Disclaimer: The below is not investment advice. If you do want investment advice, speak to your friendly SEC registered Investment Advisor, instead of relying on random blogs on the internet. We are merely laying out parts of our investing framework as an exercise in organising our own thinking and opening up to the light of public feedback.
Surviving the Abyss
I’ll admit I was wrong. Very wrong. Given the depths of the crisis merely 18 months ago, I did not expect us to achieve stability this fast. Very few countries ever have. While things in Sri Lanka are still extremely difficult, we have made astonishingly good progress from where we were. We were at the edge of the abyss, and many thought we were too far gone, but we have managed to turn around and survive. In the context of where we were, the fact that we have a functioning country is a win in my book.
There has been a lot of good news since those crazy days in July 2022 when some folks found themselves swimming in the presidential swimming pool. A few highlights:
We have gone from multi day fuel queues and shortages to being able to fill up as much as we want with no queue
The absurd fertiliser ban has been reversed, and fertilisers are now freely available
For 2023, Sri Lanka was self sufficient in rice, and a bumper rice harvest is expected for 2024
Inflation has slowed from a peak of over 70% to 4%, although a small acceleration may occur due to taxes.
Interest rates have been lowered from a crushing 30% to 12%
Importantly, credit is also starting to flow again to corporates and consumers. A key first step in economic recovery
We no longer have forced power cuts
We have agreed an in principal deal with our bilateral creditors, with reasonably good terms for Sri Lanka. (The presence of large debt balances with Chinese entities makes this much harder than usual and a good outcome was not a foregone conclusion)
Large amounts of funding tranches from the IMF, ADB World Bank were released in December, significantly helping our reserves
While tax administration still has a long way to go, tax inflows are at a record, with the treasury accumulating a good cash buffer
There are no strangers in the president’s swimming pool
The fact that the country stabilised so quickly is a testament to the importance of good disciplined policy and the support of foreign institutions and friendly nations like India.
Why Aren’t We Rich Yet?
While we are not out of the woods yet, and have many tough months ahead, I believe things have gone much better than most educated market participants expected. The general feeling is one of positive surprise. If so then why haven’t markets rallied strongly as positive news such as the bilateral debt agreements and the release of IMF funds occurred? I have had several conversations with market participants, all expressing surprise at the sluggish nature of the market in response to all this objectively good news. Typically when reality outperforms market expectations, we see a strong market performance, this time we haven’t. If things have gone better than expected, why has the market underperformed expectations? This is a valid question.
Back to Basics: Demand and Supply
Like all other prices, the price of equities is determined ultimately by the interaction of demand for shares from buyers and the supply of shares from sellers.
In the long run, we are firm believers that the ultimate driver of this is the fundamental performance of the company. If a company performs well, its profit will grow, and it will be able to pay out growing dividends, while also reinvesting in itself at high returns on capital, allowing further growth in the future. This compounded growth in profit and dividends will attract buyers while also encouraging existing holders to continue holding the shares. This increase in demand and reduction in supply will, over time, lead to an increase in the price of the shares.
While the above is how things should work, in the near term, supply and demand for shares are driven by other factors, more specific to the market participants. I refer to these as the “technical” drivers. Speculative activity is the best example of this. Often when a share does well, speculators buy in attracted to rising prices like moths to a flame. This new demand further raises prices, attracting even more speculative buyers, in a feedback loop.
While our view is that equities are attractive today from a long term fundamental perspective, we also acknowledge that these technical factors are not the most supportive in the near term.
To explore these technical factors, we first have to understand more about the typical participants in the Colombo Stock Exchange, and the drivers of their supply of, and demand for, shares.
Demand in particular is key (supply is usually just the inverse of this). The key driver here is the willingness and ability of an investor to buy shares in the CSE.
Exploring the Different Participants
I would categorise market participants into the following blocks:
Local Retail
Local Institutions
Local High Net Worth Investors
Foreign Investors
Local Retail
These are the smaller investors who actively participate in the market. They tend to have the following characteristics:
They trade in small sizes, some as small as a few hundred rupees but usually in the tens of thousands.
Due to low purchase sizes, illiquidity is not a big deal, enabling them to invest into any share in the market
They have a very high trading frequency, executing multiple small trades a day
They tend to follow and amplify market moves in virtuous and vicious cycles. When markets are going up, they buy more, when markets are dropping they sell out.
They over concentrate on specific “meme” stocks that are well recognised amongst the retailer community.
The performance of these stocks relative to a market are a very good indicator of what retailer activity is like.
They have very short holding periods, with many day traders holding for just a couple hours.
They quite often invest on margin, further weakening their ability to hold long term.
They generally do less detailed fundamental analysis, investing based on what shares are hot and technical charts.
They are usually focused on short term gains, not long term compounding of an investment.
