ECHELON | 22.07.2019
EQUITY HAS BEEN A POOR INVESTMENT FOR THE LONG TERM. BUT HAS THE CURRENT LOW VALUATIONS CHANGED THE EQUATION?
Not every investment truism applicable in rich countries are relevant in Sri Lanka. Or so the data suggests. Over 35 years, Sri Lanka’s stock market returns, including dividends, haven’t beaten by much risk-free returns of fixed income. In that time, the one year T-bill has returned 13% annually. As a norm, investors expect listed companies to generate a return 5% more than fixed income. However, in those 35 years, stocks returned just 13.2% annually, including the dividend yield (12.2% excluding dividends).
So how should that inform asset allocation for the next couple of years? We discussed a potential strategy for equity, fixed income and real estate with three investment bankers and one fund manager. The investment bankers joining the discussion were Dimantha Mathew, Head of Research for Investments at First Capital Holdings, Kavinda Perera, Senior Vice President Research at Asia Securities and Udeeshan Jonas, Head of Research at Capital Alliance Securities. They were joined by Rusiru Abeyasinghe, Chief Executive at National Asset Management, a fund management company. Excerpts of an asset portfolio strategy discussion are as follows:
Until recently, portfolio managers advised clients to stay liquid and in fixed income for the most part as the returns were phenomenal while uncertainty was high in equity. With stock prices now having declined in 2019, do you think that investors must reconsider their portfolio allocations?
Dimantha: We are forecasting rates will fall. One year T-bills are coming down to 8.5%, and five-year bonds will fall to 9.5% over the next couple of months. That means a decline of 30-50 basis points (0.3% to 0.5%) from current levels. It’s linked to banking rates too. From July 1st, the fixed deposit ceiling is to come to less than 10%, which will be after a long time. That’s the point when investors usually feel returns are insufficient. We expect rates to remain low over the next six months to one year because the Central Bank is looking to raise another US $2.5 billion before the elections. We are sure to have sufficient resources to absorb any shock if we go ahead with the planned debt raising.
Are you forecasting a change in the attraction of equity as an asset class?
Kavinda Perera: Fixed income’s attractiveness won’t reduce so much in the near term. There is already excess liquidity in the system. Yesterday it was Rs48bn. Low investor confidence will keep credit growth down for another few months. If another International Sovereign Bond is issued, there will be a lot of liquidity in the market. It’s best to then stick to the shorter end of fixed income. On the equity front, the critical catalyst we see are the elections which favour equity as an asset class at the moment.
Rusiru Abeyasinghe: I agree, interest rates will decline, and assets should shift from fixed income to equity. On a one to two-year view, things are positive. However, the next six months will be turbulent in the market, which requires long holding power. Anybody buying stocks with a one to two-year view is entering at almost the bottom of the market. Valuations are low compared to other frontier markets. The apparent upside depends on how companies react to the events of April 2019 and how agile they are. So, a long term investor should gradually start shifting to equities. The strategy must account for two changes; that yields are coming off their highs and that any shift into assets such as equity should take into consideration the expected turbulence during the next six months.
THE SLOWDOWN DUE TO THE EASTER SUNDAY TERROR ATTACK IS A TEMPORARY PHENOMENON AND NOT A STRUCTURAL IMPACT ON THE ECONOMY
Real returns or risk-adjusted returns on fixed income are difficult to ignore?
Udeeshan Jonas: I agree interest rates will decline in the short term. Budget funding has been addressed, for now, since we secured US $5.8 billion in sovereign loans, enough to settle the maturing $5.9 billion in loans this year. With the planned further borrowing we are creating a buffer for 2020 as well. Hence there is no pressure on interest rates. Private sector credit demand is also low. Businesses are waiting for clarity from the elections. So the economy is operating at low capacity. Market Debt to Equity ratio (total debt in a company compared to equity) shot up to 40%, which is high for Sri Lanka in comparison to historical levels. Companies are trying to reduce their debt. Some companies, such as Hayleys and Laugfs Gas, are heavily borrowed.
What you are saying is that economic stability will return at the cost of growth. This is not the sort of economic recovery we would have liked?
