Heraymila hails potential prospects

Heraymila Securities Limited, the key global speculation arm of the wealthy Saudi Arabia’s Al Mashal family, has released an evaluation report analysing Sri Lanka’s economic outlook based on extensive research.

Daily FT publishes a summary of the report detailing the potential of post-war recovery that focuses on raising productivity. The report titled “twelve Yearbook 2010- Sri Lanka” also contains an equity strategy and valuation and analysis framework

A FAVOURABLE ECONOMIC BACKDROP

Sri Lanka economic outlook

Sri Lanka is a small island economy in the Indian Ocean. It is strategically located in a busy maritime shipping route and is close to the rising economic powers in Asia. It has a relatively well educated population of around 20 million and population growth is relatively low (for Asia) at 1%pa. Average income per capita is around US$2,000 per person.

Sri Lanka is transitioning from its historic plantation economy to an industrialised one. Garment manufacturing has grown in prominence and tourism is also a key component of the Sri Lankan economy.

A civil war in the Northern and the Eastern regions ended in mid 2009. This combined with improving economic performance has led to better risk ratings (S&P, B+ with a stable outlook; Fitch, B+ with a positive outlook; Moody’s B1 with a stable outlook).

This should lower the risk premium, cost of borrowing and encourage investment. The war torn regions are economically under-developed; bringing them up to speed with other regions would be worth around 13% to the national GDP over the medium term.

Sri Lanka’s institutions are around the median standard of all countries according to the Ease of Doing Business Survey by the World Bank and Transparency International’s Corruption Perceptions Index. There is room for improvement.

The medium term outlook is positive, supported by its geography, escalating pace of industrialisation and a relatively well educated workforce and reduced political instability. However, sustained budget and current account deficits are a source of vulnerability.

Sri Lanka’s economy looks set to perform strongly through 2010 and 2011. We expect economic growth of 8.4% and 10.4% in 2010 and 2011 respectively (consensus 6.6% and 6.5%). We expect growth to be driven by the lagged influence of reduced interest rates, resilient consumption, recovering tourism, exports and post war rehabilitation of the Northern and the Eastern regions. Significant infrastructure investment will also be a positive influence, both for near- and long-term economic growth.

There are some near term risks to the economic outlook. The three most prominent headwinds are: a vulnerable global recovery; strained Sri Lankan fiscal position; and low velocity of money. A sustained global recovery will be a key factor in supporting the Sri Lankan economy, particularly tourism and exports.

The budget deficit has been on a widening track. However, recent announcements by the government suggest a better focus on costs and revenues. This combined with robust economic growth should see the fiscal deficit start to narrow. The velocity of money is low, meaning credit creation is weak and growing money supply is not yet supporting economic activity. This is beginning to turn and will eventually super-charge the recovery.

The investment climate in Sri Lanka is improving in line with the economy. However, the equity market is richly priced. Valuations are at all time highs and the market is pricing in very little risk. There is risk of a correction.

Post war recovery – Significant potential

The Sri Lankan economy is now in the second year of peace, following decades of civil war (1983-2009). Other countries that have recovered from prolonged civil wars have typically experienced steady to strong economic growth once peace began.

Experience of other post-war countries suggests growth will at least remain around 6% per annum, but may be up to 12%pa. Our bottom up analysis of war affected regions of Sri Lanka suggests the economy may be 13% larger, without accounting for additional multiplier benefits. This means economic growth may accelerate by 1%-2%pa over the next decade.

The initial growth spurt will be from investment in infrastructure, buildings and businesses. The long term benefit will be from sustained growth in household income and spending. Peace and improved economic infrastructure will also support exports and services.

Comparison of other civil wars

The closest comparisons to Sri Lanka’s long civil war are Peru (1980-2000), Angola (1975-2002) and Guatemala (1960-1996). Other civil wars have tended to be short and violent (such as Bosnia, Tajikistan and Georgia).

In Guatemala, the growth rate decelerated slightly post civil war. In Peru and Angola, growth accelerated strongly. The post war recovery tends to be broad based across the board. Consumption, investment and exports all benefit from peace, particularly in the first five years of peace. In outer years, consumption tends to benefit more.

