After an uncertain period, the Colombo Stock Exchange (CSE) is back on an upward trajectory, supported by the improving economic climate. The market will see significant reforms in 2018 to strengthen regulation, increase the bourse’s independence and efficiency, and broaden the range of products available.
Deep Roots
Capital markets in Sri Lanka have a long history, dating back to the foundation of the Colombo Share Brokers Association in 1896; however, the domestic stock exchange was not formally established until 1985, with the founding of the Colombo Securities Exchange, which was rebranded as the CSE in 1990.
While the history of share trading in Sri Lanka is fairly long, it was modernised comparatively late, due partly to the near elimination of the market between 1956 and the late 1970s, when state socialism was the prevailing paradigm. During this period, only one university taught market-related subjects. Liberalising reforms introduced from 1978 onwards reawakened the sector. Since then, the market has continued to develop well, even weathering the 1983-2009 civil war.
Peace Dividend
The end of the conflict came during the worldwide wave of monetary and fiscal stimulus following the global financial crisis 2008-09. This saw the benchmark All Share Price Index (ASPI) soar from a low of 1500 in 2008 to nearly 7800 in 2011, according to Bloomberg. The index was boosted by more than 60 initial public offerings (IPOs), as domestic firms and companies tapped into resurgent investor confidence and popular enthusiasm for equities.
However impressive this looked on paper, the country was ill prepared for the soaring equity prices and rapid increase in leverage, and in the end, cracks started to appear. The CSE and the Securities and Exchange Commission (SEC), the sector regulator, moved to tighten the market and rein in excesses by introducing price caps and credit controls. Efforts to investigate wrongdoing were not always successful, running up against interference and pressure from vested interests.
The subsequent market correction pushed the ASPI below 4800 by June 2012. Thereafter, a recovery in the global economy, and Sri Lanka’s own growth and confidence in the CSE as a guardian of an attractive asset class, saw valuations recover to a peak of nearly 7600 in early 2015. This was followed by a period of relatively strong valuations, before a market drop in late 2015 and early 2016, linked partly to political uncertainty following early parliamentary elections conducted in August 2015, which saw the formation of a fractious coalition government. The index bottomed out just below 6000 in March 2016, though a recovery was cancelled out by a further drop in late 2016 to early 2017, with the index sinking below this point. However, the ASPI picked up strongly thereafter, nearing 6770 in July 2017 and closing the year at 6370.
Overall, in the period between March 2009 and September 2017 the ASPI clocked a compound annual growth rate of 16%, according to investment bank First Capital Holdings. Yet over this period, the price-to-earnings (P/E) ratio dropped sharply, from nearly 40 to 11.
Performance
Following two years of decline, in 2017 the CSE saw annual turnover of LKR220.59bn ($1.4bn), up 24.7% from LKR176.94bn ($1.2bn) in 2016. Average daily turnover rose from LKR737.23m ($4.8m) to LKR915.32m ($6m). Foreign investors accounted for 47% of trading, up from 42% in 2016, with net foreign inflows increasing from LKR2.3bn ($15m) in 2016 to LKR17.6bn ($114.9m) in 2017, suggesting that more long-term foreign investors were attracted to the CSE. At 94.5%, domestic investment accounted for the lion’s share of individual trades, showing that foreign investor activities tend to be concentrated in bigger transactions. This is mostly due to their focus on higher-value companies and larger stakes.
Entering 2018 market-watchers are upbeat, with Sri Lanka’s economic growth expected to pick up to between 5% and 5.5% and maintain this pace in the medium term, according to Central Bank of Sri Lanka. The three-year IMF programme launched in June 2016 has encouraged structural reform and fiscal consolidation, strengthening macroeconomic fundamentals. “We expect foreign investors to increase their exposure in 2018,” Dimantha Mathew, head of research for First Capital Holdings, told OBG. “We saw huge outflows in 2016, but earnings hit an all-time high in 2017, and I believe activity will pick up in 2018 thanks to attractive valuations and lower interest rates.”
By the Index
The CSE’s leading blue-chip index, the Standard & Poor’s Sri Lanka 20 (S&P SL20), has performed fairly steadily since its launch in June 2012. The S&P SL20 closed 2017 at 3672, and as of mid-March 2018, the index was up 5.73% year-on-year at 3649.
