Investment Themes to Mitigate Risk in Sri Lanka

Overview of Opportunities in Consumption

Sri Lanka’s stock market provides a large number of opportunities for investors to gain access to domestic middle-class consumption.  In order to mitigate risks amid the economic uncertainties that are ahead, the following two themes are crucial:

  • Growth is a better strategy for investing in Sri Lanka at the moment, although there are a large number of consumption themed stocks that trade at a discount to the CSE Index.  A value investing strategy would be more ideal when the economy enters a positive cycle.
  • When accessing consumption, it is best to avoid the high-end segment and to note how certain sectors may face the risk of consumers switching to inferior goods.

Some of the most favorable investment areas of Sri Lanka’s Stock market include FMCG, retail, and healthcare, while banks and construction stocks are two value areas to note as well.


Consumer Spending Surge

Consumption in Sri Lanka has risen substantially since the end of the country’s civil war in 2009.  Moreover, GDP growth has averaged slightly over 6% in Sri Lanka since 2003.

Retail Segment Growth: Sri Lanka’s retail segment has experienced CAGR of around 6% from 2011-2016 and is poised to continue this trend of growth amid the rise of the country’s middle class.   The country’s private consumption expenditure also rose by 8% during FY2016, led by growth in the following areas: clothing and footwear(6%), communication(18%), and health(23%).  A.T Kearney projects that the country’s retail sales per capita will grow by 6% over the next two years, driven by economic growth, increasing disposable incomes, and the increase in tourist arrivals.

Domestic Savings(% GDP): Sri Lanka’s domestic savings as a % of GDP also lags behind much of frontier Asia, and is currently 24% according to the World Bank.  Other markets have higher rates, including India(31.1%), Thailand( 30.8%), Vietnam( 30.1%), and the average for South Asia is 30.1%.

 

Healthcare Expenditure: Sri Lanka’s health care expenditure per capita( USD) is currently 127, compared to 142 in Vietnam, 36 in Pakistan, 360 in Thailand, and 456 in Malaysia.

Sri Lanka’s ICT sector is another strategic area for investment, for several reasons:

  • Sri Lanka was the first South Asian nation to adopt 4G technology in 2013.
  • Broadband, leased-line and satellite connectivity is also widely available.
  • Mobile phone penetration has grown from 16.8(per 100 persons) in 2005 to its current amount of 113.
  • Internet penetration grew from 1.1(per 100 persons) in 2005 to its currently level of 30.
  • Mobile internet connections grew by 22.2% during the year, while fixed internet connections grew by 12.6%.
  • Internet Users: There are roughly 30 internet users per 100 people in Sri Lanka, as compared to 14.4 in Bangladesh, 52.7 in Vietnam, 18 in Pakistan, and 23.6 in South Asia according to the World Bank.
  • Mobile Cellular Subscribers: There are roughly 113 mobile subscribers per 100 people, as compared to 83 in Bangladesh, 67 in Pakistan, 131 in Vietnam, and 78 in South Asia according to the World Bank.
  • Sri Lanka’s internet and mobile phone rates are extremely cheap, which has resulted in the high penetration/strong growth rates.

Moving forward, the increase in value taxes (11% to 15%) for items such as alcohol, cigarettes, telephone services, electronic equipment, perfume, jewelry, and powdered milk will present a threat to consumption in Sri Lanka in the future.  This began in November last year.  This hike in VAT was considered a necessary component of the assistance from the IMF, which should help the country experience an economic turnaround.

#1 Alcohol Industry Outlook: Why a Glass Bottler May be the Best Bet

I am ambivalent about alcohol themed investments in Sri Lanka for a large number of reasons.  As opposed to Vietnam, where one can easily see beer being consumed on nearly every street and in restaurants, consumption of alcohol is less visible in Sri Lanka and is primarily sold in bottle shops.  However, this is not to say there Sri Lanka presents no opportunity.  In particular, liquor consumption is extremely high in Sri Lanka.  Sri Lanka’s liquor consumption is five times higher than Europe, and Thailand and Sri Lanka have the highest levels of liquor consumption in South Asia according to NATA.