The experience of other post civil war economies suggest Sri Lanka should maintain at least its war period growth rate of 6%pa or boost it up to 12%pa. The potential is huge.

Bottom up analysis of potential

The end of the long civil war has thrown the spotlight on the shattered Northern and Eastern regions. There is considerable need for humanitarian relief work, and also reconstructing the physical infrastructure. These are being implemented by the government, NGOs and supra-national agencies such as the UN.

The length of time required to rebuild and rehabilitate the Northern and the Eastern regions is uncertain. However, we can make rough estimates of the region’s economic potential. Our analysis shows that these regions are under-developed.

A prime example is the agriculture sector, which created value of just Rs. 4 m per km2, compared to a regional median of Rs. 11 m. Other parts of the economy are also small. Relative to agriculture, both industry and services are smaller in the Northern and the Eastern regions compared to the national norm.

We construct a simple scenario, where agriculture production is similar to the performance in other regions, and industry and services are a similar ratio to agriculture. These calculations are very broad estimates only and do not take into account quality of labour force, capital stock, access to resources and other features.

If the Northern and the Eastern regions’ economies can be transformed, we estimate this would add around 13% to Sri Lanka’s national GDP. Including multiplier effects this may be higher. If realised over the next decade, it may equate to additional 1%-2% growth per annum, compared to an average growth rate of 6% in the past decade.

The scenario setting will not be achieved in the short term, given the extent of reconstruction and investment required. However, the post war economic rehabilitation holds the promise of considerable economic gain.

Raising productivity the key to potential

Sri Lanka is a relatively well resourced economy. With further investment, the potential is much larger. With investment in human and physical capital and productivity gains, Sri Lanka can be the next Asian success story.

As with most developing economies, Sri Lanka has a large labour pool, but its capital base and the rate of technology adoption are relatively low. To improve economic growth and prosperity Sri Lanka needs to expand the stock of capital and use it more productively. With investment in human and physical capital, and technology, the potential of the economy is huge.

Sri Lanka’s institutions are of average quality compared to the global economy. The main areas of weakness are around enforcing property rights, contracts and dealing with taxes and licenses. These can be addressed through policy and enforcement.

Sri Lanka’s geography is a key strength. The island’s proximity to a key shipping route and rising economic prominence of Asia and Middle East are the key drivers.

Experience in other Asian success stories show that labour productivity is at the root of higher incomes and economic prosperity (Figure 7). Countries like Hong Kong, South Korea, Taiwan and Singapore should be the aspiration for Sri Lanka. Our analysis shows that labour productivity in these countries has improved from Sri Lanka’s current level over the last 20 to 40 years at an average rate of 3%pa (Figure 8, similar to Sri Lanka over the past decade).

Investment in physical and human capital, adoption and diffusion of technology through the economy are sure-fire ways to supercharge economic growth.

EQUITY STRATEGY

The Sri Lankan economy is an exciting frontier market. The economy is growing and transforming. The equity market is currently extremely over-valued. However, there are a number of companies that offer good long term prospects.

Over the next one to two years we like companies that are exposed to the cyclical recovery and rehabilitation of the North and East following the end of civil war. Construction, banks and tourism are set to benefit the most.

Over the longer term, up to 10 years, we like exposures that will enable productivity gains in the economy and gain from increased incomes. In particular, companies that are involved in capital expansion and technology transfer. We also like companies that will capitalise on megatrends like wealthier consumer preference (eg increased protein consumption, shift towards upmarket shopping experience and sustainable practices).

Favourable macro exposures

The Sri Lankan economy is on the cusp of significant expansion and transformation. Sri Lanka is industrialising, this will be the dominant force. End of the civil war will free up the economies in North and East. Over the next 1-3 years the areas of most activity will be construction, tourism, investment in infrastructure and economy wide spending.

Medium term, there is a super-trend of an industrialising economy. As the economy’s productive capacity increases, labour productivity and household incomes rise, the ranks of the middle class will swell significantly. This will give rise to increased and changing mix of consumer demand and economic structure.

