Investing in Sri Lanka in ‘The New Normal’

Inspired by questions posed at a recently-held webinar on the topic ‘Investing in Asia in The New Normal’ organised by International Chamber of Commerce Sri Lanka, together with Boston Consulting Group, Daily FT and CIMA, NP Capital Ltd. Chairman Nimal Perera shares his thoughts on the topic of ‘Investing in Sri Lanka in The New Normal’ with a particular focus on investing in the Colombo Stock Exchange and private investments

‘The New Normal’

Before we dive deeper into ‘Investing in Sri Lanka in The New Normal,’ let’s first ask ourselves, what is this ‘new normal?’

In the short term, ‘the new normal’ refers to trends and challenges that came along with the pandemic. We were tested on our

readiness in multiple fronts, such as:

• Tech readiness – where educations systems, businesses, and even governments were lacking readiness without the necessary tools and systems in place to operate remotely, impacting productivity. 

• Healthcare readiness – where our hospitals lacked beds and ICU units, and the Government lacked testing capacity and scale.

• Financial readiness – due to Sri Lanka being a largely cash-based society with a great deal of red tape surrounding P2P transfers and a general lack of integration among both consumers and institutions

• Retail and supply chain readiness – due to the lack of e-commerce infrastructure, not wide enough distribution networks, and consumer friction towards e-commerce, with higher preference for touch and feel shopping. 

However, what is more important is what ‘the new normal’ refers to in the long-term. The pandemic has put us on a fast track to change some habits and behaviors that will inevitably stick even once the pandemic is long gone:

• Organisations have placed huge importance on technology, looking for ways to digitalise workflows – through virtual meetings, electronic document signing etc. as opposed to the traditional methods.

• Companies are also more comfortable with the Work-From-Home culture, which will be a huge boost especially for the female workforce in a country like Sri Lanka where the gender parity is still not up to par with our regional peers in corporate settings due to issues such as insufficient childcare facilities.

• Increased digitalisation will require better privacy, cybersecurity, and better internet and wireless facilities from our ISPs.

• Telehealth facilities are digitally connecting healthcare networks.

• Digital financial systems with more online shopping and online banking will drive toward a more cashless society overall.

Understanding the relevant financial instruments in ‘the new normal’

In the backdrop of these new behaviors, it is important to note what the relevant financial instruments are from an investment standpoint. 

It is my opinion that the instruments have not changed much, but it is the way we approach these same instruments that needs an update. Yes, there is the newfound popularity on Bitcoin and Non-Fungible Tokens (NFT) and such, but even these have existed pre-pandemic and are now being looked at in a new light due to the change in our approach towards both traditional and non-traditional investments.

To update our approach, it is important for us to educate ourselves on what has changed since the pandemic at a macroeconomic and an organisational level:

At a macroeconomic level:

• We are going through a period of economic contraction with low interest rates and increased money supply through Government incentives and handouts.

• Lower rates are intended to stimulate personal consumption and private investments, and it is important that we achieve the desired economic growth to avoid a stagflation.

• With low interest rates, personal borrowing and corporate borrowing increases.

• However, it is not attractive to save in FDs during this period, with deposit rates hovering around 4.5-5.5% and a current headline inflation of 4.5%, giving a meager adjusted return of 1% a year at most.

• Put that return against the likelihood for inflation to increase due to consumer spending and a weakening rupee against the dollar, which has a 10-year average depreciation of around 6-7% annually, we are not only getting poorer in real terms, but we are also getting poorer against the rest of the world.

At an organisational level:

• However, at an organisational level, things are looking a little more positive in Sri Lanka. CSE has recently had a record-breaking earnings seasons with superior earnings growth compared to MSCI Frontier, Frontier Asia, and Emerging Markets. This comes on the back of clear Government policy to boost local production supported by low corporate taxes and import restrictions. 

• Further, increased corporate borrowing, if spent on CAPEX, will bear fruit in the medium to long term. 

