*Uncertainty hits capital market, but current price levels provide opportunities for the futureInvestor sentiment is expected to remain weak as uncertainty grips the country’s equities market with economic growth is expected to slowdown to 7.9 percent this year, but better positions could be built in the medium to long term, John Keells Stock Brokers (JKSB) said in a comprehensive economic and capital market report titled "Timing is Everything: Sri Lanka Market Strategy".
"A steady decline in the indices over the last 12 months has resulted in the market trading at more rational valuations having priced in the macro head winds the economy faces at present. The significant correction on the indices followed a sharp rise in largely credit driven speculative trading on illiquid and second tier stocks in 2011. The ASPI declined by 8.46% in 2011 and is down a further 101.11% YTD in the first two months of trading in 2012 registering an overall decline of 29.98% from its peak in end February 2011.
"Near term valuation of Sri Lankan equities now rank more favourably with regional peers. Whilst we expect market sentiment and overall buying interest to remain weak in the short term given current concerns over the exchange rate, higher energy prices and a moderate rise in interest rates, current price levels do provide medium to long term investors with an opportunity to incrementally build fresh positions in the market," JKSB said.
With the end of the post war bull run, several fundamentally strong counters are trading at single digit and low double digit multiples on 1 yr forward earnings estimates, whilst exhibiting a healthy sustainable earnings growth outlook of 18% - 25% over the medium term. While timing is everything in generating returns in such an environment we remain bullish on the long term post war growth prospects for the Sri Lankan economy and fundamentally sound stocks positioned to benefit from this growth should provide sound returns over an 18 to 24 month period," it said.
"An ever widening trade deficit has created some uncertainty as to the extent to which the LKR will depreciate in the current year while interest rates as anticipated trended higher towards the end of CY11 on the back of strong credit growth over the last 18 months. This together with the passing of the expropriation bill has had a dampening impact on sentiment over the last quarter which has been further dampened by the sudden steep fuel price increases in February this year which will cascade into increases in cost structures across the board. The cost increases will have an inflationary impact which is somewhat cushioned by current low food prices compared to the corresponding period last year.
Corporates are also unlikely to be able to pass on the cost increases in full to consumers without an adverse impact on demand. The resulting cost increases and the depreciation of the currency will however curtail imports and reign in the trade deficit as well as reduce the extent of state borrowings to fund the country’s oil imports.
The initial increase in domestic economic activity and the re-integration of the North and East province and the infrastructure building across the country should lead the economy to expand by 8.1% in 2011 and 7.2% in 2012. However sustaining these growth rates for CY13 and beyond would require investment levels to rise in order to enhance scale and productivity in the economy. Private investment levels via local investment or foreign direct investment although expected to be significantly higher than last year still continues to lag behind our initial expectations following the end of the war.
Lower domestic debt finance expense, higher tax revenues and lower defense spend relative to GDP should see the fiscal deficit decline to 6.9% in CY11 and 6.4% in CY12. Increased food production in the North and East provinces and improved yields should cushion the country’s exposure to imported inflation on food items in the medium term although the country’s exposure to supply side shocks still remains significant with its sensitivity to global commodity prices, with world crude oil prices being the most pressing concern. Our projections for annual average inflation for the year end are at 8.8%.
The ASPI declined by 8.46% in 2011 and is down a further 10.11% YTD in the first two months of trading in 2012 registering an overall decline of 29.98% from its peak in end February 2011. The significant correction on the indices followed a sharp rise in largely credit driven speculative trading on illiquid and second tier stocks in 2011.
Corporate earnings growth remains sound with expectations of FY12E normalized earnings growth of 22.3% and FY13E of 16.2%. We anticipate businesses to continue to display healthy volume growth stemming from sustained demand and investment in new capacity.
Inflationary cost increases are expected to impact margins while finance expenses are expected to rise whilst the net margin boost from the tax reduction will be normalized in the current year. It should also be noted that the adoption of IFRS for presentation of financials from 2012 onwards would require closer scrutiny to decipher recurring company performance With the end of the post war bull run, several fundamentally strong counters are trading at single digit and low double digit multiples on 1 yr forward earnings estimates, whilst exhibiting a healthy sustainable earnings growth outlook of 18% - 25% over the medium term.
Despite the sound corporate earnings outlook, current headwinds of interest rates trending higher, higher operating costs for businesses, uncertainty over the exchange rate as well as intermittent selling pressure stemming from unwound credit positions in the market, still cloud investor sentiment. While timing is everything in generating returns in such an environment we remain bullish on the post war growth prospects for the Sri Lankan economy and fundamentally sound stocks positioned to benefit from this growth should provide attractive medium to long term returns over an 18 to 24 month period.
