Stock market reaching unsustainable valuations?

John Keells Stock Brokers (JKSB) has analysed the Colombo Bourse’s recent sharp gains as well as bizarre valuations of some stocks. Here are excerpts from the report done by JKSB’s Research Team.

The CSE’s doubling for the year to date and the 51.7% increase in the last quarter (June to

September) in particular has raised questions as to whether the current market is reaching unsustainable valuations. The average daily turnover of the quarter to date of Rs.3,124m was also  significantly higher than the year to date average of Rs.2,293m with much of the volumes driven by domestic demand.

Much of the gains made over the September quarter have been in anticipation of the forthcoming budget which is due on the 22nd of November. The government has proposed significant fiscal reforms in the form a more simplified taxation structure as well as revisions on taxation of particular sectors such as banking. Plans to rationalize the Board of Investment Incentive Regime reducing excessive concessions and concentrating on large investment projects have also been mooted.

Heavy government spending on infrastructure should help improve future growth momentum.

Simplifying the tax regime and broadening the base may generate a rise in government revenue.

Lower inflation in the longer term will help reduce the cost of government financing and strong capital inflows with the end of the war and building of foreign reserves have already led to healthy balance of payments. Broad macroeconomic fundamentals are improving with 2Q10 GDP growing at 8.5% YoY while September 2010, CCPI inflation was 5.8% YOY.

Sri Lanka’s stock market capitalization accounts for roughly around 44% of GDP and important sectors of the economy remain unrepresented (most notably the garments sector) which we feel signifies ample potential for eventual expansion over the longer term. The forthcoming IPO pipeline is strong with Laugfs Holdings, Softlogic among the announced issues over the next 12 months along with the mandatory requirement for insurance and finance companies to list over the next two years. Higher market valuations will tempt further listings from corporates who have been holding back for the last five years.

While estimation of equity value in the Sri Lankan market has mostly revolved around earnings multiples we feel that it cannot always be relied on as the sole measure of value in the current post war context. PE multiples are frequently seen from the perspective of a single period earnings number without factoring in the longer term prospects of growth.

By our estimates Sri Lanka’s quoted companies have had a 10 year CAGR (from FY2001 to FY2011E) for net earnings growth of over 20.6%. Earnings growth for our coverage universe is estimated as 78.4% for FY2011 (which is boosted by Dialog Axiata’s return to profitability). We have conservatively estimated cumulative normalized (excluding exceptional items) earnings growth for the following years to be marginally in excess of 20% up till 2013. Forward earnings multiples as per our JKSB coverage universe are currently 20.9x FY2011 earnings, with the multiple declining to 17.1x in FY2012 and 14.2x in FY2013.

With the government expected to focus on reducing budget deficits and debt levels and containing inflation in the coming years we feel that expected costs of capital should substantially reduce also providing a boost to valuations. As revenues improve along with a broader macroeconomic improvement, higher margins and lower finance costs should see sharper earnings increases. Medium to longer term planning for capacity increases have not been built into existing forecasts and are more feasible given increased demand and comparatively moderate finance costs.

The recent unprecedented rise in the index has resulted in some comments of stock market bubbles. Part of the  reason for the sharp upward movement in prices is a result of s significant shift of funds by all local retail, HNI’s and institutions from fixed income investments into equities which has lead to certain stocks being over bought by speculators. Prior market bubbles in the region in the last decade have occurred at multiples of 40x – 100x earnings such as those witnessed in Japan, China, Vietnam and Taiwan. Whilst no one can predict market peaks it is clear that while certain stocks hold strong long term prospects others are excessively valued. Those that display excessive valuations despite offering less scope for a significant build in capacity in the medium term warrant investors to reduce positions.

We believe that our core recommendations in banking, leisure and property development groups, and construction related manufacturing companies still display clear long term visibility of sustained demand. Companies with a robust balance sheet and asset base displaying an ability to build fresh capacity are likely to still deliver sound returns in the medium to long term. These in our opinion would be less susceptible to any downward corrections which may periodically occur despite overall upward market momentum.