken Spence Hotels, Chevron Lubricants, Access Engineering, Melstacorp
GAP BETWEEN EARNINGS GROWTH AND SHARE PRICE DECLINES
Negative sentiment drove Colombo’s All Share Index down by 6% during the period and my model portfolio underperformed the market by declining 16%. However, the long-term return of my portfolio over the last five-year period is encouraging, returning 6.7% annually against the market’s 0.7% return.
I will continue to hold the same stocks for 2019, only changing the allocations. I am confident that these stocks have significant upside potential and their valuations are quite attractive. The year ahead will be a challenging one for the economy. However, investor sentiment could improve now that the constitutional crisis is behind us. Foreign inflows to capital markets and FDI could also improve. These are critical to shore up reserves, given Sri Lanka’s large debt servicing commitments in 2019. Th e alternative, going to global capital markets with sovereign bond issues, will be too costly with the US Fed expected to tighten rates and recent downgrades of Sri Lanka’s credit ratings. But 2019 being an election year, inflationary pressures could ease if the government throws caution to the wind, rolling back fiscal reforms in a bid to woo voters. Stable government and consistent policy may even relieve some pressure on the rupee. In a sentiment-driven market, we can’t always expect share prices to reflect the fundamentals of companies. We’re also seeing a growing disparity between earnings growth and share prices. For instance, Access Engineering shares fell 32% during the period despite earnings growing 106% in the September 2018 quarter from a year earlier due to improving performances in the group’s construction, building materials and property segments.
Textured Jersey declined 13% during the period, but earnings grew 15% year-on-year in the September quarter. Commercial Bank, which reported earnings growth of 24%, saw its share price fall by 10%. Hatton National Bank declined 18%, but earnings had grown 17%. Lanka IOC saw profits surge 217%, but the share declined 7%.
Hemas Holdings experienced the same trend. Earnings grew 28%, but the share price declined by almost 30%. However, share prices of Tokyo Cement, Dialog, Sampath Bank and Chevron Lubricants declined in line with falling earnings. Th e steep rupee depreciation and rising raw material costs impacted earnings at Tokyo Cement, Dialog and Chevron Lubricants.
Tokyo Cement declined 61% as earnings fell 90%, and Dialog’s earnings declined 54%, while the share price decreased by 11%. Chevron Lubricants’ earnings fell 21%, while its shares shed 35%.
Sampath Bank’s earnings were impacted by rising provisioning for non-performing loans. Earnings declined 1%, but its share price fell a steeper 25%. I believe a correction is long overdue, which is why I will continue to hold on to these stocks.
Softlogic Holdings is the growth catalyst in my portfolio, gaining 62% as earnings improved significantly driven by its retail, healthcare and financial services segments. John Keells Holdings gained 4%, with profitability improving owing to foreign exchange gains despite the group’s leisure, consumer foods and retail, and property businesses showing poor results. Despite improving earnings and attractive valuations, negative sentiment in the equities market prevailed throughout the year.
Policy uncertainty, which had been an issue over the past few years, heightened after local government elections in early 2018. Th e US Fed tightening rates and fears of a full-blown trade war between China and the US saw foreign investors exiting the market. The outflow accelerated during the constitutional crisis. Sharp rupee depreciation, inflation picking up, rising interest rates and sluggish economic growth further eroded sentiment in stocks.
Despite all this, valuations continue to be attractive. Commercial Bank (non-voting) is trading at 0.7x the book value discount, so I will double my exposure to the banking stock with a 10% allocation. The bank’s voting share is trading at book value, so I have doubled my exposure up to 10% here as well.
I have increased my allocation to HNB from 8% to 10% because of its attractive valuation of 0.8x book value. Dialog’s valuation of 1.4x book value has also compelled me to increase the allocation to 10% from 8% the previous ear.