The recent recovery of Sri Lanka’s equity market can be seen in the S&P SL20’s calendar-year returns. Following a drop in total returns of 8.81% in 2015 and 0.38% in 2016, in 2017 the total return index of the S&P SL20 rose 8.60%, according to the US-based stock exchange index company S&P Down Jones Indices. Price returns decreased by 11.33% in 2015, followed by increases of 3.56% and 5.01% in 2016 and 2017, respectively.
The S&P SL20’s performance is based on the 20 leading stocks on the exchange and aims to provide investors – particularly foreign investors – a solid reference point. The index was developed by the CSE in partnership with S&P Dow Jones Indices. The shares included in the index are categorised and vetted under the Global Industry Classification Standard, developed by S&P Indices and MSCI, another index operator. This allows investors to more easily compare leading Sri Lankan stocks with international benchmarks.
Eligibility
To be included in the S&P SL20, companies’ stocks must have a minimum float-adjusted market capitalisation of LKR500m ($3.3m), and must maintain this above LRK300m ($2m) to remain eligible. Stocks must also be relatively liquid, having a minimum six-month median daily value traded of LKR500,000 ($3300), to be maintained above LKR350,000 ($2300). Other requirement include that stocks have been traded at least 10 days of every month for three months prior to the index’s rebalancing reference date, which is the annual reassessment of the index, when companies are added or removed depending on their performance and eligibility. They must also have positive net income for 12 months prior to the rebalancing reference date. December 2017, for instance, saw Sri Lankan multinational conglomerates Hayleys and Melstacorp removed from the index and replaced by telecoms company Dialog Axiata and conglomerate Richard Pieris & Company.
To avoid over-concentration, the S&P SL20’s constituents are capped at a 15% weighting in the index, meaning that the index does not always directly correspond to the relative market capitalisation of its members. Nonetheless, as of end-February 2018, the top-10 constituents accounted for 76.3% of the index’s weighting; even the carefully selected grouping of the top-20 listed companies is made up of a handful of big players. As of end-February 2018 the S&P SL20 was dominated by the financial services sector, accounting for 52.2% of the market capitalisation, followed by industrials (25.9%) and consumer staples (11.4%). Companies from other sectors were relatively small, with materials accounting for 5.0%, and followed by telecoms with 3.7%, and consumer discretionary with 1.8%.
Debt Market
Sri Lanka’s corporate debt market is relatively underdeveloped and dominated by financial institution issuances. Total turnover was LKR3.59bn ($23.4m) in 2017, up from LKR2.93bn ($19.1m) in 2016. While increasing liquidity remains low, the secondary market saw LKR35.7m ($233,100) traded over 529 transactions in 2017, up from LKR28.36m ($185,200) over 291 transactions the previous year. The market is dominated by domestic investors, with foreign investors preferring government securities or equities.
There are several reasons for the market’s small size, Rohan Goonewardene, managing director and CEO of brokerage First Guardian Equities, told OBG. Past bond scams have made investors wary, while the imposition of a withholding tax on interest paid on bonds – reversing a tax break introduced in 2013 – has made the asset class less attractive and created uncertainty about the regulatory environment. While the government is theoretically keen to boost the corporate bond market, cash-rich government institutions tend to prefer the security of Treasuries in practice. Private investors are also drawn to the government debenture market, leaving little demand for corporate paper.
Comparative Performance
The S&P SL20 has proved an important asset for Sri Lankan capital markets, performing reasonably well given the political and macroeconomic environment. The slight underperformance compared to the benchmark S&P frontier broad market index (BMI) can partly be attributed to the exchange rate as the BMI is dollar-denominated.
In the five years to end-February 2018 the S&P SL20 achieved annualised total returns of 6.44%, against 8.73% for the BMI, while price returns were 3.04% against 4.83% for the BMI, according to S&P Dow Jones Indices. The S&P SL20’s three-year annualised total and price returns were negative, at 0.08% and 3.4%, respectively, while recovering global confidence lifted BMI total returns to 8.58% and price returns to 4.64%. Nonetheless, compared to many regional peers, Sri Lanka is an attractive prospect. At 23%, the country’s low market capitalisation-to-GDP ratio signifies a considerable upside, according to First Capital. By comparison, Indonesia, which has a similar per capita GDP, has a ratio of 46%. Regional leader Malaysia stands at 130%, followed by the Philippines with 100%, India (69%), Vietnam (33%) and Pakistan (30%).