 

Vietnam’s alcohol industry is comparatively preferable for its robust middle-class growth story (10% CAGR projected until 2019 according to BMI),  while Sri Lanka’s alcohol sales may decline on the back of the increased VATs that are ahead.  Two of the main ways to access this theme in Sri Lanka, which investors can continue to monitor, includes Lion Breweries and Distilleries Company of Sri Lanka ( Liquor producer), although valuation for Lion Breweries is quite high.  Some positive aspects of Sri Lanka’s alcohol industry includes its relatively higher level of regulations. However, Sri Lanka will still be making considerable efforts to improve the regulations for alcohol include increased regulations for illicit alcohol, including moonshine and beer manufactured with questionable quality.  This should support the industry amid other challenges that it is sure to face this year.

One of the most interesting trends to note is the opportunity to indirectly access this industry by investing in glass bottle producers.  Piramal Glass Ceylon is therefore one of the most convenient stock picks in this industry, trading at an attractive P/E of 10.97.  The consumption of soft drinks and alcohol in glass was highly visible for me during my time traveling there.  All of the smaller restaurants I ate at in Sri Lanka offered soft drinks in glass bottles, and even a small shop at one of the train stops sold soft drinks in glass bottles.

Some of Piramal Glass Ceylon’s main clients include the following: Carlsberg Beer, Viva, Antiquity, MD, Horlicks, Asia Pacific Brewery, Sunquick, Distilleries Company of Sri Lanka, KIST, KVC, ID Lanka Limited, Lion Lager, Secrets, and Goya.  This provides an interesting way to gain access to Sri Lanka’s beverages industry at reasonable value.


#2 Cigarettes: Lower Valuation Reflects Competition from Beedi

This is a tricky area.  The first challenge that hit this industry was the introduction of pictorial warnings on products, although Ceylon Tobacco fared well amid these new changes.  After spending some time in Sri Lanka, I was able to observe that most cigarettes were sold loose, making this threat somewhat irrelevant at many levels.  Besides, pictorial warnings can already be found in many markets in Asia where cigarette sales are already prevailing, so I do not think this is the primary issue.

The main challenge includes the increase of prices of cigarettes in Sri Lanka, which would easily result in price sensitive consumers continuing to switch to beedi.  This trend has already been occuring for many years, which does not make this a daring and unique call.    Moreover, smoking is less prevalent in Sri Lanka, as compared to other countries in Asia.  According to data from the World Bank smoking prevalence in Sri Lanka is only 29%, as compared to 48% in Vietnam, 42% in Thailand, 72% in Indonesia, and 45% in Cambodia.

Although beedi has consistently been growing at the expense of CLC’s products, CLC has still been able to deliver respectable financial growth.  Despite challenges this industry has faced and will face, Ceylon Tobacco is an obviously attractive stock pick on many levels, and valuation is at an attractive level at the moment.  Ceylon Tobacco is the country’s only legal producer of cigarettes and has 16 exclusive distributors which are able to reach over 72,000 outlets in the country.  The company’s only real competition is beedi, as illicit cigarettes account for a minute portion of the market, and it does not have any other competition.

Previous Insight: Sri Lanka’s Tobacco Industry


#3 Healthcare: Valuation is Justifiable Given Sri Lanka’s Favorable Demographics

Healthcare is another strategic area to access in Sri Lanka, and there are a large number of private hospitals for investors to consider. Sri Lanka’s healthcare industry is a clear cut way to access Sri Lanka’s economic rise:

  • 9% of its population is currently over 65 years old, and this amount is likely to double by 2030.  This presents a strong opportunity for increased demand for hospitals, specifically private hospitals.
  • Private Hospitals have achieved CAGR of around 21%( 2013-2016), compared to the public sector’s growth of 10%.
  • 70% of the country’s population uses private hospitals.
  • Health expenditure per capita in Sri Lanka is only $127, significantly lagging behind much of emerging Asia.
  • The medical tourism industry is also another potential advantage of Sri Lanka, due to its lower costs of high prevalence of English in business.  Medical tourists account for approximately 15% of patients treated in Sri Lanka’s private hospitals.


