The stock market is a lumbering elephant

Thursday, 24 July 2014 00:00 - - {{hitsCtrl.values.hits}}

Without a vibrant stock market, Sri Lanka cannot create a private sector economy that will drive high growth

Make the elephant dance

There has been a lot of focus recently on the stock market. Amongst many activities perhaps the highlight was a recent high level team to the UK. Speeches, meetings, presentations to fund managers, etc. Will this revitalise the stock market? Without getting get a lot of things now wrong, right, it is difficult to see a strong revival in the lumbering giant. Therefore I felt that perhaps it is time to revisit this subject.

Why make the elephant dance

Without a vibrant stock market, Sri Lanka cannot create a private sector economy that will drive high growth. To achieve growth, it is essential to make the elephant dance. The strategy of the Government is to have a private sector driven model of growth. The role of the Government is to be a facilitator providing the essential infrastructure, and the basic services of health, education, power, etc., which must necessarily be the role of the Government.

Investment and growth

Growth is a function of investment. No investment, no growth. It is as simple as that. Some of the investment will come from the Government. However, it is neither wise, or feasible, for the Government to sustain, year after year, high investment in infrastructure in order to get the growth target. A lot of what the Government has done is based on borrowed funds. This has made up for the shortfall in private investment and made it possible to get to around 8% growth. In the long term, the two other components – private investment and foreign investment – must kick in to be able to sustain the high growth numbers. If the elephant does not dance, private investment will not deliver the numbers to support 8 to 10% GDP growth.

All efforts to revive the market have failed

Various efforts have been made. Exhortations from the SEC and CSE, seminars, conferences, foreign junkets, etc. All to no avail. The market is lumbering along. The elephant shows no sign of dancing! A closer look at the overall problem will reveal what needs to be done.

Role of the stock market

To create dynamic economic growth, a vibrant stock market is essential. It is the primary vehicle for providing the private sector with funds for investment. Successful companies can go public and invite the public to buy their shares. This gives the funds for expansion. To support further growth they can come back to the market and make further rights issues or new issues or issue debentures, etc. The public must have a home for their savings. In all the successful economies a significant part of savings goes into shares. A part will go into fixed interest securities and a small portion will be kept in cash. Sadly this is not happening in Sri Lanka. As I said in my previous article, only 1% of the population owns shares which compares with 39% in Malaysia owning shares. That vital pipeline, of savings going through the stock market to companies to fund investment, is not working. The stock market is not performing its vital role. That is why I call the stock market a lumbering giant like an elephant. It is certainly a giant and the value of the market capitalisation of the stock market is nearly 30 % of GDP, but the elephant is not dancing. The intriguing question is, what will make the elephant dance and create a dynamic stock market? Two closely connected things must happen. The private sector must be committed to creating a dynamic stock market and the public of the country must be prepared to invest in shares. This key equation will be balanced when companies provide a satisfactory return to investors. If the returns to shareholders are right, the public will invest in shares. If it is not, the public will not invest in shares. So to get the elephant to dance, it is essential to get the right returns to shareholders.

The return to shareholder or to use the jargon total shareholder return is the dividend received plus the increase in the value of the share as a percentage of the price paid for the share. The public will consider this return with what is available from a finance company or a bank. Rates of return must relate to the security of the investment. A major bank can pay less interest than a finance company. A small less known finance company must pay a higher rate of interest than a well known finance company to persuade people to invest. The rate will be linked to the risk in that investment. Shares due to the inherent risk must provide a higher return than the solid safe fixed deposit rate from major banks.

Shares and returns in FY 13/14

A look at what has happened in the S&P SL 20 gives a reasonable random picture of what has happened. It relates an interesting story. The dividend yield is the bedrock in terms of returns, because, regardless of the share price movement, dividends put cash in the pockets of shareholders. Except for one company the dividend yield from the other 19 companies is poor and well below the safe bank deposit rate. The more relevant return is TSR or total shareholder return. This is the dividend plus the change in share price during the year divided by the price of the share at the start of the year (expressed as a %) The answers are all over the place. Ten out of the 20 companies provided very attractive returns, due to big gains in the share price. The other 10 provided very poor TSR returns as the share price gains were not there or they were negative gains returns. The table gives the rates of return from S&P SL 20.

Things that will get the elephant moving

1. The private sector must make a serious effort to improve total shareholder returns. One part of this equation namely the dividend is entirely within the control of the company. They can determine the dividend and companies should commit to paying out 50% of earnings. 2. The other part which creates shareholder return is the movement in the share price. This is not directly within the control of the individual company. However, all the levers that move share price are within their control. The share price is basically the discounted value of future earnings. If companies publish their view of future earnings and if these views get endorsed by the analysts, it will influence the share price. To put this another way, if a share is trading at five times earnings and if earnings double the share price will skew towards doubling. Managing one’s share price is by no means a straight forward exercise but the levers that matter are clear enough. 3. The biggest weakness is the lack of liquidity. There are very, very few shares where it is possible to trade large blocks of shares. The market in many shares is not liquid. This is largely due to the fact that the percentage of shares on the market of many companies was close to 20%. At the end of 2013, 70 main board firms had a public float below 20%. The SEC stepped in and from January 2014 all main board listed companies must have a minimum public float of 20%. This will not get the elephant dancing but at least it might start swinging its trunk. A study in 2012 revealed that 2.2% of total shareholders owned 95.7% of the market. Another interesting statistic is that 951 shareholders held 89% of the shares by value There was excitement recently that Black Rock, one of the global mega fund managers, said nice things about our attractive share valuations. All this means nothing as there are very few shares they can trade in because they only trade in large blocks of shares. 4. Educating the punter. The public must be educated about shares, companies, movement in share price, and understanding information about shares. Brokers must wake up and publish much more information in the press about shares. That’s what most punters will read (not the research reports). 5. Facilitating investment in shares. It is not easy for the individual to maintain a portfolio of shares. When to buy and when to sell on a regular basis will be too much for many people. There is a simple solution to this dilemma widely used around the world. Professional fund managers run funds. They will buy and sell and maintain an optimum fund. The individual investor buys shares or units in the fund. At the end of the year just like with individual shares one can work out the total share holder return. 6. Confidence that the SEC will prevent malpractices. People save for the future. They must be able to sleep peacefully in the full knowledge that their savings invested in shares will not be seriously diminished due to malpractices. In a significant percentage of companies a majority of the equity is held by family/associates. There will always be concerns that these shareholders through related party transactions may siphon out funds and profits to their own private companies and thereby subvert the interests of the public share holders. Therefore the SEC has a large role to play to sustain public confidence If all these things are done, the elephant will hear the music that will make it dance. But so far this music has not been played! (The writer has a Master of Arts Degree from Cambridge University, UK, and the AMP of Harvard Business School USA. He counts over 40 years of board experience having served as a Director of several companies in Sri Lanka and abroad. He was a Director on the main Board at Reckitt Benckiser PLC, UK, where he worked most of his career and at the time of his retirement was Global Director – Pharmaceuticals. He has served as the Chairman of the Board of Investment and Sri Lanka Telecom Limited and was a Senior Advisor to the Ministry of Finance. Currently, he serves as Chairman of Hemas Holdings PLC and First Capital PLC.)