Reversing concentration and profitability can scale up investor interest

Did you know Sri Lanka’s large companies were amongst the most productive in terms of asset-turnover ratio for the 5-years till 2016, from a sample of 27 prominent emerging/frontier markets? Or did you know Sri Lanka was one of the 6 markets from this sample that saw more than 50% of its large companies deliver positive profit-growth over the 5-years upto 2016? Large companies here refer to the Top-200 listed companies by 2016 Bloomberg market cap. They have better access to resources, so are better proxies for market performers. But despite this performance, hardly any global portfolio fund had over 90% allocation of their corpus to Sri Lanka as of early-2017. In comparison, Bangladesh, Pakistan and Vietnam had about a dozen each, while Indonesia and South Africa had about 50 each.

This performance-data also reveals two key challenges, which is constraining the scale of investor interest the market deserves. Sri Lanka saw reasonable economic growth in recent years (GDP grew at 6% CAGR from 2012-2016, as per IMF), and IMF expects a similar CAGR for the next few years till 2021. If Sri Lanka wants this economic story to translate into a corporate story (and an investor story), it has to reverse these two challenges.

Profits are too concentrated: The contribution of the largest 3 sectors to the profit-pool of its Top-200 companies was as high as 77% in 2016, which has held firm from 5-years ago. These were finance, staples and materials. Most Asian peers have a lower concentration level. A high concentration indicates the impact on profit-pie due to increased focus on a few sectors of competitive advantage at the expense of others. Most developed markets had a concentration level between 60-70%, if that serves as a benchmark. Interestingly, most of the companies that saw maximum growth in profits from 2012-2016 came from only two – finance (CBSL, Hatton, Sampath, Ceylon Ins., Seylan, Orix) and industrial (John Keells, Vallibel, Hayley’s, Access Eng.). Ceylon Tobacco was the only one adding weight to staples, and this business bears regulatory risks. In the other sectors, there were only a few that saw healthy profit growth (Dialog, Teejay, IOC, Asiri, Chevron), implying a dearth of a broad-base of profitable companies to add weight to the profit-pie. There is a need to grow the profit share of the other sectors so that any risk to its large sectors does not derail market performance. That would push the case for more Lanka-dedicated portfolio funds. But which areas hold promise? It already spends a high portion of its GDP on private consumption, much more than this sample-average. An average Sri Lankan spent ~$8000 out of a per-capita of ~$12000. Pushing the consumption habit further may prove detrimental for savings in the long-term. The services sector forms ~60% of its GDP which is again similar to the sample-average.

The LKR lost competitiveness as the BDT or PKR dropped more, hence textile and food export may not be supportive. Sri Lanka’s investment rate averaged in the early-30%s for the five years till 2016, and is estimated to be similar till 2021. This needs to be ramped up to 35-40%, in line with the initial experience of China and Southeast Asia. This pushes the case for demand in sectors like materials and industrial; and these may lead its growth momentum. This also means pushing domestic saving to fund it rather than depend on external borrowing; hence it needs to keep consumption in control. Also, the good performers from other sectors who are unlisted need to be listed. Its ratio of large companies’ revenue to GDP is relatively low, and this gap between the real and listed economy has to reduce.

Profitability is missing: Sri Lanka was one of the smallest markets in our sample of 27, if one looks at the average profit-per-company of its Top-200 companies. The average Chinese company was 220X larger, India 35X, Thailand 15X, Indonesia 12X, Pakistan 4X, Kenya 3X, Nigeria 2X and Bangladesh 1.4X. But its large companies have been investing to scale up. Their combined equity has grown more than profits in the last 5-years, indicating fresh equity has been added. Its leverage has steadily increased in this period. Also, its 5-year profit growth lagged its topline growth, indicating the impact of higher capex on near-term profitability. But while this investment to scale up is a positive, the operating leverage has to kick in now. The lack of current profitability has pulled down its ROE, despite the companies being very productive in sweating their assets. If the operating leverage from these investments can kick in soon, it would bring in the long-term consistency in performance. It would also make the market relatively attractive vs. peers.

So while the world appreciates Sri Lanka’s recent market performance, the country has to reverse these two challenges so that it evinces the scale of investor interest that a high-growth market deserves.

By Sourajit Aiyer

Image Courtesy: InvestLanka

Originally published here –

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