Bullish DNH forecasts ASI hitting 7,500 in 3Q; 9,000 by year-end

DNH Financial Ltd. appears to be highly bullish of the Colombo stock market as it is forecasting the benchmark All Share Index (ASI) to hit the 7,500 points level by end third quarter and 9,000 points level by end 2011.

“While the SEC’s decision to allow stock broking companies to provide margin facilities to clients based on their liquidity capacity is definitely encouraging, we expect investors to now focus more significantly on corporate fundamentals which would provide the necessary catalyst for a sustainable rally leading to the market re-rating comfortably above the 7500 levels during 3Q2011 and reduce the somewhat fear-based emotional selling that has characterised certain periods of trading over the last few weeks,” DNH said in its weekly stock market review.

The broking firm expects a number of themes to emerge over the next few weeks which it said will shape market trajectory; prolonged nervousness in the global markets as they continue to capitulate to US and Eurozone debt tensions, conversely, record performance in the Sri Lanka economy and strong double digit corporate top line as well as bottom line growth and improved margins, cheap PEG valuations in the majority of the companies in our universe, and the relative unattractiveness of alternatives such as T-Bills, fixed deposits or real estate.

“The convergence of all these factors will provide the perfect backdrop for the Colombo bourse to comfortably breakthrough the 9000 resistance level by year end generating a return of 25-30% from current levels. We are not unaware however that we may encounter sporadic lumps and bumps along the way as we climb a solid upward slope, but our conviction for equities remains well and truly strong and justifiably so,” DNH said.











Noting that although from an absolute PE valuation yardstick, the Colombo market at current levels may appear relatively expensive vis-à-vis regional markets DNH said from an all important PEG basis, the Colombo bourse can be described as not only attractive but cheap and getting cheaper as the full impact of the current earnings cycle is absorbed.

“At a PEG of 0.6X, we believe that the market offers considerably attractive buying opportunities for investors seeking double digit returns over a minimum three-four month investment horizon. For those with an investment horizon of even greater, we believe the returns will be considerably higher. We advise investors however to be ultra-selective in their stock selection and focus on companies that are fundamentally sound with a strong domestic consumption theme,” said DNH which comes under the ERI Group.

“While some industry commentators have expressed concerns over the prospect of an over-valuation of the market and a possible correction, we disagree and take a markedly different view. The fear and panic that have been rattling global investors over the US and Eurozone debt crises is unlikely to impact the Colombo bourse as we believe that there is a clear polarisation between the performance of the domestic bourse vis-à-vis its global peers. Consequently, lead by domestic factors, we believe the market will end 3Q2011 at least 8-10% higher characterised however by sporadic periods of volatility,” DNH said.

Supported by leadership mainly from large and medium sized stocks with a strong domestic theme, we believe that the bourse is well on course to breaking through the psychologically important 9000 key resistance level by year end and making the crossing at a prospective PEG of1.0X.

“We believe that the next few months will offer an attractive opportunity for risk savvy investors to be able to proactively position themselves to capitalise on a 25-30% rise in the market. Investors are advised that temporary dislocations in the market cannot be discounted and when they arrive many will question the ability of the bourse to bounce back; but bounce back it will. With alternatives to domestic equities becoming increasingly unattractive, we see a strong liquidity driven impact on equity returns.

Continued low interest will make equities more attractive and cash unattractive,” DNH said.

It pointed out that although inflation has been crawling upwards in recent months and is currently hovering at 7.0%, it still remains at relatively benign levels and is not a concern at this stage. While strong domestic consumption and resultant increased demand pull factors could stoke inflationary pressures going forward, we believe that given the increasingly cost push nature of the CPI, domestic inflation should remain at current levels as demand pull inflationary pressures will be comfortably offset by cost push factors, namely lower import costs a result of lower global commodity prices. 

Given the Central Bank’s increasingly accommodative monetary policy, we expect interest rates to continue to remain at current levels notwithstanding the Bank of Ceylon (BOC)’s recent decision to cut loan interests from 12% to 9% which although could have the ability to trigger similar action from other commercial banks, is unlikely to result in an industry wide reduction in rates as we believe that the majority of banks will face increasingly downward pressure on margins if rates are actually reduced.

Meanwhile, despite the ‘safe haven’ appeal that cash instruments offer, an important point to note is that taking into consideration the current low interest rate environment, investors who maintain savings in the form of fixed deposits are now generating negative real returns given current inflation levels.

The scenario does not change significantly in the case of those currently invested in T-bills either, as the real rate of return on T-Bills was a mere 25 bps in July 2011. Consequently given DNH’s expectations of a 25-30% rise in the bourse by year end, the opportunity of not investing in the Colombo bourse could be painfully high for those investors sitting in cash, the broking firm argued.

“Considering the unattractiveness of either fixed deposits or T-bills in real terms, we therefore recommend a shift to high yielding equities which is likely to generate significantly higher returns. In this respect, we re-iterate the need to however adopt a rigorous stock selection strategy to identify fundamentally solid stocks that will outperform and generate above market risk adjusted gains,” it said.

DNH also said it is remains overweight on the Manufacturing, Banking, Diversified and F&B sectors which it opined have a strong domestic focus and will benefit fully from rapidly rising local consumption. “We are also bullish on the Hotel sector which has performed surprisingly well notwithstanding increasing global recessionary pressures,” it added.

Focusing on corporate results released so far, DNH said companies have definitely exceeded market expectations with average consolidated EPS growth of 30-35%.

“While we are certainly pleased that the majority of companies have recorded both healthy top as well as bottom line growth and improved margins, we advise investors to be somewhat wary of those that have reported unusually sharp earnings growth without a corresponding increase in top line revenues. This could mirror a non-recurring event such as an unusual or infrequent item (included as part of ‘Other Income’), which is unlikely to recur going forward or an extra-ordinary item. Consequently, we emphasise the need to select companies that are likely to report sustainable earnings growth going forward with top line revenues LEADING EPS growth,” DNH said.

With regard to the economy, DNH said having grown by an impressive 8.0% in 2010, GDP growth during the 2Q2011 is expected to remain strong notwithstanding the turmoil in the global markets. This is high by any standard. Growth will be broad-based across all sectors, most notably from the Industrial, Services and Hotel sectors and will be fuelled by strong domestic consumption at all levels as a result of a rise in consumer disposable income and corporate profitability. While export growth could tail off slightly as a result of a modest dip in demand from international buyers, we do not see any significant impact on the Balance of Payments as we expect tourist arrivals to continue to remain high while expatriate remittances will continue lend support to household spending.

Having enjoyed welcome gains from the real estate sector during last couple of years as a result of the end of the war, we see little to encourage investors to re- enter the market this year as we believe that much of the ‘easy’ gains in the sector has already been realised. Considerable value increase has pushed yields down to 5-6% levels, which, when considered against risk free T-Bill rates, do not appear overly attractive and certainly compares unfavourably when juxtaposed against equities. In the medium to longer term however, we expect the real estate sector to benefit from the ongoing domestic economic expansion which we believe will result in a re-rating of the real estate market.

Strong opportunity for foreign fund managers and unconstrained local fund managers  

Given the expectation of continued nervousness in the global markets during 4Q2011, we expect most international fund managers to square their books ahead of the new year. The dislocations in the global markets will consequently offer significant opportunity for global asset managers to invest these surplus funds in markets such as Sri Lanka which is currently at the top of economic performance.

“We believe that local fund managers meanwhile whom are unconstrained in their mandate will also be able to generate significantly positive alpha by exploiting market opportunities using an active portfolio management approach in their stock selection thereby outperforming those that are linked to indexes,” DNH said.