Udeeshan: Monetary policy measures don’t immediately translate into credit growth. It takes 12-24 months for interest rate adjustments to be reflected in rates of changes to credit. The slowdown due to the Easter Sunday terror attack is a temporary phenomenon and not a structural impact on the economy. So it’s possible to buy into equities and expect things to get better. The Price to Earnings ratio (PE ratio) is at 8.2 times. We have to consider the market earnings yield versus fixed income yields. If I’m putting down a dollar of investment, how much profits are the companies making? The market earnings yield now is lower than fixed income returns. It is 8% plus whereas one year T-Bill is around 9%. So there is a case to start allocating to equity because fixed-income yields are falling. When bank fixed deposit rates come down below 10% from July 1st 2019, people will start considering investment in equity as an opportunity.
Kavinda: The valuations being so low, can be attributed to two facts. First, the political instability we have and that has been going on since February 2018, after the local government elections. When that happens, there is policy uncertainty and leads to investors moving out of risk assets. The second is the overall macro weakness we are seeing. Companies, consumption and earnings are all affected. Once the political instability is addressed, that will impact valuations.
How would you advise someone about equity investing knowing that we have this big election around the corner?
Rusiru: The straightforward answer to that is an investor needs to have a long term view. You have to look at the fundamentals and ensure the stock has the right recipe for success, in terms of product, market and people. Historically, across the globe, equities outperform other asset classes in the long term. So, you’ve got to take that long term view. These valuations might not be available for a long time. Political uncertainty should clear after the elections, and there should be some clear policy direction on where we are heading. The economic trajectory of this country is uncertain. There are many contenders from Democrats with a commitment to openness and economic nationalists who are popular now. This does not look like a regular time for Sri Lanka. What economic policy trajectory will this country take?
Dimantha: The base case scenario we are looking at is that we are more likely to have a Presidential election first, followed by a general election after February 17th, when it’s possible for the president to dissolve parliament. Provincial council elections will follow all of these. Once the elections are over, there will be some stability. There will be three nationwide elections; the presidential followed by the parliamentary and then the provincial government one. There will be plenty of spending, which is different from the situation now. Currently, money circulation is low. We will see a reversal in that, and we expect consumer demand will pick up from there. On the external sector front, in the March quarter of 2019, our exports were growing, but imports crashed.
Tourism earnings plus worker remittances were equal to the trade deficit in the early part of 2018. In the 2019 first quarter, before the Easter Sunday attacks, tourism earnings and worker remittances were double the trade deficit. If there isn’t a lot of debt maturity or debt payments, we will have a balance of payments surplus. Unfortunately, in the first quarter of 2019, we had a significant amount of debt repayments. Once tourism earnings come back to normal around December, the macro environment will stabilize. In a stable macro environment, investors can go long term and then it makes sense to switch into equity.
Rusiru: One thing to watch is the China-US trade war and what potential benefits are for us there. Industrial activity picked up in the first quarter of 2019. This could be an indication of a shift in supply chains to our region. Obviously, we will see supply chains shift to our region; Sri Lanka, Bangladesh and Vietnam. There can be a positive impact here, especially in the apparel sector.
POLITICAL UNCERTAINTY SHOULD CLEAR AFTER THE ELECTIONS, AND THERE SHOULD BE SOME CLEAR POLICY DIRECTION ON WHERE WE ARE HEADING
Are you at all concerned that following the presidential election there will be instability because of a power struggle between the executive and parliament?
Udeeshan: The most likely scenario is when the President is elected, parliament will be dissolved by February 2020, which is the earliest it can be dissolved. Historically, in terms of how the market has performed during the previous election cycles, from 1994 to now. The market on average has returned 22% six months ahead of a Presidential election cycle. So there is sentiment which builds up in the system. This is also because the government accelerates its campaign spending program. For instance, we will see the impact of the salary and pension increases start from July and all that will trickle down to the economy. In the first quarter, consumption picked up, companies started to do well, and GDP growth inched up to 3.7%. The agriculture harvest was good, which had a positive impact on overall consumption. But the temporary impact from the terror attack has put a foot on consumer spending.
But we are just four months away from the elections?
Rusiru: I agree with Udeeshan. There was a consumer pick up during the last quarter of 2018 and in the first quarter of this year. We saw this in some of the FMCG company results. Like Dimantha said, elections will increase spending and this will fuel consumption, which will be augmented by the Rs2,500 public sector salary hike.
You are optimistic of some economic spark still, despite the setback of the April 21st incident?
Rusiru: My view is that a spark has not happened because people are unsure of who is going to contest the presidential election.