• Many corporates have also taken ‘the new normal’ seriously and are radically adopting technology and digitalisation efforts. It will be important to pay serious attention to these corporates.

For certain companies, the new business avenues and opportunities that opened up due to the pandemic would not necessarily go away once the pandemic is done, making it misleading to categorise them as mere “COVID stocks.”

Based on these insights, I would like to share my views on investing in one traditional type of investment in Sri Lanka, which is the stock market, and one non-traditional type for Sri Lanka, which is private investment in startups in ‘the new normal.’

Traditional and non-traditional investments that can be used in ‘the new normal’

It is no secret that the Colombo Stock Exchange is highly undervalued currently relative to other Frontier Market indices. In fact, Mr. Dumith Fernando, Chairman of CSE and Asia Securities, in his presentation at the Sri Lanka Investment Forum, said CSE is trading at a discount against the MSCI Frontier Market indices to the tune of 35-45%. CSE currently trades at a Price-to-Earnings (PE) multiple of around 7.5x, significantly cheaper compared to our regional peers like India and Pakistan, where the markets trade at a PE of above 30x and 10x respectively. 

Our three largest private banks, for example, trade at a Price-to-Book Value (PBV) of between 0.45x-0.75x. If you consider the current PBV of the CSE, it is at a 10-year low of 0.6x and at a huge discount to peers, while the Emerging Market and Frontier Market indices are trading above 1.5x-2.0x PBV. It is also no secret that foreign participation in the CSE has been a net outflow, with only about 8% of trading consisting of foreign participation. 

What all this means is that, assuming pro-growth Government policy remains stable and no other significant external shocks, CSE would be the first destination foreign investors would consider when looking at equity markets, giving an opportunity for significant upside for a medium-to-long term investor. 

The short-term behaviors of ‘the new normal’ also give many opportunities for investors to make capital gains by carefully analysing and following the new trends in the market. For example, as per my observation, except during the initial crash in March 2020 when curfews were announced, during which the market was closed for a month or more, I noticed that the market tends to move up whenever lockdowns are announced or extended. This could be due to more people being stuck at home with limited access to work and places to spend their money on, thereby making that money work in equity markets. So, a strategic short-term trader can ride these lockdown upticks to make significant gains, cash out and keep cash in hand to buy a dip and ride another lockdown, which will inevitably happen due to multiple waves of COVID until enough of the population is vaccinated. So, for the strategic trader, this volatility can be a great friend. 

When picking companies for longer term investment in ‘the new normal,’ it is important to consider a few factors:

• We must pay attention to companies with strong fundamentals, such as a solid balance sheet, strong cash flow, and strong top and bottom-line growth, as these will come out of difficulty sooner. 

• Second, we must pay attention to companies who are using the low interest environment to finance CAPEX on expansions.

• Third, we must consider the pricing power companies have, as this will help against inflation risk.

• Fourth, we must consider thematic investments, such as telco companies for a wireless economy, construction and materials companies for a construction boom driven by low interest rates, and travel and leisure companies, because once the population gets vaccinated and the pandemic situation subsides, people will have massive pent-up demand for travel causing leisure sector companies to experience a demand boom.

• Finally, and most importantly, we must pay serious attention to companies that are radically adopting technology and digitalisation. 

This is important because technology and data are overtaking how businesses operate. Although Sri Lankan businesses complaint of consumers being traditional and preferring to do touch-and-feel shopping, with online sales going back to pre-lockdown levels after a surge during lockdown, I believe sooner or later consumers will demand great digital experiences from Sri Lankan companies, including banks, retail, healthcare, and even other financial services, like trading apps. What will decide winners will be companies that invest heavily to provide the best user experience, through the entire supply chain from the point of purchase until the point of delivery. 

