Market Overview and Strategy

THE ASPI has risen by 16.2% for the year to date on the back of a 96% increase in 2010 and a 280% increase since the end of the war. The recent upward movement in the ASPI is largely a result of strong retail and local HNI participation which has seen significant price movements in second tier and illiquid stocks not necessarily reflective of broad based healthy buying interest.

Furthermore the more liquid MPI index that contains most heavily traded large cap counters has increased by just 2% this year and is still 8.43% off its peak in early October 2010.

Average daily turnover levels in the market have increased from 2.4bn in 2010 to Rs. 3.64 b year to date. Expectations of 50-60 new listings in 2011/2012 will push turnover levels even higher with small to mid-sized listings conducted during the year so far attracting overwhelming local interest. These proposed listings include a host of finance companies whilst a few sizeable state run entities as well as firms in the retail, logistics and construction space are expected to attract significant institutional interest.

The market has witnessed a fresh influx of new funds stemming from investors shifting money from low yield fixed income securities into equities. In addition the market has also experienced a sharp rise in credit driven investments.

Last year witnessed a doubling of active trading accounts in the system with market velocity increasing from 26.3% in 2009 to 32.8% in 2010 and market capitalisation to GDP rising to 41%.

Foreign participation in the market which amounted to 30% of turnover in 2009 has declined to 19% in 2010. Foreign selling in the market has increased in recent months with near term valuations looking less favourable in comparison to regional peers although Sri Lanka ranks more favourably in terms of a sustainable medium term earnings outlook. Several mid to large cap counters such as those in the manufacturing and banking sectors still hold sound medium to long term value with low double digit multiples.

Sectoral earnings prospects

Corporate earnings growth has also been strong with expectations for a 108% yoy growth in earnings for the current Dec/Mar financial year as businesses benefit from low finance expense and increased capacity utilisation. The increase in volume driven growth across most sectors has resulted in several listed entities crossing breakeven thresholds and returning to profitability.

Increased volumes are driving core earnings higher whether it is excess liquidity in the banks being mopped up by sharp growth in private sector credit, or increased capacity utilisation at manufacturing plants, higher occupancy levels at hotels or even a modest rise in minutes of use among mobile phone subscribers. The current

December 2010 quarterly results for 192 companies reported filings thus far in the earnings season amount to 84% yoy growth. Earnings are also driven by lower finance expense which has helped drive increased private investment with private sector credit growth expanding by over 25% in 2010. Downward revisions in taxation will enhance earnings prospects further in tandem with increased volumes.

Businesses will benefit from increased domestic demand in the medium but will also be required to invest in building scale and enhancing productivity in anticipation of new competition that is inevitably ushered in by an improved operating environment.

Sustained local retail buying interest in the market has pushed near term market multiples to 15.2x FY12E earnings, with aggressive buying on selected mid cap and speculative trading on illiquid counters having pushed the indices higher at an excessive pace thus far this year, warranting a modest correction. A medium term outlook of sustainable normalised earnings of approximately 25% should see the index trend higher over the medium to long term.

We remain bullish on the medium to long term earnings growth prospects of Manufacturing, Banking and Leisure stocks. The sharp earnings growth in the Telco and Energy sector is due to a recent return to profitability, while earnings growth in plantation stocks have been driven by steep appreciation in rubber prices caused by a significant drop in global supply.

n Banking

The banking sector witnessed a sharp increase in credit growth over the 2H of 2010 with loan book expansion estimated to be 22.6% for 2010. The sharp loan growth helped push earnings higher for the sector in comparison to the previous year where bond trading gains augmented earnings. The outlook for credit expansion over the next three years is approximately 20-25% yoy given increased private investment and consumer spending.

Net interest margins will moderate on account of competitive pressures and therefore would require more robust management of the asset/liability mix. Asset quality has improved significantly reflective of the lower credit default risk in the present environment. Increased recoveries has seen gross NPLs in the industry declining from 8.49% in 2009 to 5.33% as at end 2010 while provision cover the industry is estimated to have increased to 44.9%. A 15.6% growth in deposits has seen a steady shift towards low cost savings deposits on account of the narrow rate differential against term deposits.

The reduction in corporate tax and financial VAT has resulted in effective tax rates for the banking sector declining from 60% to 45%. As a result average ROE at banks which ranged from 13% to 16% has increased to a range of 16% to 20% across the listed banks. This permits greater capital accumulation to fund aggressive loan book expansion. Scope for a further sharp improvement in ROE could potentially stem from consolidation in the sector in the medium to long term.

Banks have also recently started to issue scrip dividends in favour of cash dividends in a bid to retain further Tier 1 capital. The collective result of these measures as well as the fact that most banks still exhibit a statutory liquidity ratio in excess of 25% means that banks are unlikely to require fresh capital infusions over the next 18 months.

Government plans of a doubling of per capita GDP in the country by 2015 would effectively warrant a doubling of credit into the economy and Commercial banks continue to be the dominant financial intermediary in the country. The country has a commercial bank branch per 29.4sq km, and a population to bank branch ratio of 4,200 persons, including district co-operative rural bank branches.

Whilst access to banking services is widely available actual credit penetration is still modest particularly in the personal and SME lending segment. Total licensed commercial bank advances amount to just over 25% of GDP.

n Manufacturing

The listed manufacturing sector entities are mostly oriented towards domestic market needs. With borrowing costs having sharply gone down over the last two years and improving revenues we have seen companies starting to improve utilisation of their capacity. Thanks to belt tightening during the 2008/2009 period, reduced finance costs as well as scale economies from improved utilisation has resulted in better margins on higher revenues leading to faster earnings growth.

Construction in particular has boosted volumes sold of the cement and floor tiles companies, and both major floor tiles players have indicated higher capex for expansion.

n Leisure

The leisure sector recorded a 46% growth in arrivals last year, with the increase in arrivals pushing average occupancy to 67% in CY10 compared to 47% recorded in CY09. The 4QCY10 alone recorded over 200,000 tourists and an average occupancy of 74%. The South of Colombo is estimated to have enjoyed occupancy of 92.8% in December 2010 while the North of Colombo recorded 86% in occupancy.

Sri Lanka has a current capacity of 14,593 rooms, and requires a further 15,000 graded hotel rooms to achieve the industry’s 2016 target of 2.5mn visitors. The unlikelihood of sufficient room capacity coming on stream continues to be a key driver of medium term earnings prospects for the sector.

Equally challenging for the sector apart from expanding the physical room capacity would be the ability to source and train the required skilled staff that would deliver service levels that can consistently demand increased rates. Most incumbents have already undertaken refurbishments of their existing properties while also commencing construction of newer properties.

With increased demand for tourism coupled with stagnant room supply at least for another one to two years, we expect the local hoteliers to enjoy higher room rates along with greater occupancies. However, their ability to charge higher rates will very much depend on the quality of the product offered.

More recently, the recent Budget proposals have indicated an increase in the minimum room rate to US$ 125 for all 5 star properties across the country from April 2011. Five-star operators failing to charge the minimum rate will be charged a bed tax of US$ 20 per bed per night. This would collectively yield to consistently higher earnings growth rates for the sector in the medium term till such time significant additional room supply comes on stream.