Udeeshan: Once the candidates are announced, that will be the trigger point.
Dimantha: The Election Commissioner has announced, November 15th to December 8th where the elections are going to be held. October 20th is the last day for nomination. Often one month or three weeks before that is the announcement of elections. Probably end September or early October could be the trigger point. We are two to three months away from this.
Udeeshan: Market earnings won’t improve immediately. But on anticipation that things will be better, the market might start moving.
But it is not going to yield the 22% upside in six months?
Udeeshan: You never know. In 2014, the market rallied 23%. For the market to get back to last year’s level, you have to now get a 20 odd per cent return. That scenario cannot be written off.
Equity outperforms all other asset classes over the long term, that’s an investment maxim. But over the last decade, it’s not been a pretty picture. I’m trying to reconcile this maxim about long term equity returns to what happens in Sri Lanka?
Udeeshan: One of the reasons is that structural reforms have not taken place. If you consider a foreign portfolio manager, they are not concerned about terror attacks. They look at three things; political stability, fiscal discipline, and how well the debt is managed. If two of those issues were addressed, we would have seen foreigners coming back into the market. Since it has not happened, they are taking a wait and see approach until two of these three issues are sorted. They believe that stability will come if there is one party in power after the election for 4-5 years. Debt repayments, we are solving, to a certain extent, by finding funding at a reasonable cost. The more significant problem is the fiscal deficit, which is not addressed. Our spending is skewed towards recurring expenditure, not towards capital expenditure. Structural issues are linger, which is why market rallies have been short-lived. In the last 20 years, fixed income returns have outperformed equities in Sri Lanka.
FROM 2012 ONWARDS IF YOU DRAW A CORPORATE EARNINGS GRAPH, THERE HAS BEEN A LOT OF VOLATILITY, BUT IT IS MORE OR LESS FLAT
Will equity returns beat fixed income in the future?
Dimantha: From 2009 it has performed positively. But, from 2011 onwards returns are definitely below fixed income. From 2012 onwards if you draw a corporate earnings graph, there has been a lot of volatility, but it is more or less flat. Then it is understandable why the market has not performed. That means over a 5-6 year period, earnings growth has been almost zero. In such circumstances, you attach a lower multiple for that market. Over the past few years, every year, there has been at least one uncertainty. There has also has been some sort of reform happening every year. That is one reason why we see export growth. Obviously, GSP+ would also have helped.
Rusiru: What factors are going to support that earnings growth? One key element I feel is tourism. We witnessed traction in tourism growth over the last 2 to 3 years when Sri Lanka started getting on the map as a tourist destination. When that growth happens, it has a knock-on effect on the rest of the economy. On the other side, there was a lull in the construction sector, but there are projects which will come on board over the next few years. For example, the Port City reclamation is almost complete and that activity will have a knock-on effect to the broader economy. So there are certain things which emerge in the next few years which we didn’t have over the last few years, which will have a knock-on impact on consumption and through that corporate earnings.
Would you allocate the asset classes of equity, fixed income and real estate differently now than you did six months ago?
Dimantha: During the 12 months before the Easter Bombings, we saw tourism earnings growing at a much faster pace. Increasing numbers of arrivals were not just backpackers, we were starting to see high spenders also coming in. We see tourism services being marketed, some tourists come for adventure. That was the change that was happenings. Six months down the line once it revives in full, that will have an impact. Tourism earnings will grow faster than the arrival numbers.
How does this impact your view on asset allocation?
Udeeshan: Even during late 2018, we were advising investors to move into fixed income and lock in for two years. Portfolios have to be leveraged for the best returns. Now with single-digit interest rates, I would say if your allocation previously was 80% fixed income and 20% equity; now should be 60% fixed income and 40% equity. Now you are weighing more towards equity.
How do you see that evolving Udeeshan?
Udeeshan: Probably we would see another 50-100 basis point (0.5 to 1%) interest rate reduction very soon. At that point, it might change. But we will also have to take political instability in to account.
Does it look like the Easter bombing has helped put right some of Sri Lanka’s macro imbalances?
Rusiru: That also and the dovish stand the US Fed is taking. Analysts are expecting Fed rates to be low. There has been a shift in foreign fund managers to different countries. The yields were 50 basis points lower than the past for the five-year US $2 billion sovereign loan. But the spread with the 5-year US bond has increased. So we’ve taken the benefit of dovish central banking regimes of rich countries.