I have been investing for 30 years and I deal with brokers on a daily basis. But my children, for example, hardly speak to any brokers, and sometimes they do not even ask me for advice anymore. Instead, they do their research online and trade entirely online, only with brokers that provide a particular trading app that is more user-friendly than the others. That is how important the digital experience is to the younger generation. Companies that get the digital user experience right will be winners in ‘the new normal.’ This is the same with banking too, where people now choose their bank based on how good or user friendly the mobile app or website is. This will be the same with grocery shopping and same with food delivery.

This brings me to my non-traditional type of investment under ‘the new normal,’ which is private investment in startups, particularly technology startups. In a country with 92% literacy rates, 44% digital literacy rates, an economy slated to be a services hub with the advent of Port City Colombo, and with many corporates and even the Government sector still far behind in terms of digital adoption, startups in the tech space are perfectly positioned to capitalise on the new urge for companies and the Government to digitalise.

Similar to a State Minister of Capital Markets, Sri Lanka now has a dedicated State Minister of Digital Technology and Entrepreneur Development too. I believe the emphasis this Government places on technology and entrepreneurship presents tremendous opportunities for investors interested in private investments in Sri Lankan startups. We already have a great tech startup space which has attracted investments from US-based PE firms, Singapore-based technology giants, and even the IFC. In fact, a few tech companies may even be listed in the CSE soon giving equity market investors with a thirst for pure technology firms an opportunity to be part of the action as well.

However, many regulatory changes will be required to reap the full benefit of both these investment options – and these reforms are needed now more than ever during this ‘new normal.’

Regulatory changes required to broaden investing in ‘the new normal’

On the startup investment side or even for established technology companies, it is almost impossible to obtain loan funding from banks, since our banks are still not geared to engage in the role of investment banking or development banking. Banks assess technology companies through the same old-fashioned lens, requiring collateral assets and focusing on technology companies as high-risk ventures without considering the high growth potential of such companies. Tech startups by nature do not have much tangible collateral assets to place against a loan facility. 

I believe the Government needs to take a more active role in recognising startups as a special SME sector, requesting banks to assess startups based on human capital, technology IPs or the business model when providing loans. Banks can also partner with incubators, accelerators, and large PE funds when assessing risk. I believe ICTA is introducing a new Credit Evaluation Framework for tech companies and the State Minister of Technology and Entrepreneur Development is looking into credit facilities for startups. I am hopeful these efforts will improve the survival and success rate of startups giving better investment opportunities for private investors as well.

The Government and Government institutions could also support local tech firms by making full use of their talents to power digitalisation efforts of Government institutions instead of outsourcing projects to foreign companies. We have unbelievable talent in Sri Lanka that have delivered solutions to global giants like VISA and Mastercard, global telecom providers like Vodafone, and even foreign governments and foreign banks, garnering international awards for the best solutions, but are supposedly not “qualified enough” to provide the same solution to Sri Lankan Government institutions. The process breaks down somewhere along the line due to vested interests of one or two people at these institutions and this can be demoralising to our tech talent. The Government should make the effort to protect and nurture these talents, at least for the sake of export revenue potential and foreign investment potential into these companies. 

On the CSE front, good progress has been made already in terms of digitalising the CSE with facilities for local companies, Sri Lankans living abroad, and foreign individuals to open CDS accounts online. 

However, regulatory changes are needed in multiple other fronts at the CSE. One of the biggest impediments to the success of CSE is the lack of liquidity. CSE these days does about Rs. 3-4 billion in Average Daily Turnover, which is much better than what it was over the past five years. However, when compared to regional peers like Pakistan, that has a daily average of about Rs. 25 billion, we are far behind. One way we can improve the liquidity issue is by introducing better regulations on the minimum public float of a company that should be made available. So many listed companies in the stock market are tightly held by the owner and family members of the owner that there are barely any shares trading on the market. 

