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CSE has been a strong diversifier in the last decade or so with its low correlation to other markets and comparatively higher return. The main reason for the low correlation with other market lies in the fact that the island nation was battling out a civil conflict for 30 years and hence despite the country being strategically located with strong prospects for economic growth, the market and the economy remained dormant till the war ended in 2009. Due to this lacklustre nature, the capital market was less exposed to foreign investors, making them less dependent on global markets’ behaviour.
Furthermore, in 2009 with the end of war, equity market catapulted giving more than 100% returns for two years, even when the global market conditions remained gloomy. The market still remains fairly untapped with market cap to GDP at about 37% and overall market cap amounting to only about US$ 19 b. It is also worthwhile to note that comparatively only few counters are exposed to the export market. Therefore there is only small portion of corporate profits that is directly affected by external developments, making the price movement triggered by earning potential of the counters less correlated with the export markets.
In terms of market returns, CSE beats most of its peer markets (Chart 1) especially because of the low base (low prices) of pre-war end era due to economic uncertainty of the country, and the rapid market rally that took place in 2009 and 2010 due to optimism of the economy after the end of the war. Therefore, even after the correction took place in 2011 and 2012, CSE still have given annualised 
return over 25% for the last five years. Yet, even though CSE has given higher returns, the valuations still look very attractive especially considering the growth prospects of the island economy.
Colombo Bourse continues to trade at attractive valuations
With the end of the civil conflict, there was strong optimism in the eyes of investors, which resulted in a rapid bull run. Even though the initial phase of the bull rally could be justifiable with valuations, the rapid returns produced by the market resulted in an influx of speculative investors pushing the prices considerably higher than the intrinsic values of the underlying companies. This resulted in the market as a whole becoming overheated, forming a bubble like behaviour as reflected by considerable high market price to earnings ratios (See Chart 2). Especially the latter part of the rally resulted in speculative investors investing with credit increasing overall systematic risk of the market. The Securities and Exchange Commission of Sri Lanka (SEC) had to intervene, by bringing more strict credit rules and trading rules, bursting the bubble.
Since early 2011 the market took the correction dropping close to 40% in a period of 18 months, bringing most of the companies back into attractive valuations. The attractive valuation coupled with improving economic prospects of the country attracted the long-term investors led by foreign investors, which has resulted in the market trending back into an upward direction. The market has appreciated at a more moderate pace gaining about 22% from August 2012. But the market still trades below historical PE average, 
reflecting the companies’ attractive valuations amidst continuous strong financial performance.
If we compare the Colombo Bourse with other global markets, the ASPI trades at comparatively attractive valuations with its PE Ratio standing at 12.08 (as at 17 October 2013). Especially if we consider the growth prospects of the country, the market seems to be trading at a considerable discount. We have compared different markets attractiveness based on future growth potential by dividing the PE Ratio with the economic growth forecasts using the IMF’s forecasts for 2013 and 2014 (Chart 4). If we further drill down to other relative valuation indicators, it can be seen that the ASPI fares well compared to the world (Chart 3).
Listed entities continue to show robust financial performance
One of the main reasons for the investment attractiveness of the Colombo Bourse is the continuous strong financial performance of the underlying companies, especially the larger blue chips. If we look at the last few years, the companies have shown impressive performance in terms of both top line and bottom line. One reason for the rapid growth is the lower base in 2007/2008 with 30 years of conflict weighing on the companies’ performances resulting in low base figures in profits and revenue.
On the other hand most of the companies have continued on positive performance through process improvement, leaner cost structures and improving economic conditions in the country. The companies increased performance can be seen clearly if we look at the weighted EPS growth of CSE. For the period 2010-2013 EPS has recorded an impressive annualised growth of 66% (see Chart 5).
The growth has been subdued in 2012 with slowdown of credit growth with higher interest rates resulted from credit controls imposed by the Government of Sri Lanka to stabilise the overheating balance of payment situation prevailed by the end of 2011 due to rapid growth in 2010 and 2011. By the end of 2012 and during this year credit controls are relaxed again, but the credit condition of the economy has not eased up enough to really stimulate the earnings of the corporates. But medium to long term we can expect the corporates to return back into growth phase with the economic growth prospects on the table, especially with downward trending interest rate and easing inflation.
We can take the S&P Sri Lanka 20 index’s member companies to further analyse the performances of more liquid large blue chips’ performances. It can be seen these corporates on average have been able to produce strong results over a five-year period (see Chart 6).
The leverage level of the listed corporates is comparatively low with debt to equity level of the overall market at about 60%. One of the reasons for lower gearing is the corporates are predominantly dependent on banking finance with lesser access to corporate bond market. Nevertheless the lower gearing levels reduce the leverage risk for an equity investor for his/her investments and companies will be less vulnerable for credit shocks of the economy. Furthermore it gives access for more external finance for the corporates for their expansion projects.
Highest foreign investor buying interest (on net buying basis) in 2012 and 2013
There has been considerable increase of foreign interest for Sri Lankan listed equity during the last five years as investing through listed equity is one of the easiest gateways for the Sri Lankan economy’s growth prospects. Furthermore CSE investments are fairly open for foreign investors with very limited restrictions. Out of the overall market value foreign holdings accounted to 26.88% (as at 31 
December 2012).
During 2012 the Colombo Bourse recorded highest-ever foreign net inflow and in 2013 it has followed a similar trend, recording similar foreign net inflow. The main reason is due to continued foreign purchases and considerable drop in foreign sales due to attractive valuations from the market correction (market decline by c.40%) which took place in 2011. The foreign investments to CSE have been mainly value based entries and higher price multiples in 2010 saw the highest-ever foreign sales with the foreign investors booking hefty capital gains on the bullish rally. But since the market correction, price multiples have come down to attractive levels with most of the counters trading below PE ratio of 15 and hence foreign selling has dried up considerably since 2011. (See Chart 7)
Limitations of Colombo Bourse
The limitations of CSE are more or less common with the limitations attributable to frontier markets across the world. One of the main limitations in the eyes of a foreign investor is the lack of investments of size. CSE is still comparatively small with a total market capitalisation of US$ 19 billion and market cap to GDP hovering around 37%, which is considerably low compared to global equity markets. Therefore there are only a handful of counters where an investor can invest in the sizes of USD millions without amounting to strategic stakes. But there are few strategic stakes available which can be of material investment size for a foreign investor.
The liquidity of the CSE is also considerably low, which may result in an exit position of an investment of more than a few hundred thousand dollars taking several days. But large blue chips such as JKH may have sufficient liquidity to absorb large positions as well. One of the reasons for lower liquidity is low free float in the market with CSE’s free float standing at c.24% as at 30 April 2013. But then again some of the large blue chips have large free float of more than 50%, providing more liquidity.
The lacklustre local retail participation since the market correction in 2011/2012 is also a key reason for the low liquidity. But we believe with the positive trend forming in the market and relaxing credit environment, there will be increased retail participation mid to long term, increasing the liquidity considerably. Furthermore, regulatory bodies are contemplating increasing the free float requirement of the listed entities, which should further increase market liquidity.
One of the key concerns in investing in frontier market is weakness on the currency front. The Sri Lankan Rupee (LKR) is also susceptible for currency volatility with the LKR depreciating by annualised 3.42% against the USD for the last five years. But the LKR in recent times has been relatively immune to world currency fluctuations as opposed to the general weakness shown by emerging market currencies this year on US developments. Accordingly the LKR has only depreciated by 2.9% against the USD, and it has appreciated against the Indian Rupee, Japanese Yen and Australian Dollar for 2013 (as at 17 October 2013).
Future outlook for Colombo Stock Exchange
