Market returns in Sri Lanka look positive thanks to economic and public investment reforms

Sri Lanka’s third quarter 2018 GDP growth dipped to a record eight-year low of 2.9% – compared to 3.3% in the third quarter of 2017 and 3.7% in the second quarter of 2018 – leading to a cumulative expansion of 3.3% for the first nine months of 2018, which was expected to continue to the end of the year. The struggle was primarily evident in the industrial segment, which rose by a mere 1.8% year-on-year (y-o-y), while over the first nine months of 2018 the agriculture and service sectors expanded by 4.3% and 4.4% y-o-y, respectively. The main reasons for this sluggishness were weak domestic demand, government consumption spending and lower export performance. Incompatible economic policies driven by political instability also postponed public and private investment, key drivers of the economy.

Despite this, First Capital Research (FCR) expects macroeconomic conditions to improve in 2019, with a GDP growth target of 4.3% for the year. In line with GDP, earnings growth in listed companies for FY 2019/20 is likely to improve to a modest level of 8-10%, supported by a sharp decline in commodity prices led by the dip in oil prices. This should benefit Sri Lanka’s balance of payments and positively affect the cost of living. While consumer demand is likely to benefit from a potential consumer friendly budget before upcoming elections, earnings should accelerate by 10-12% towards FY 2020/21, backed by further improvement in the economic health of the country as a result of policy easing and renewed stability in the system due to structural reforms that have already taken place.

Valuations & Markets

The All Share Price Index, the main benchmark of the Colombo Stock Exchange (CSE), declined by 5% in 2018, down from a 2.3% gain reported in 2017. Meanwhile, the bourse’s Standard & Poor’s Sri Lanka 20 index, which features the CSE’s 20 largest and most liquid stocks, recorded a dip of 14.6%.

Current valuations display attractive opportunities, with an average market price-to-earnings ratio (PER) of 8.5, which is a significant decline from the 16.7 seen in 2015. Meanwhile, the current average price-to-book value (PBV) is 1.2, down from 2 in 2015. Dividend yields increased to 3%, compared to 2% in 2015. Sri Lanka therefore provides an attractive window, as regional peers trade at much higher multiples: India’s National Stock Exchange NIFTY50 boasts a PER of 27 and PBV of 3.3, while the Ho Chi Minh City Stock Exchange averages a PER of 17 and a PBV of 2.4.

Market returns are likely to be slow but positive in the first and second quarter of 2019 due to attractive valuations. Overall returns are forecast to be 10-12% above expected earnings performance, with the promise of a better macroeconomic landscape in 2019. Furthermore, returns should accelerate approaching 2020 to about 15%, with boosted earnings performance and renewed confidence as reforms come into play. However, the expectations are dependent on the current stable outlook and reform agenda continuing over the short term.

Equity Performance

From a sector perspective, FCR continues to expect banking to outperform other sectors in the market. Credit growth in the last few years exceeded economic growth by a wide margin. Many large banks have a solid capital base preparing for full implementation of International Finance Reporting Standard 9 and Basel III. We expect the consumer-led food, beverage and tobacco sector to also recover beyond the first quarter of 2019 amid lower commodity prices and consumer-friendly government measures, which will improve consumer spending power.

Additionally, Sri Lanka expects around 4.5m tourists by 2020 and needs to increase the number of hotel rooms by about 41,000, while the rising of the middle-income class is expected to require at least 5000 condominiums, and boost the food, beverage and tobacco sector. Apparel is predicted to progress due to the restoration of the EU Generalised Scheme of Preferences, boosting trade with European markets. The sector contributed around 47% to total exports in 2018 and export growth is expected to continue.