How to time equity investments?

Investment returns are highly correlated to the risks that they are exposed to. Investors look for risk rewards characteristics of investments to determine an investment portfolio that best suits their individualistic risk appetites.

Risk seeking Vs Risk aversion
Based on the risk appetite, investors can be classified into risk averse, risk neutral and risk seeking. Risk seekers would potentially invest in securities, which offer the greatest returns while exposed to an extremely high level of credit risk and market risk. Investing in more speculative stocks in the equity market with the aim of short term profit making is a typical example of risk seeking.

Risk averse investors will opt for treasury bills issued by the Government, which are considered to have zero credit risk. Risk neural investors would like to balance a strike between the risk and rewards.

Yields on Treasury bills will have lower returns compared to other investment securities with similar maturities. The key reason is treasury bills are issued at the full faith and credit of the Government in each country.

A traditional mismatch between risk and rewards in Sri Lanka
However, Sri Lankan treasury bills are an exception. They have a historical track record of providing higher rate of interest compared to the fixed deposits with similar maturities. Hence, a traditional risk reward mechanism does not exist in a local context. Historically high level of budget deficit driven by high fiscal spending on defense and fuel subsidies, led Government to borrow aggressively in the domestic market pushing the interest rates higher. This has been the rationale behind the high interest rates on treasury bills. Due to the high level of Government borrowing from the local money markets, private sector borrowings and investments are often crowded out. A historically high borrowing rate has been a hurdle for private sector investments.

Alternative investment opportunities in a Sri Lankan context
Moving back to the topic, majority of the retail investors in Sri Lanka are comfortable depositing the money in fixed deposits and treasury bills. Equity markets are a substitute for fixed deposits and treasury bills. However, the equity participation rate is considerably lower due to the lack of awareness of the equity market.

Relationship between interest rates, inflation and stock market growth
Looking back at the last 10 years of historical data in Sri Lanka, it is clear that money market investment in many years provided investors with a negative real return. Real returns exclude the element of inflation from the nominal returns of investment and provide a better basis to compare between investment returns in the process of investment decision making.

Suppose, if the interest rate is 10% for a fixed deposit and the average annual inflation is 12%, by investing in the fixed deposit an investor is losing 2% per year, after factoring in the inflation. Hence, the real return is negative 2%. This is a call for investors to look at alternative forms of investments such as equity markets.

When the interest rates on deposits is lower than or same as or marginally higher than the rate of inflation, investors exit from the fixed deposits and invest in real estate and equity markets. Hence, there will be new cash inflow to the equity market (switch from fixed deposits to equity shares), this will generally lead to a bull run in the equity market.

Conversely, if the real return is significantly positive (deposit rates are higher than the rate of inflation), then investors will queue up in banks to deposit money in fixed deposits. This will trigger a sell off in equity markets, dragging down the stock market indices and returns.

Effect of margin trading on equities in Sri Lanka
In the mean time, if the interest rates are high on borrowing, margin trading on equities will not be attractive. This puts investors again on the existing mood, triggering a margin sell off in the equity markets. Likewise if the borrowing rates are kept below the inflation rate, margin trading will look lucrative. As a result, equity markets will see a considerable growth.

It is clear that a country’s macro economic climate and key variables such as interest rates and the rate of inflation will play a significant role in the equity market. If the Central Bank of Sri Lanka increases the interest rates to keep the inflation under check, it will badly reflect in the company share prices as investors will switch investments from equity to fixed deposits and treasury bills. Likewise, if Central Bank is comfortable with the rate of inflation and it wants to facilitate the economic growth, the interest rates will be reduced. This will transfer wealth to equity markets, triggering more demand for company shares and will push the returns higher. Hence, it is important for an investor to decide when to enter the equity markets and when to exit.

We have undertaken a historical evidence check to evaluate the relationship between real interest rates and Colombo stock market growth. It was noted that stock market indices rose when the real return on fixed deposits were negative or marginally positive. Likewise, when the interest rates were increased to control the inflation, stock prices have been hit hard.

2006 stock market growth – key drivers
2006 was a fantastic year for the share market where the All Share Price index (ASPI) shot up by 42%. In 2006 Sri Lankan Central bank adopted an expansionary monitory policy to facilitate economic growth. As a result Sri Lankan real GDP expanded by a healthy 7.7%. However, this was done at the expense of inflation. Interest rates were kept low despite worries over high inflation. Investments in fixed deposits were bleeding cash due to low interest rates and high inflation (negative real returns). An additional key driver for the ASPI growth in 2006 was margin trading. Banks were lending money at lower interest rates and this made investors to borrow money from banks to invest in equities. Macro fundamentals were very weak and were further dampened by the Central Bank’s move to facilitate growth at the expense of inflation.