Retail investors have been the mainstay of the CSE, continuing to participate even as other investors pulled out. Their activity comes in waves, with a boom of high participation followed by a blowup and a period of inactivity. In the recent past, retail activity has remained quite high, but we believe that they are now running out of steam.
The Demand and Supply Drivers for Retail Investors
The huge squeeze in disposable incomes driven by a nightmare trifecta of high interest rates, high taxes, and high inflation have reduced the funds these investors have. Retailers are usually willing to invest in shares, if they have the spare funds. The problem is right now they just don’t have any purchasing power available. Hence, regardless of the fundamental attractiveness of the market, retailers are willing but not able to buy equities right now. This means demand from retail investors is quite muted.
While these will partially ease as the economy recovers, I think the damage to the consumer is done, and it will be some time before they have material disposable income to start throwing at the markets again
To make matters worse, some retail investors are probably selling their investments to raise funds to maintain their lifestyles, actually increasing supply in the market. Hence retailers are probably putting negative pressure on prices right now and this is unlikely to change in the near term.
Local Institutions
This segment consists of the large scale professional investors in Sri Lanka. This includes, for example, the pension funds like the EPF/ETF, the life and general insurance funds, and the larger corporate treasuries with spare funds seeking a return. They tend to have the following characteristics:
They have large trading sizes, with a lower trading frequency.
Due to liquidity requirements, they tend to stick with blue chip shares with large market capitalisations.
They have longer holding periods with less short term trading.
They invest with their own funds, with little borrowings, and hence have holding power if required.
They aim for longer term capital gains and are usually not into short term trading
The Demand and Supply Drivers for Local Institutions
These institutions are extremely underallocated into the equity market. Having been burned before on some bad faith transactions, the big government run pension funds have generally avoided the equity markets. Similarly, the larger private and public insurance funds with huge sums to invest have generally stuck with fixed income securities, preferring the false comfort of a guaranteed return, despite the erosion to inflation adjusted wealth that such securities have suffered in the recent past. For example, Norway’s Sovereign Wealth Fund (The largest in the world) has approximately 70% of its portfolio in Equities. Meanwhile, Sri Lanka’s EPF has a whopping 2% of its portfolio in equities.
In short, the local institutional investors are able to buy enormous quantities of shares, but are simply unwilling to do so. I believe that the fundamental reasons behind their very low allocation to equities are not based on good reasoning from first principals and will change over time. However, these investors tend to be governed by slow moving investment committees and investment policies which, once written, take some time to change. Such changes will also be gradual. No one is going to go from 2% equities to 30% equities in one go. Hence the lack of catalyst and the slow moving nature of these institutions means that this will be a slow structural change playing out over the medium to long term.
However, this transition, while slow, will drive large and sustained price moves as these sleeping giants wake up.
On the supply side, as these institutions already have very few shares there is not much risk of material shares coming to market from their near negligible holdings. There is nowhere to go but up in this category.
High Net Worth Investors
These are a varied bunch. Some behave like retail investors, only with larger trading sizes. Some behave like institutional investors. Some show mixed behaviours of both. However, they do have unique demand and supply drivers.
Demand and Supply Drivers for High Net Worth Investors
The three main asset classes in Sri Lanka are Property, Fixed Income (mainly deposits and treasuries) and Equities. Of these, equities get by far the smallest allocation, as per cultural norms in Sri Lanka.
These investors are highly flexible and able to move fast between the asset classes, based on their own beliefs on what will generate the best returns. When treasuries went to 30%, there were huge flows from these investors into the treasury market. At this stage our belief is that these investors still remain there and will be looking for their next destination as treasury yields rapidly fall.
In our belief, equities are now a compelling option for these investors:
Property yields remain very low, and there is concern of the upcoming wealth and property taxes. Property is also hit by VAT, Income Tax (for rent) and Capital Gains Tax, making them relatively inefficient ways to grow wealth. This is in contrast to equities where the capital gains tax rate is 0% and dividend tax rates are either zero or 15% depending on source.
Interest rates for deposits and treasuries have crashed from their highs of 30% to around 12%. After tax, yields are now below 10%. Some equities pay out a higher tax adjusted dividend yield ignoring any possible capital gains (which are tax free).
For the above reason, I anticipate that we should expect to see more demand from these investors. It is in fact quite surprising to me that this has not yet happened, and may be due to investors choosing to sit on the sidelines until after the elections, or alternatively being invested in treasuries and deposits that are yet to mature.
Foreign Investors
Sri Lanka gets barely any foreign retail or high net worth investment (aside from Sri Lankans living abroad). Almost all foreign investors into Sri Lanka consist of professionally managed frontier market or emerging market funds. These investors exhibit very similar trading characteristics and investment preferences to the local institutions, but have different demand and supply drivers. They are also much faster moving.