Udeeshan: The reduction was because US yields are coming down. In Sri Lanka, we are going through a cycle of monetary and fiscal easing. Its a double boost to the economy. Surely there will be long term repercussions, but in the next 12 months, it will be an economic boost.
Rusiru: Most investors haven’t looked at the property market. The land price index, which the Central Bank publishes every six months, has grown by double digits between 2015 to 2018. If you look beyond the ritzy, high risers which cater to a niche market, there still is value and returns to be obtained in different segments of the real estate market.
IF YOU LOOK BEYOND THE RITZY, HIGH RISERS WHICH CATER TO A NICHE MARKET, THERE STILL IS VALUE AND RETURNS TO BE OBTAINED IN OTHER SEGMENTS
How will the rest of you allocate a portfolio across these three asset classes?
Dimantha: At the beginning of 2019, we recommended a very low allocation to equity. It was 80% fixed income and 20% equity. We were also wary about real estate due to the economic downturn in the last 3-4 years. Gradually however, we have started allocating assets to equity. In early April we significantly increased the equity allocation to 45% and 55% on fixed income on an expectation of consumer demand picking up. We had an excellent first quarter in 2019. After the Easter Sunday attacks, we again increased our fixed income allocation to 65%. In around a month, we will move back to previous ratios as we forecast interest rates will decline. Equity allocation will increase to 45%.
Kavinda: In a general sense, allocating more towards equity is a good idea now. Fixed income hasn’t lost its appeal either. Real estate is something you need to approach selectively. Lower interest rates will boost property demand. We are bullish on the consumer sector stocks. It was one of the sectors primed for a pick up this year. However, after the Easter bombings, we are cautious. The June 2019 quarter is going to be the worst quarter for earnings. The results will prove which companies are the most resilient.
I am sure June quarter financial results will be revealing. But where are the opportunities in equity now?
Rusiru: Let me start with real estate. Given the trend in real estate prices and the demand in the economy, we need to give importance to real estate as an asset class. It’s not something you want to miss out on. I would increase exposure to equity with a one and half to two-year view. When you do that, look at where the economy is heading and what will drive growth. Which sectors are going to drive the economy upwards? In that movement upwards, what other areas are going to benefit? Ideally, look at stocks which would move well with the market.
Where are the other opportunities in stocks?
Dimantha: Telco is one area we are positive on. Exports are also untouched by domestic troubles and are doing reasonably well. Possibly, in around two months from now, opportunities in the consumer sector will emerge.
Kavinda: Telco, healthcare and insurance, these are the robust sectors that you can pick stocks from.
Udeeshan: Telcos have inelastic demand. If you are getting into the market immediately, telco and exports will be the sectors to consider. There is a spillover effect from the US-China trade war that will benefit us. With consumption stocks, the market reacts to earnings. So you might be better off picking consumption-related stocks probably towards September. So there is a sequence almost; telco, exports and then consumption. You move into banking and finance afterwards. If banks don’t perform well, that means the market isn’t very healthy because banks and finance are 45% of market capitalisation and 60% of earnings. Eventually, that sector will move up, and the valuations are low. But the movement will happen later in the cycle. It won’t be the first to move. That is my order of preference on how to approach equities.
Dimantha: After consumption stocks, I think the banks have the best investment potential and the finance companies after that. With real estate prices off their peaks, I may allocate a portion towards the end of the year to real estate as well; around 10-15%. With an LRT under development, I may allocate to suburban real estate.
AFTER CONSUMPTION STOCKS, I THINK THE BANKS HAVE THE BEST INVESTMENT POTENTIAL AND THE FINANCE COMPANIES AFTER THAT
Real estate options are diverse; from condos, land and urban and suburban areas. Where do you see an opportunity for investment as an asset class?
Rusiru: Let’s take a long term or twoyear view on this. We have got to see the areas where there is going to be development. You need to tie it down to Western Region Megapolis plan. There are the Meerigama and Horana industrial zones that are a focus of the Megapolis plan. There are Homagama, Kaduwela and Malabe for the IT zone. Airport to Colombo Port logistics corridor. We are going to see demand growing in these areas. Regardless of which government is in place, this development is going to be driven through. Connect to that the multi-modal transport hubs being established. The first one is up in Kottawa. Moratuwa, Panadura and Kaduwela are planned. We are going to see more development activities in these areas.