Drastic fall in the stock markets in 2008 – key drivers
In the latter part of 2007 and throughout 2008 when the inflation accelerated to an un- acceptable level Central bank started to tighten the monitory policy by increasing the interest rates and introducing stringent credit criteria for bank lending. Due to the loose monitory policy in 2006, inflation hit 23% in 2008, a figure still considered by economists as significantly understated. Inflation calculation in Sri Lanka has not been accurate due to the consumer price index weighting.

Due to the tight monitory regime in the later part of 2007 and 2008, banks were collecting fixed deposits at 20-24%. Additionally, banks were involved in an extremely cautious lending and temporary overdrafts were provided to businesses at 40%. Treasury bills were issued at an average rate of 20%. This led a permanent sell off in the equity where the ASPI fell by 41% in 2008 followed by a dip of 7% in 2007. In addition, earnings of listed corporates were negatively affected with high interest rates on borrowing. This led value investors too exiting the market. This significantly wiped out the gains made in the equity market in 2006.

Effective timing in equity markets is a must
The above is a very good example of policy effects in equity markets. Equity markets are generally based on investor sentiment rather than key fundamental drivers. Therefore, there are a lot of arbitrage opportunities for investors exist, who are capable of timing their investments efficiently. When to enter and exit the equity market is the key challenge.

Bull markets Vs bear markets
When the investor sentiment is high and market is already in a bull mood, it does not always indicate a sell call, although a technical correction is generally inevitable. Likewise, in a bear market when the investors are jittery about the market outlook, still the bottom fishing may not be always rewarding. It’s very difficult to catch a falling knife; it requires great skills, knowledge and experience. But, still could be painful.

The way forward
According to the March 2010 Central Bank monitory policy review, the average annual inflation as of Feb 2010 was contained at 3.1% and year over year change in consumer price index increased to 6.9%. According to the policy review, it is clear that Central Bank is comfortable with current rate of inflation and will not hike the policy rates at least during the 1st half of 2010. Currently Central Bank adopts an expansionary monitory policy with lower interest rates to facilitate the economic growth. However, if this continues, inflation fears will be mounting. Lower interest rates and higher rate of inflation will trigger sustainable growth in the equity markets where the fixed deposits are not attractive and margin trading becomes less expensive.

Moreover, the stock market also depends on how fast the lower interest rates on borrowing turn to positively affect company earnings. Lower interest rates are beneficial to companies in two ways. Firstly lower borrowing rates will trigger consumer demand and would support company profits. Secondly, if the company has high level debt in its balance sheet, it will benefit from lower interest rates and the P&L effect could be considerable.

Therefore, the stock market will see sustainable growth (at least modest growth) post election, if the central bank continues to hold its policy rates. But, in contrast, when Central bank starts to increase its policy rates to control inflation, Colombo stock market will start to tumble.

However, it is evident that the Central bank currently wishes to maintain its easing monitory policy stance. Sri Lanka is forecasted to grow at an average of 6.4% over the next three years, with high growth forecasted in 2012.

We have to wait and see how central bank manages the country’s growth expectations while managing the inflation risk. This will have a greater impact on general economic environment as well as on equity markets.

Are Sri Lankan equities trading at high valuations?

World's second best performing equity market

Colombo stock market index (ASPI) has increased by ~94% since May 2009. The key reason was the Government victory against LTTE, which ended a 30 year ethnic conflict. The equity market picked up drastically and investor sentiment improved significantly. The equity story is very much associated with an expected economic revival and the resultant positive effects on corporate earnings.

Sri Lankan economy - historical drawbacks

Sri Lanka, a South Asian Island has a GDP size of ~USD40bln. The market capitalization of the listed companies accounting to ~USD10.8bln. An unacceptable level of budget deficit led by high defense spending due to a 30 year old war and fuel subsidies coupled with a balance of payment crisis remained the historical problems of the Sri Lankan economy. Extremely high defense spending by the Government, unjustifiable level of Government subsidies, no tax revenue generation from state workers have been the culprits behind the high level of budget deficit, which kept the economy under a 'vicious circle'.

Current account surplus in 2009 after 33 years - Is this a random event?
However, the current account in balance of payments turned positive in 2009, after being in red for the last 33 years driven by a reduction in trade deficit and a measurable expansion of worker remittances. Trade deficit in 2009 was USD2,799mln (USD5,898mln 2008) supported by significantly lower crude oil prices, despite an year on year reduction in exports. Workers' remittances rose by 14.1% to USD3,330mln, which helped to fully offset the trade deficit of USD2,799mln, leading to a current account surplus.