Furthermore, the P/E ratio on the CSE is fairly low, at 11x, according to First Capital, suggesting that stocks may be relatively undervalued. In Vietnam, the P/E is 16x, followed by the Philippines at 22x, and India and Indonesia at 23x. Only Pakistan has a lower P/E ratio at 8x, possibly due to the political instability and security risks associated with the country.
“The P/E ratio isn’t the lowest but is quite low,” Nishantha Hewavithana, head of research and new products at the CSE, told OBG. “The market is undervalued, and there are a lot of attractive buying opportunities by regional standards for foreign investors.”
There were 299 companies listed on the CSE as of March 2018, with the top-10 listed companies accounting for more than 40% of the exchange’s market capitalisation. The biggest listed company by market capitalisation was conglomerate John Keells Holding, accounting for 8.25% of the exchange’s overall value. It was followed by Ceylon Tobacco Company (7.34%), the Commercial Bank of Ceylon (4.67%), Dialog Axiata (4.16%) and Hatton National Bank (3.50%).
Sector leaders hope that the level of market concentration will decrease in the future as more medium and large companies list, making it less dependent on the performance of a few large players.
Reform
There is still a sense that the stock exchange is performing considerably below its potential, given the country’s economic growth, and its renewed political openness and stability. The long-awaited new SEC Act was published in December 2017 following many months of drafting. The bill aims to improve regulation and strengthen capital market operations more broadly. It will replace the SEC Act of 1987, which is widely seen as ineffective and outdated.
The new act allows the SEC to take action against capital markets infringements through civil – as opposed to criminal – proceedings. Meanwhile, penalties will become more stringent, including larger fines and the threat of jail sentences, and the SEC will have more scope to recover damages. The legislation will also be tougher on illegal activities such as market rigging and manipulation, while broadening the reach of the SEC to include areas not currently covered by the regulator, including the capital markets activities of non-listed companies. In addition, the commission will have greater independence from the government, giving it more freedom from political pressure. Lastly, the bill will strengthen protections for auditors, with a view to ensuring professional and accurate auditing and early warnings of financial distress.
These rules should not only improve the functioning of the market, but also boost investor confidence after a series of controversies in recent years. These, combined with the market plunge in 2011-13 have made domestic and international investors warier. “We need a modern regulatory framework that protects the interest of investors and deals with market misconduct to instill trust and confidence in our capital market,” Ravi Abeysuriya, president of the Colombo Stock Brokers Association, told OBG. “This has a huge role to play in the development of the market”
Demutualisation
Progress is also being made on the demutualisation of the CSE with another longawaited reform bill. Put before the Parliament in early 2018, the bill will convert the CSE’s operator from a company limited by guarantee – that is, one owned by its members, which are brokerages – to a jointstock company. The reform is designed to help the CSE develop as a corporate entity while removing any potential conflicts of interest that can arise from the exchange’s ownership by its participants – a system that some feel has significantly held back broader reform. Under the new legislation, members will be strictly limited to a 40% stake in the CSE.
The process may lead to a portion of the CSE being offered on the exchange itself, which will both boost liquidity on the market and allow the company to raise capital from investors to fuel further development. “Demutualisation will allow the stock exchange to make decisions independently, thereby making it more profit-oriented,” Hewavithana told OBG.
Hewavithana believes that in the longer term, the bourse is likely to seek an international strategic partner to invest in the newly formed joint-stock company. This partner – a foreign stock exchange company – is expected to bring financing as well as knowledge and technology transfer. A number of major international stock exchange operators have stakes in other exchanges, and international investors have expressed interest in taking a share in the CSE.
Upgrades
The CSE is continuing work on the introduction of a central counterparty (CCP) system that will 30 50 enhance the settlement of securities, thereby reducing settlement and default risk for buyers and sellers. The CCP system – most likely to be a clearing house – acts as a counterparty to both sides in secondary market transactions, often allowing for the simultaneous exchange of funds and assets. The new system is expected to facilitate a better basis for the development of derivatives trading – including short-selling – by broadening the range of products available to investors, and allowing them to better manage investments and hedge risks. Following some delays, the CCP system is set to be operational by the end of 2019.
The CSE also aims to introduce rules to create an enabling environment for real estate investment trusts (REITs) to increase access to property investment and exchange-traded funds. REITs have proved hugely successful elsewhere in Asia, and with Colombo’s real estate market seeing a period of strong growth, demand in Sri Lanka is also likely to be strong (see Construction & Real Estate chapter). “We expect a more efficiently run exchange after demutualisation, as well as new instruments that are in line with more developed exchanges in the region and internationally, which we have lagged behind for some years,” Mathew told OBG.