The close family hold of listed companies is also a reason why investor relations of local companies is not up to par with peers. For example, there are many delays when it comes to reporting of earnings, and frankly I have personally spoken to many CEOs and MDs of listed companies who have openly said they do not care about the share price of the company. Obviously, they would not care about investors then. This is a severe injustice to the investors and shareholders of that company and will demotivate foreign investors looking to invest in CSE. However, in more developed markets, companies have dates set out well in advance for when reports will be published and when earnings call will be held, so executives of those companies can be questioned by shareholders. There is no such practice here in Sri Lanka, except among maybe a handful of companies. Mandatory regulations on improved corporate governance are an easy fix which I believe will improve transparency and resolve many of the issues around insider trading claims and rumours impacting the market sentiment as well. 

Regulators should also consider introducing more advanced asset classes, such as derivatives, commodities and even cryptocurrency, giving investors more variety. Currently, there is no way for investors of the CSE to hedge their portfolio due to the inability to short or trade options to play the downside. Such tools will enable investors to not only make gains during the upside but also during red days. However, before introducing such tools, we need to focus on educating our retail investors.

Risks associated with investing in ‘the new normal’ and required protection for retail investors

In his presentation, Dumith Fernando also mentioned that in ‘the new normal,’ retail participation has overtaken the CSE, with 56% trading done by retail investors in 2021, compared to 22% in 2018. Now we see much more interest in research reports, technical charts, and people being driven by WhatsApp groups, Twitter messages, and YouTube videos. It has come to the point where research reports sometimes act as self-fulfilling prophecies of the Target Price presented on those reports. Although in my 35-year career as an investor and trader I have never used technical analysis to trade, the trend is now changing. Therefore, when investing in ‘the new normal,’ it is important that we educate retail investors on proper fundamental analysis and technical analysis, enabling them to make more informed decisions and protect themselves against the high volatility that comes with sentiment driven decisions, investing based on WhatsApp groups, and herd mentality. This will reduce the unwarranted buying frenzies we saw recently due to splits, which fundamentally do not change the value of a share by any means. 

The increase in retail activity is another good reason for regulators to reconsider the high transaction costs of trading in the CSE. While the current policy of no capital gains taxes and no tax on dividends for foreign investors is appreciated, the current transaction cost structure incentivises day trading, through buy-side only transaction costs, and large players, through volume discounts. The former is not helpful in curtailing market volatility, while the latter is not helpful for incentivising retail investors. A reduction in transaction costs could incentivise more retail investors to invest in the CSE, allowing them to take smaller positions at a time as a risk minimising strategy, while also giving a much-needed boost to liquidity levels.

Speaking of volatility, caution must be exercised when trading in a volatile market environment. Depending on one’s risk appetite, retail investors can choose to safeguard themselves against a volatile market by:

• Diversifying their portfolio with stocks, bonds, real estate, and other such non-correlated assets, thereby minimising the systematic risk. 

• Investing in large cap, low multiple stocks with consistently high dividend payouts. 

• Holding cash.

• Or simply, by doing nothing and having the patience to hold. Time tends to be a great risk minimiser, more so in developed markets than in the Sri Lankan market. Still, I have many past experiences earlier in my investing career in which had I been more patient, I would have made gains through my investments instead of panic selling during volatile periods and losing significant amounts.

Finally, regulators should consider opening the local market to global markets. Currently, Sri Lankans have severely limited access to trading in global markets and are missing out on the opportunity to capitalise on amazing returns some of the best companies in the world are producing. While the argument against giving access revolves around exchange controls, regulators should also consider the flipside, where money made in foreign instruments can be spent locally on consumption, taxes, and even on local investments. This would give local investors another channel to invest money in, especially during slow, red periods of the CSE. In the least, Government and private institutions should build ETFs that invest in foreign assets, giving locals access to and exposure to foreign assets through these funds.

(Disclaimer: Nimal Perera is an investor, and a trader with significant positions in CSE at any given time. He is also the Chairman of Arimac Digital, a trailblazing end-to-end digital solutions provider in Sri Lanka. Any improvement to the investment landscape at CSE or to the digital landscape will stand to benefit him directly.)