BETS ON NATIONS TRUST BANK, CITIZENS DEVELOPMENT BUSINESS FINANCE AND JANASHAKTHI PAYOFF
My anticipation was that Nations Trust Bank would perform well given its small size and general scarcity of shares. The bank is well managed and is perhaps the only banking stock that appreciated during the year. I will continue to hold NTB and invest in NDB Bank because I believe the bank is substantially undervalued with considerable upside potential. I am partial to the insurance sector given my involvement with Janashakthi Insurance. The share had a windfall after Janashakthi exited the general insurance business, which was followed by a share buyback. However, the insurance sector continues to be undervalued with valuations continuing to be depressed. This is why I am increasing my exposure to the sector with HNB Assurance. Citizens Development Business Finance is the pick of the non-bank finance sector. The company continues to deliver consistent profitability growth. There are some concerns about rising non-performing loans and the vehicle leasing segment slowing down due to import restrictions, but the stock is substantially undervalued. LB Finance is also trading at low multiples and is undervalued. The outlook for the entire non-bank financial institutions sector is tough, but this has been factored into the valuations. Once credit restrictions on vehicle imports are eased and the economy improves, these stocks will see immediate gains.
Bairaha Foods had a tough year due to the rising cost of chicken feed. I think the food sector is an important exposure to have in the portfolio, but I avoid those food companies challenged by sugar taxes and other controls. I can only see the poultry sector doing well going forward and will increase exposure to the stock.
Access Engineering didn’t perform to expectations, but it’s the only stock with considerable exposure to the construction sector and they’ve also moved into property development, which I think will give them an advantage.
I exited Hemas Holdings because, despite being a well-governed group of companies, its pharmaceutical business has experienced issues after the government introduced price controls. Its hotels segment is also not delivering the required returns on capital employed, and this is typical of any conglomerate with high operating costs.
Last year (2018) was a difficult year for equities that weren’t valued by their fundamentals but more sentiment-driven. Mixed signals from a coalition government, inconsistent policy, rising interest rates and the rapid depreciation of the rupee negatively impacted sentiments. China-US trade tensions and the US Fed tightening rates also dragged down the market as foreign investors exited. I believe the market will largely be driven by how large-cap John Keells Holdings moves. Unless sentiment improves, we are unlikely to see true value this year as well.
Dunuwille is a Fund Manager at Candor Asset Management Private Limited, making her initial allocation to Echelon Hot Stock Picks. She’s picked two banking stocks for their attractive valuations. Confident that consumption will drive economic growth in the long term, supermarket chain Cargills and Hemas Holdings are in her model portfolio. Dunuwille’s portfolio is also exposed to tourism, manufacturing and healthcare, sectors with strong potential for growth. Dunuwille explains the rationale behind her stock picks:
Despite increased non-performing loans, the more stable banks continue to be resilient. I picked Commercial Bank due to its ability to give above-average profits on a consistent basis. Th e share has fallen by 13.4% year-to-date on 30 November 2018, while Colombo’s All Share Index has fallen 5.5% in comparison, largely owing to foreign selling of the share. However, I believe it is an opportune time to get into the share. I’ve allocated Sampath Bank due to its above-average loan growth, healthy cost-to-income ratios and higher return on equity. It is a good medium-term share. Th e share price has declined due to heavy foreign and domestic selling in recent times, presenting attractive price-to-earnings and price-to-book value ratios.
The formal retail sector will gather momentum in the longer term, and Cargills has been successful in capturing a major portion of the formal retail sector. I am confident in its business model in the medium-to-long term. I’m bullish on Lion Brewery because the soft liquor business will continue to grow with improvement in tourism, and the company continues to reduce debt in the coming year. A healthy order book for the 2019 financial year, coupled with better cost efficiencies and a new product mix, make Teejay Lanka an attractive investment; hence, I’ve included this in my portfolio.
Hemas Holdings has declined 29% year-to-date on 30 November 2018. Despite the negative impact of the depreciating rupee and price controls in the pharmaceuticals segment, we can expect to see some improvement in the group’s FMCG business in the coming year. I am confident about Hemas Holdings as a long-term pick due to its
diversification into international markets and its strong presence in growth sectors in the local economy.
[Illustration by: Yomal Vajrajith Payagala]