Inclusive Growth
The CSE is in the process of obtaining regulatory approval for another two significant developments: the launch of a separate exchange for small and medium-sized enterprises (SMEs), and a US dollar-denominated trading board. The SME board will have fewer listing requirements, allowing smaller and less-developed companies to go public and access capital, while also providing equity investors the opportunity to tap into a thriving segment that accounts for just over 50% of GDP. Once listed on the SME board, the intention is that companies will strengthen their finances and management practices, giving them the opportunity to move up to the main index. “SMEs can increase their visibility to investors and work to improve their corporate governance through listing on the board,” Hewavithana told OBG. “It will also provide an exit for funds and family-owned businesses.”
The dollar trading board, meanwhile, will allow companies incorporated in other countries to list their shares, while also giving domestic companies the opportunity to raise equity and debt in foreign currencies. This will help companies and investors cushion themselves against foreign exchange risk. This is an important consideration given the Sri Lankan rupee’s occasional volatility, although companies earning most of their revenues in rupees will still see US dollar share price fluctuations. One such potential market for new listing opportunities is the Maldives, where capital markets are relatively underdeveloped. Other markets to be targeted in the CSE’s expansion push include Bangladesh, Bhutan and Pakistan, offering companies from those countries the opportunity for greater exposure on international financial markets. These reforms, while important, need to be seen as part of a broader set of improvements to Sri Lanka’s business environment. “While the proposed multi-currency board can work as a gateway for foreign and local companies to raise foreign currency denominated capital, further action is needed from policymakers and the private sector to enhance the confidence of foreign investors in Sri Lanka’s economy,” Rajeeva Bandaranaike, CEO of the CSE, told OBG. “However, we can all agree that foreign interest in the country is at an all-time high.”
Going Public
Attracting more companies to list on the CSE is essential to its long-term development. New IPOs increase liquidity and visibility, and may help nudge the exchange closer to the achieving MSCI emerging market status, which will open it up to a wider range of investors. “We need more equities and instruments if we want to develop into a serious market,” Goonewardene told OBG. “Currently, we don’t have enough to offer in terms of liquidity, as all but the biggest companies have free floats of between $20,000 and $25,000. There just isn’t enough to attract big fund managers.”
In 2016 there were three new listings on the CSE, raising a total of LKR1.8bn ($11.8m) on the primary market, according to the SEC. All three were financial services companies: People’s Insurance, Orient Finance and Amãna Takaful – one of the few insurers offering sharia-compliant insurance.
In December 2017 the CSE saw its biggest IPO since 2015 as LVL Energy Fund (LEF), a subsidiary of capital market company Lanka Ventures, raised LKR1.2bn ($7.8m) to finance hydroelectric power plants in Sri Lanka and Nepal, and to pay off debt to reduce its financing costs. The same month, Jetwing Symphony, the investment arm of hotel and tourism company Jetwing Group, raised LKR753m ($4.9m), also to finance expansion and pay down debt. This followed the successful IPOs of personal grooming manufacturer Beira Group in February, raising LKR368m ($2.4m), and the LKR960m ($6.3m) raised by RIL Property in March.
The CSE could receive a substantial boost from the listing of major state-owned enterprises (SOEs). Given that many private and foreign investors do not wish to list their businesses, large SOEs are among the few firms in the country with the potential market capitalisation needed to make an impact on liquidity and help the exchange meet MSCI requirements. Major state-owned banks, utility companies and the national carrier SriLankan Airlines have been among those suggested for IPOs of majority or minority stakes. However, floating shares in SOEs is politically sensitive due to the unpopularity of privatisation, with which public listing is sometimes incorrectly conflated. The government may therefore focus on listing non-strategic assets at first.
Outlook
While the CSE has had its ups and downs since the civil war ended, its overall trajectory has been positive. Turbulence in recent years led to improvements in regulation, much to the benefit of market stability and transparency. The implementation of long-awaited reforms is a sign that the authorities are putting an emphasis on capital market development. This suggests that there is the potential for new momentum behind the diversification of product offerings and investment platforms, which should draw more investors to the market. Attracting the IPOs needed to raise liquidity and obtain the MSCI status remains a challenge.
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