With interest rates rising, stock selectivity becomes vital: DNH

Broking firm DNH Financial Ltd. is stressing that with interest rates on the rise, stock selectivity becomes even more vital for investors.

It said Treasuries yields have risen across maturities with the three month, six month and 12 month yields rising by 31 bps, 24 bps and 15 bps respectively to 10.11%, 10.18% and 10.45% respectively. A total of Rs. 10 billion were offered for sale at the last bill auction while Rs. 9.47 billion of bids were accepted.

“Rising interest rates are likely to dampen credit growth at least in the short term, and will also impact negatively on companies that are highly leveraged resulting in margin erosion for those that are unable to successfully pass over the cost increases via higher selling prices,” DNH said. “Consequently, for an investor, stock selectivity will become even more important to determine the winners from the losers,” it added.

DNH is also advising investors to avoid the ‘herd mentality’ which it described as the main catalyst for bullish or bearish trajectories of the market in the recent past.

“This should be avoided in order to preserve capital and generate sustainable alpha in the medium to longer term,” it said. However, it said if an investor is still seeking short term gains, then it may be far more prudent to sit in cash as an asset class rather than invest in the expectation of overnight gains which could lead to a potentially loss making position.

“However for those investors who prefer long term sustainable returns, a bottom up stock selection approach is advised in order to build a quality portfolio which will generate double digit returns over a wider investment horizon and weather market volatilities,” DNH said.

“In order to benefit fully from a flight to quality strategy however, investors may need to maintain a healthy investment horizon and provide sufficient time for their investments to generate necessary alpha. Consequently, we advise investors to consider investment as opposed to speculation,” it added.

Whilst pointing out that the equity market has a notorious tendency to rush from one side to another in response to the ebb and flow of optimism or pessimism, DNH is recommending investors to make a directional call, build a quality portfolio and take advantage of what is increasingly becoming a ‘stockpickers’ market.

Focusing on overall growth prospects for the economy, DNH said there has been much concern over the prospect of a slowdown in real GDP growth on the back of the fuel price hike and rising interest rates. However it believes that although a slowdown from the current growth of 8.0%+ may be inevitable this year, prospects for the medium to longer term are likely to remain strong as economic activity in the northern and eastern parts of the country becomes more apparent and GDP contribution from these areas start to be more absorbed.

“Contrary to some market commentators, Sri Lanka does not share the same economic fragility or uncertainty currently evident in the Eurozone or the US given the country’s robust domestic consumption cycle that currently underpins the country’s economic growth,” opined DNH Financial.

The broking firm is also expecting bank credit growth to slow down in the second quarter of 2012.

It said in line with the Central Bank’s efforts to tame credit growth, bank credit growth may slide in 2Q2012 as a result of rising interest rates. Credit growth in 2011 rose by a significant 31% to Rs. 1906 billion, outpacing most emerging markets.

“One potential risk to the credit off-take in previous months is the loan-to-deposit ratio rising to well over 90% for select lenders indicating that greater amounts of high cost borrowed funds may need to be used to cover loan books,” DNH said.

“In Sri Lanka, credit growth is not only pro-cyclical, but tends to grow faster than GDP during expansions and more slowly during recessions. While credit growth may continue to slow down going into the 2nd quarter, however, underpinned by strong macroeconomic fundamentals and a continued expansion in both the private and Government sectors, we expect momentum to resume in 2013/2014. With real GDP growth forecast at over 8% in the coming years, bank credit should recover and grow faster enabling commercial banks to sustain earnings growth,” it added.