Economic theory suggests that labour productivity has to underpin income gains. The success of economies such as Malaysia, South Korea, Singapore and Hong Kong are excellent examples. These success stories have accumulated productivity gains at an average rate of 3%pa. This suggests a long positive process.

Our favoured cyclical exposures are construction, banks and tourism. Longer term, companies involved in technology transfer to enable productivity gains will be vital. As will those involved in capital deepening, banks, construction companies and companies that carry out the investment (eg deep pocketed diversified companies).

Market valuation

The Sri Lankan equity market has surged by 121% over the year to 22-Sep-2010, far in excess of the 6% gain in the MSCI world total return index (Figure 11). This soaring performance follows a 36% increase in the previous year, while the global index fell by 6%. The recent impressive performance means valuation measures are very expensive and there is a risk of correction (Figure 10).

While a near term correction is possible, over the long term, we see two possible positives from (1) the market recognising long term economic growth and (2) equity market risk premium reducing from current above average levels.

Equity market valuation signals are universally expensive. From quite expensive to extremely expensive. In particular, the price to earnings (PE) ratio is at a new high (Figure 13). However, when the dividend yield is compared against the commercial bank prime lending rate, a proxy for the opportunity cost of investment funds, the equity market looks slightly less – but still – expensive (Figure 14).

The equity market appears fully priced when we compare equity market price growth prospects to Consensus Forecasts. We use the dividend discount model (DDM) to estimate implied economic growth by the equity market and compare economic growth prospects over the next two years in the Asia Pacific Consensus Economics Survey.

Our analysis suggests the market is currently pricing in roughly 7% economic growth over the next couple of years, compared to consensus forecast of 6½%. This suggests that there is little upside to equity prices (Figure 15). While our growth forecasts are more comparable to current market valuations, we are still wary.

Our DDM analysis needs to be seen in the context of a changing risk premium. Our analysis suggests the equity market is currently pricing in modest risk. International volatility measures such as the VIX index have been elevated in recent months. If the Sri Lankan equity market risk premium increases in line with international volatility measures, there may be scope for a correction in the Sri Lankan equity market (Figure 16).

While the economic backdrop is positive, it is important to remain cognisant of stretched valuations. The market is poised for a correction. The long term outlook is indubitably positive, supported by a robust economic outlook and a reducing risk premium.

VALUATION AND ANALYSIS FRAMEWORKS

We are pleased to introduce our valuation and analysis frameworks. To date our analysis has been purely top down and our forecasts reflect the broad macroeconomic environment and publicly available information. We have not yet incorporated nuanced company details, which we will following company visits and deeper analysis. We have not introduced our recommendation framework yet, as Sri Lankan equities are currently expensive relative to valuations.

Valuation and recommendation framework

We look at companies and sectors both at the bottom up and top down levels. We begin our analysis by considering the macro settings (economic, regulation, competition, etc). We then look at the company level data and forecast future earnings based on our macro forecasts. Over the next quarter we will engage in direct conversation with company management and industry contacts to further refine our current purely macro driven earnings projections and valuation estimates.

As a base case we construct a DCF valuation for each company. Given potential gaps in any valuation framework, we also compare valuations against other relative metrics, such as P/E, EV/EBITDA, FCF yield, etc. In future, we will overlay this with our qualitative judgement on transparency, strategy and execution risk.

We have not implemented our recommendation framework yet. At present, we consider the Sri Lanka equity market to be expensive.

Stock screen

Figure 17 is a sample stock screen we employ to identify strategic stocks. This is a macro screen that looks at the company’s beta to its relevant sector and the sector’s beta to the overall economy (Sri Lanka and global, depending on its revenue exposure). We look at this macro exposure in terms of its average operating, financial and total leverage.

When we expect economic conditions to recover, we prefer exposure to those sectors with high beta to the economy (for example construction) and with companies that have plenty of leverage to the sector. Similarly, if there is a growth scare we would prefer to trim exposure to these stocks and prefer companies that have a lower beta to the economy and have less leverage – the defensive plays.

Our analysis is then further refined to consider company specific issues, such as costs, financial leverage and interest rate exposure among many others. This screen allows us a quick rule-of-thumb analysis of which companies will be best placed to capitalise on accelerating economic growth and vice versa.