Political Overview…
With the removal of the constitutional bar on the president having a two term limit on the 8th September 2010, Sri Lanka started a new chapter in its political history. With the ruling United Peoples Front Alliance (UPFA) having only 144 seats the amendment had a smooth passage with 161 members voting in favour, and only 17 voting against.
Current administration firms up hold on power…
President Rajapaksa has astutely levered his post war popularity into what appears will be a long stay in the seat of power. The dominance of the Rajapakse administration is also partially due to the weakness of Sri Lanka’s second major political party the United National Party (deleted). Wracked by internal dissension the party has seen members defect once again to the ruling party while the remaining MPs have publically come out against Ranil Wickremasinghe’s party leadership.
The executive president enjoys enormous powers under the 1978 constitution. He can dissolve the parliament and declare emergency. He also appoints judges, heads of armed forces and police, election commissioners and secretaries to the government.
Consolidation of power should deliver stability…
Sri Lanka has long suffered under political uncertainty with wafer thin majorities in Parliament exacerbating the effects of the turmoil of the nearly three decade long ethnic war. This focus on political uncertainty due to the possibility of a change in regime means many investment decisions were postponed. It is hoped that this current consolidation of political power will give an environment of stability in which faster economic growth can occur. The budget delivered in November 2010 and 2011 underlined the importance the government places on catching up on the economic development that the country forfeited during its period of turmoil.
Much of the success of the war effort can be attributed to the Rajapakse administration’s foreign policy which prioritized improving relations with regional powers like India and China as well the Middle East. These relationships are also important from an economic standpoint. India and China are committing substantial amounts to investment in infrastructure in post-war Sri Lanka. China is now Sri Lanka’s largest donor of developmental assistance after Japan. India is also one of Sri Lanka’s most important trade partners and is one of the largest sources of tourists into the country. Sri Lanka’s increasing links to the Asian region should prove important in continuing export led economic growth in the coming years.
Economic Overview…
Domestic economic activity continued to expand at a healthy pace with the economy growing by 8.3% in the 3Q CY11. Improving business sentiment in the 1H of CY11 that stemmed from strong domestic demand, a low and benign interest rate environment and relative macro stability together with continued infrastructure spend reinforced a strengthening economy. However an ever widening trade deficit has created some uncertainty as to the extent to which the LKR will depreciate in the current year while interest rates as anticipated trended higher towards the end of CY11 as excess liquidity dried up given the strong credit growth in the 2H of CY10 followed by a 34.5% credit growth witnessed in CY11.
This together with the passing of the expropriation bill has had a dampening impact on sentiment over the last quarter. Sentiment has been further dampened by the sudden steep fuel price increases in February this year which included a 36.9% increase in standard auto diesel, a 49.3% increase in kerosene and an 8.8% increase in petrol has cascaded into increases in cost structures across the board.
This includes a rise in electricity costs which include a 15% increase in electricity tariff for industries and the leisure sector and a 25% to 40% increase across low to high consumers of electricity. The cost increases will have a significant inflationary impact which is somewhat cushioned at present by current low food prices compared to the corresponding period last year. Corporates are also unlikely to be able to pass on the cost increases in full to consumers without an adverse impact on demand. The resulting cost increases and the depreciation of the currency will however curtail imports and reign in the trade deficit as well as reduce the extent of state borrowings to fund the country’s oil imports.
GDP growth of 8.3% in the third quarter CY11 was in line with expectations with contributions from the agriculture sector rebounding as anticipated to grow at 6.2% for the 3Q after growing by just 1.9% in the 2Q and contracting by 5% in the 1Q.
Private sector credit growth up to December of CY11 was as high as 34.5% but is expected to taper off moderately in 2012 to around 20%. We anticipate the services sector to grow by 8.4% in CY11 and expand by 7.1% in CY12 driven by wholesale and retail trade, transport and communication and leisure activity.
Large scale infrastructure spending continues to take place simultaneously across all parts of the country relating to ports, roads, airports, power, and irrigation facilities in addition to small scale rural infrastructure projects.
Private investment levels via local investment or foreign direct investment although expected to be significantly higher than last year still continues to lag behind our initial expectations following the end of the war.