Demand and Supply Drivers for Foreign Investors
What is unique for these investors is that the world is their oyster. Unlike other participants, they are not constrained to Sri Lanka. Hence they will be comparing Sri Lanka with a wide variety of alternative options. Their buying and selling flows will also be correlated with global fund flows into frontier and emerging markets which depend on things such as interest rates in the United States. Hence there are a lot of complex factors driving their investment decision. However, a few key factors that we believe will be the main drivers are illustrated below:
Most of these investors are constrained by their fund policies, which would prevent them investing into countries in financial default. The conclusion of our debt restructuring, and upgrading of our rating will open the floodgate of these investors.
These investors have minimum liquidity requirements. As markets here rise and trading volumes increase this should make Sri Lanka investible for them creating a virtuous cycle of increased activity bringing in even more investors, and hence more activity.
The third key factor is the very high political uncertainty. Foreign investors care deeply about good governance, and policy consistency. They will hence likely wait until the end of the elections for visibility on this.
The most important fact here is that foreign investment into Sri Lanka is VERY low. As a result, portfolio managers have a lot of space to invest in the country at their discretion. They are likely watching Sri Lanka very carefully, and continued good execution, combined with a good election outcome providing policy consistency is likely to open the floodgates here.
On the supply side, most of these investors wisely exited Sri Lanka in 2019, 2020 and 2021. Hence their current exposure is very low, and there is very little supply to come from them even in a bad outcome.
The flows of foreign investors are key to monitor. They are, by far, the largest pool of capital in the market, and unlike our institutions, they can move quite fast. I view foreign investors as a “free option”. There is little risk of further selling, and there is a tsunami of them at the ready IF we deliver on our IMF commitments and have a “good election outcome”.
The Elephant in the Room
In our view, the biggest driver of the sluggish market is the uncertainty regarding upcoming elections. This affects pretty much every market participant. We believe these will be the most important elections the country will face in our generation. Discussing all the possible outcomes, probabilities and their impact is well beyond the scope of this article.
A Short Recap
So we see that despite the theoretical attractiveness of the market, in the short term, there are specific factors affecting the market participants that have prevented the typical surge in demand that you would expect after all this good news. To summarise:
Investor Type | Willing to Buy Shares | Able to Buy Shares |
Retail Investors | Yes | No (until disposable incomes improve) |
Local Institutions | No (But they should be and this will probably change slowly) | Yes |
Local HNWI | No (But we expect this to change in the near term) | Yes |
Foreign Investors | No (This could change in a big way after a good election outcome) | Yes |
How Will This Play Out?
Like Sri Lanka as a whole, the market feels like it is “stable at the bottom”. We anticipate minor up and down swings but an overall sideways market, until the bursting of the dam on the demand side, from one or more of the below triggers:
A good election outcome and continued good macroeconomic policy bringing investors (especially foreign) into the market
The local high net worth investors shifting from bonds into equities as post tax interest income finally becomes too low
A steady recovery in consumer purchasing power brings back retail investors again
Aside from the election, none of the above have any firm dates. While we don’t have dates, it feels highly likely that the above will happen at some point. It is even possible that all three could happen around the same time, in which case we may see a “supercycle” opportunity in the CSE.
So What Are We Doing?
We cannot predict when any of the above catalysts will trigger a rerating in the market. We will only know after the fact, which will be too late. Trying to perfectly time the market is nearly impossible, and there are some further exacerbating facts against this strategy:
Equities in Sri Lanka are highly illiquid. You cannot just buy the quantities you want at an attractive price at short notice. Hence to build a diversified portfolio in advance of an event, you actually need to start accumulating months before.
Attractive dividend yields of certain shares also make the cost of waiting while invested (after adjusting for tax) not too punitive compared to alternatives of Real Estate and Fixed Income.
For this reason, we are about 95% invested in equities, and intend to be 100% invested over the next few months. I caution that this is unusually high for Sri Lanka. Most investors I speak to are between 30 to 75% invested with the rest usually in fixed income.
When the Facts Change, Remember to Change Your Mind
All of the above conclusions are based on the facts today as we see it. These facts are likely to change given how volatile things are right now in Sri Lanka. For example:
There could be another global pandemic
The upcoming election could lead to the election of a populist party that does not understand basic economics and blows up all the reforms done to date
China could invade Taiwan
A devastating natural or man made disaster could occur in Sri Lanka or somewhere around the globe
A severe global recession could occur
In the event the facts have changed, the conclusions derived from the facts have to be thrown out, and we will have to reason again from the ground up, based on the new facts. Hence it is highly possible that any conclusions from this article can become stale very fast. Again I refer the reader to the disclaimer at the start of the article.
Great insights! I cannot agree more. It is amazing what we have achieved so far.