The urban sprawl is now evident. People are moving into suburban areas for the affordability of housing although they have to give up family time to make the long commute. The urban sprawl is also creating pressure on services like garbage collection and sewerage. Segments of this population would gradually now shift to condos to be able to live closer to the city. Apartment living in Colombo is significantly lower to peer cities, and there can be demand in the Rs25-40 million range. With changing lifestyles, families no longer need large spaces to live in. Real estate is a challenging asset class to invest in administratively, you have to do it on your own because nobody else is going to do it for you. This will drive a lower asset allocation, possibly 25-30% allocation into property given where the country is moving to.
If you have Rs50 million in investible assets and you are 45 years old, how here would allocate it now?
Dimantha: Roughly, 45% into equity and 45% in long term fixed income and 15% in shorter-term fixed income.
Kavinda: For a 45-year-old, with moderate risk appetite and 15 more years for retirement, I would look at 20-25% into equity 30-40% to fixed income and the balance in real estate.
Udeeshan: In the longer term I will go 25-30% in equity, 20% in suburban real estate—since a Rs250,000 monthly income can meet the commitments of a Rs20-25 million loan—and 30% to fixed income. My view is that in 12-18 months, fixed income returns will probably start bouncing back.
Rusiru: You are looking at a 45-yearold who has only 15 years to work at least. I would go with 35% equity with a long term view. 25-30% in real estate, ideally look at suburban. Balance into fixed income.
I am struck by how little you are all allocating to equity. Is it because you are not optimistic?
Dimantha: I allocate 45% but the majority, or 55% it is either in the short term or long term fixed income. Zero per cent into real estate. It’s Rs50 million to allocate, which is not sufficient for real estate in my view. In a Sri Lankan context, listed equities don’t represent the full market. Only a handful of companies represent the export sector on the market. Whereas fixed-income returns have been actually attractive.
The preference for fixed income is also because you anticipate inflation to remain low?
Dimantha: Instability in the system usually pushes up interest rates giving higher real returns in the fixed income side.
Rusiru: It also reduces your downside risk. Equity allocation here ranges between 25 to 35%, with the balance in fixed income and real estate. What is the theme across those two asset classes? Its a way of retaining value whereas with equity it could go the other way.
Udeeshan: Structural problems have not been solved, the fiscal and current account deficits have not been addressed. We are borrowing at lower rates now, but that is temporary. Very soon our debt to GDP will be 100%. In three years, we have to find some new tax increases to pay the debt, and that will impact corporate earnings. If you take a long term view, equity will underperform. The all-share index in 1985 was 100, it is now at 5,500. So on a compounded annual basis, its a 12.2% return. Adding dividends into account, it’s only 13.2%. T-bills have yielded 13% return and fixed deposits 14% in that period. So historically, fixed income has outperformed equity, considering its much less risky. Until structural reforms take place—getting the budget deficit sorted, managing the debt and restructuring the government balance sheet—these problems will persist. Equity rallies will only last one to two years. After that, these same problems will emerge.
If you are managing money, you have got to be more hands-on in the next two years than you would have been in the last 3-4 years?
Udeeshan: In terms of asset allocation, I don’t believe we should buy equities and hold for 5-6 years. Currently, I would allocate 30-45% to equity now and gradually shift into fixed income when I see 13% bank fixed deposit rates, you go and lock it. I’m not suggesting that you buy and hold equity. Real estate will take much longer, but there might be distressed assets at cheaper valuations. Fixed income rates will be better in the next 18-24 months.
Rusiru: From a hands-on point of view, you should be shifting from fixed income into other asset classes, including equity. Also, you have to be more hands-on and ready to move between those asset classes as times change. Right now, shift into equity, like 35%, and given the potential of the property market, ensure that capital is protected and you benefit from the growth and demographic shifts that are taking place.
Kavinda: We should actively manage the asset classes. It’s not the overall listed stocks we are positive about but limited stocks and sectors that can provide higher returns than others. We need to be active in shifting between stocks and between the asset classes.
Dimantha: Yes, you have to be hands-on. Almost every other month, we have been changing our asset allocation, and over the next few months, we will continue to increase allocation to equities. We will allocate a portion of 10-15% into real estate towards the end of the year or early next year.