The initial increase in economic activity and the re-integration of the North East province and the infrastructure building across the country should lead the economy to expand by 8.1% in 2011 and 7.9% in 2012 according to our projections.
Fiscal Deficit…
Government revenue recorded a growth of 13.6% in the first 9mths of the CY11 with an increase in both direct and indirect taxes. Recurrent expenditure grew by just 9.6% in the same period with savings from domestic financing of debt contributing significantly to the reduction. We anticipate the fiscal deficit would decline to 6.9% for 2011 and 6.4% in 2012 stemming from lower interest expense on domestic financing, higher tax revenues and lower defense expenditure relative to GDP.
The decline in the fiscal deficit has allowed the state to relatively reduce its dependence on short term borrowings to finance the deficit thus reducing the inflationary impact of deficit financing. Total outstanding government debt stood at Rs. 5,117bn as at end Sept. CY11 with an estimated Debt / GDP ratio of 78% with foreign currency debt amounting to 44.8% of total debt. The government expects the Debt/GDP ratio to decline to 64% by end 2015.
Inflation…
The CCPI has been trending higher from an annual average of 3.1% in February 2010 to 7.19% in September 2011 before declining to 6.1% in January 2012. The sharp rise in energy prices and its cascading effect on other consumer goods will result in an increase in inflation in the current year. The effects on the CCPI will be less pronounced in the short term as a result of higher food prices in the corresponding period last year stemming from the floods in the 1QCY11.
Increased food production in the North and East provinces and improved yields should cushion the country’s exposure to imported inflation on food items in the medium term although the country’s exposure to supply side shocks still remains significant with its sensitivity to global commodity prices of which the most significant being petroleum imports. The property market has shown signs of increased activity and non-food and non-fuel inflation still remains under check reflecting unutilized capacity in the system. Furthermore evidence of demand driven inflationary effects will likely be curbed by a rise in interest rates. Our projections for annual average inflation for the year end are at 8.8%.
Interest Rates…
Interest rates, as anticipated trended higher at the tail end of last year having bottomed out in September CY11 with the 1 yr T-bill and weighted average prime lending rate rising from 7.31% and 9.26% to 10.19% and 10.4% at present respectively.
The Central Bank in February 2012 increased policy rates by 50 basis points with the repo and reverse repo now at 7.50% and 9.00% respectively having previously consistently retained policy rates since a 25bps reduction in the
repurchase rate in January of CY10. Furthermore in a bid to curtail import related credit growth as well as ensure potential demand pull inflationary effects in the 2H of 2012, the Central Bank has mandated commercial banks to moderate credit growth to ensure overall loan book expansion for 2012 does not exceed 18% whilst permitting credit growth of 23% for banks that can fund the excess 5% from funds mobilized overseas. Excess liquidity in the system which was as much as Rs. 124bn as at end 2010 now stands at approximately Rs. 15bn which we anticipate would result in a further 100 – 150 bps rise in lending rates from current levels as banks become increasingly competitive in order to mobilize deposits.
External sector…
We expect export earnings of US$ 12.69bn in CY12.
Continued import of non-food consumer goods such as consumer electronics and motor vehicles together with an increasing oil import bill and import of industrial input materials is expected to see imports grow by 20% in CY12, some what curtail by the currency depreciation and restrictions on credit growth.
The trade deficit is expected widen by 87% for CY11 as a result of export growth lagging behind a sharp collective rise in imports of consumer, intermediate and investment goods. This has been assisted by a stable exchange rate for much of 2011 and significant tariff reductions that were announced in mid-2010. Garment and textile exports which accounted for approximately 40% of total exports in 2010 has grown significantly in the current year with competing manufacturing destinations being less attractive and reliable for the niche players that Sri Lanka caters to. This has however failed to match up to the growth in imports reflective of the increase in domestic demand and business activity in the island. The resulting deficit has resulted in pressure on the currency to depreciate.
Net remittances have remained strong and grew by 25% amounting to US$ 5.14bn for CY11. Strong inflows to government securities in 2010 along with the sixth tranche of the IMF standby facility pushed gross official reserves to US$ 8.05bn at end August, equivalent to approximately 5.3 months of imports. Despite strong export growth and healthy worker remittance inflows, BOP pressure stemming from a widening trade deficit resulted in intervention by the central bank to stabilize the exchange rates. This led to reserves declining to US$5.9bn by end 2011, equivalent to approximately 3.5 months of imports.