Do not under estimate the disadvantages of a managed exchange rate mechanism
On the other hand the balance of payment crisis enlarges when the Central Bank intervenes and manages a free floating exchange rate mechanism, what is termed as a 'dirty floating'. Moreover, pegging the rupee against dollar could reveal similar problems going forward, making the exports less price competitive. In order to sustain the present current account surplus, focus should be on increasing exports and tourism arrivals. Because, as the global economy recovers, commodity prices such as crude oil will start to rise, leading to an increase in imports, dampening the trade deficit. This raises questions as to whether the present current account surplus is sustainable?

Postwar Sri Lankan economy - key drivers
The post-war economic revival is very much attached to the renewed economic activities in North & East. Agriculture, manufacturing, banking, trading, education, telecommunication and tourism are potential areas for growth in the country's former war zones. In addition, tourism arrivals have already started to pick up significantly to a level, where we started seeing 50,000 arrivals for a month. This is the start-up of a turnaround story.

To what extent the tourist arrivals can be increased?

However, the biggest hurdle in increasing the tourist arrivals is the lack of sufficient capacity to accommodate the increased arrivals. Country has to focus on expanding the capacity in the leisure sector, while ensuring that proper infrastructure is in place. The pace and size of the economy recovery would depend on how fast the defense spending could be curtailed and shifted towards infrastructure development. Post war economic policies need to be strong and an effective execution of the policies is a must.

Are Sri Lankan equities trading at high valuations?
P/E ratio was at high single digits during April 2009, before the end of the war in May 2009. However, a 94% hike in the share prices, since May 2009 have pushed up the trailing P/E of the market above 18x. Sri Lankan equity market became the second best performing market in 2009, after Russia. Moreover, the ASPI has increased by 10% year to date 2010. These facts, if looked at in isolation could mean that, the equity market is overbought and a technical correction is inevitable. However, the following factors should be analyzed further to arrive at conclusions.

The evolving questions are,
01) Is the market trading at extremely high earnings multiples?
02) Do sell side analysts find it very hard to validate value calls at the current high share prices?
03) Have all positive news been factored into the share prices?
04) Has the market over reacted to a war end scenario, as a result will the share price growth be sluggish ?

There are no straight forward answers to the above questions. However, the following analysis tries to provide a forward outlook thoroughly based on fundamental factors.

Forward outlook
Share market growth in Sri Lanka since May 2009 was driven by two main factors. Firstly, it was a re-rating of the earnings multiples in the market. Historical trading range of P/E multiples for the Sri Lankan equity market has been ~9x-12x. End of the war has made it very clear that the Sri Lankan equities deserve a much higher P/E multiple than ever before.

Secondly, the positive effect on future corporate earnings. The post war scenario is expected to bring about an economic recovery. This will help companies to increase the profitability and shareholder wealth. Hence, rating the market based on forward earnings multiples (after factoring in the positive effects of an economy revival) would result in lower than the trailing P/E multiples. It should be noted that the trailing P/E multiples could be a crude measure of a company's equity valuation during a period of economic restructuring. Simply because trailing P/E multiples (the denominator, i.e EPS), do not reflect the benefits of a post war scenario. Hence, the trading activities take place based on forward earnings multiples. Strictly speaking 2011-2012 corporate earnings need to be forecasted and a P/E multiple should be established based on the respective EPS in 2011-2012. The underlying assumption is that the positive effects of an economic recovery, will affect the company earnings significantly, only during 2011-2012.

The key challenge is to find out the real beneficiaries of the economic revival and the size of the benefits!

Hence, sell side analysts in the Colombo equity market should be responsible in carrying out rigorous forecasts of corporate earnings for the next three years. However, the earnings visibility is poor; the companies have no historical evidences of a post-war scenario. Hence, forecasting the future earnings and factoring in the benefits of a post war scenario could be very tough and would require high level of analytical thinking. Hence, at this stage the analysts can place a significant emphasis on book value based valuations to pick stocks.

Sector based recommendations could be healthy. It appears that hotel sector stocks still have potential to rise as they report positive earnings time to come. The biggest beneficiary of the economic recovery will be undoubtedly JKH, a blue-chip with the largest leisure exposure in Sri Lanka. In addition, historical P/E of JKH is ~25x, double the historical P/E of the market, i.e 12x. Hence, it is clear that the share has further growth potential going forward. The subsidiaries of JKH such as KHL, TRAN, and AHPL too are good buys. But, at this stage we should focus on the ultimate parent company, i.e. JKH. The profits of all the subsidiaries will get consolidated in JKH at the end. Hence, JKH share has a higher potential than its subsidiaries. In case, if the share reaches above Rs 200/-, nobody can rule out a share split. This could further improve the liquidity of the share and facilitate retail as well as foreign participation. Hence, it is recommended that JKH is a strong overweight at the current price levels Rs 168-170.

More thoughts will follow in the forthcoming notes.

Disclaimer : This comment is based on the author's understanding and knowledge. This is only meant for personal use and cannot be considered as an offer to buy or sell securities.