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.