The Central Bank with effect from 10th February 2012 decided to limit its intervention in the forex markets, by limiting the supply of foreign exchange to the extent needed to settle oil import bills and absorb excess forex liquidity entering the market, such as, from issuance of Tier 2 capital by banks and inflows into equity and bond markets. The local currency has since depreciated by 6.66% against the US$ to 119.37, whilst depreciating by 7.43% and 7.34% against the Euro and Sterling respectively. The depreciation of the currency and credit growth restriction on banks is expected to curtail non-essential imports while capital flows are expected to be healthy along with sound export growth and healthy worker remittance inflows and tourism earnings. We expect the exchange rate to stabilize at current levels.
Market Overview and Strategy…
A steady decline in the indices over the last 12 months has resulted in the market trading at more rational valuations having priced in the macro head winds the economy faces at present. The significant correction on the indices followed a sharp rise in largely credit driven speculative trading on illiquid and second tier stocks in 2011. The ASPI declined by 8.46% in 2011 and is down a further 101.11% YTD in the first two months of trading in 2012 registering an overall decline of 29.98% from its peak in end February 2011. The speculative run up of second tier stocks to irrational levels was largely funded by excessive and unsustainable levels of credit disbursed to local retail and HNI investors which included a wave of new investors in the market that were attracted by prospects of significant returns in excess of benign fixed income returns that had declined significantly since the end of the war. The number of new securities accounts opened in 2011 was nearly double that of the previous year. Speculative trading on second tier counters accounted for approximately 40% of turnover in the second half of 2011.
Foreign participation in the market declined to just 11% in 2011 from 30% in 2009 and 19% in 2010. Higher near term valuations of Sri Lankan equities compared to regional peers at the time resulted in foreign participation also continuing to consistently account for net foreign selling throughout much of 2011 stemming from a trend that started at the tail end of 2010. Several new listings which opened trading in a declining market performed poorly and contributed towards dampening investor sentiment. This collectively dragged the broader indices lower, with the more liquid Milanka index declining by 25.95% during 2011.
Turnover levels have since declined appreciably with average daily turnover levels in the 4Q CY11 down to Rs. 1.06bn from Rs. 2.7bn in the first 9months of 2011 and Rs. 2.4bn in 2010, indicative of weak buying interest as market participants chose to remain on the side lines
Near term valuation of Sri Lankan equities now rank more favourably with regional peers. Whilst we expect market sentiment and overall buying interest to remain weak in the short term given current concerns over the exchange rate, higher energy prices and a moderate rise in interest rates, current price levels do provide medium to long term investors with an opportunity to incrementally build fresh positions in the market.
Outlook …
Corporate earnings growth remains sound with expectations of FY12E normalized earnings growth of 22.3% and FY13E of 16.2%. This follows steep normalized earnings growth of 72.6% in 2010 for the JKSB Universe.
Businesses across most sectors benefitted from sharp volume driven earnings growth and improved capacity utilization levels. Banks recorded healthy credit growth assisted by excess liquidity in the system at the start of 2011, while the leisure sector continued to enjoy healthy occupancy levels and manufacturing and domestic retail businesses benefited from high disposable income levels and increased domestic demand. Further benign interest rates continued to result in lower finance expense for businesses, and lower credit default risk and improved recoveries for banks and finance companies. Moderate inflation kept operating expenses in check with tax reductions announced in the November 2010 budget improving net margins across the board.
We anticipate businesses to continue to display healthy volume growth stemming from sustained demand and investment in new capacity. Inflationary cost increases particularly with higher energy prices and possibilities of higher wage expense will impact earnings while finance expenses are expected to rise whilst the net margin boost from the tax reduction will be normalized in the current year. It should also be noted that the adoption of IFRS for presentation of financials from 2012 onwards would require closer scrutiny to decipher recurring company performance.
Despite the sound corporate earnings outlook, current headwinds of interest rates trending higher, higher operating costs for businesses, uncertainty over the exchange rate as well as intermittent selling pressure stemming from unwound credit positions in the market, still cloud investor sentiment.
Given this environment margin funded equity investments are unlikely to generate significant returns in the current year.
With the end of the post war bull run, several fundamentally strong counters are trading at single digit and low double digit multiples on 1 yr forward earnings estimates, whilst exhibiting a healthy sustainable earnings growth outlook of 18% - 25% over the medium term. While timing is everything in generating returns in such an environment we remain bullish on the long term post war growth prospects for the Sri Lankan economy and fundamentally sound stocks positioned to benefit from this growth should provide sound returns over an 18 to 24 month period."
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