#4 Hemas Holdings: Best of All Worlds in Sri Lanka

Hemas Holdings is perhaps one of the best stock picks in Sri Lanka and a clear example of how investors can achieve a double-digit return amid economic risks and dull stock market performance.  Hemas Holdings has returned around 35% in the past year, compared to a similar CSE Index gain of 4.5%.  This is a fine example of why growth investing in Sri Lanka trounces value investing amid the country’s current economic landscape.  Hemas Holdings primarily operates in FMCG and Healthcare(81% of revenue), and also operates in tourism and transportation:

  • FMCG: The company sells some of the top FMCG items in Sri Lanka, and one of its products currently has the #1 position in the coconut hair oil segment in Bangladesh.
  • Healthcare: Hemas is the largest private organization in Sri Lanka’s healthcare industry and is the dominant distributor of products such as pharmaceuticals, and surgical and diagnostic products.  The company owns three state-of-the-art hospitals and is also continuing to invest in a chain of diagnostic laboratories.  JL Morison, one if its holdings, is also one of the leading local manufacturers and suppliers of essential generic pharmaceuticals to the Sri Lankan government and the private sector.


#5 Sri Lanka’s Banking Industry

Sri Lanka’s banking industry is another interesting value area for investors to note, as the sector currently has a P/B of 1.1x and ROE of 15.2% according to Asia Securities.  Due to Sri Lanka’s heavy economic dependency on SMEs, it is best to access banks which have high exposure to SMEs.  Microfinance is another interesting area to note given the prevalence of SMEs in Sri Lanka’s economy, and although the “Grameen Model” has successfully been implemented for a bank I observed here, it is admittedly a small portion of its revenue.

Sri Lanka’s banking industry is also relatively favorable for its low level of NPLs, which have slightly recovered from the highs of 2011 and 2013.

 

Hatton National Bank is one of the most prevalent banks in Sri Lanka, which has a core focus on retail and corporations.  SMEs account for 24% of its advances and 46% of its net interest income, and the bank notably tapped into microfinance (HNB Grameen Micro Finance Ltd.) in 2014.  The bank has successfully adapted the “Grameen Model” of Bangladesh, and roughly 98% of its clients are women entrepreneurs.  The Microfinance sector loan book of the Bank increased by 47% during 2015, and the company currently serves over 20,000 micro-entrepreneurs.


#6 Retail Companies: Avoiding the High-End Segment

Retail is another significant segment for investors to access, and Singer PLC and Soft Logic Holdings are two of the most notable stocks in this sector that I have observed.  Both companies are active in a large number of segments, including consumer electronics, home appliances,  IT, and apparel to name a few.

Singer PLC:
Singer currently operates around 416 stores in Sri Lanka, and over 2,200 dealers( mom and pop shops).   Singer PLC focuses on retail and consumer finance, and household consumer durables, and has the #1 or #2 market position for every product category in the country.

1
Product Category Description % of Revenue
Home Appliances Refrigerators, washing machines, and air conditioners. 39%
Consumer Electronics Televisions, Home Theatre Systems, and Blu-ray/DVDs 15%
IT Products Desktop Computers, Laptops, and Smart Phones/Tablets 22%
Furniture Sitting Room Sets, Bedroom Sets, and dining room sets 6%

Penetration rates for a large number of Sri Lankan household items still remain very low: air conditioners (10%), washing machines (20%), personal computers (25%), and refrigerators (60%).


Soft Logic Holdings

Softlogic Holdings PLC is one of Sri Lanka’s most appealing diversified conglomerates, and it has a leading market position in the following industries: information and communications technology, retail, healthcare, financial services, automotive dealing, and leisure.  The company represents the following global brands through its diverse operations in Sri Lanka: Panasonic, Samsung, Dell, Nokia, Nike, Giordano, Mango, Cisco, Microsoft, Burger King and Ford.

Segment Contribution to Revenue Description
Retail 33% Leading retailer of consumer electronic and branded apparel, as well as various restaurants.
Healthcare 18% Operator of four hospitals under the healthcare chain Asiri Group.  The company is the market leader in the laboratory segment.
ICT 29% Some of its products include the following: mobile handsets, accessories, computer software, and hardware solutions.
Financial Services 17% Some of its financial services operate in these areas: insurance services, asset management, and stockbroking.

Soft Logic is notably positioned in some of Sri Lanka’s highest growth and strategic segments, yet its exposure to the high-end segment is very strong ( Odel, Burger King, Giordania, and Ford).


#7 Telecommunications: One Wide Moat Value Stock

This is a straightforward consumption area to access, and there is one wide moat company that is well worth noting.  Dialog Axiata PLC is the largest and fastest growing mobile telecommunications network provider in Sri Lanka, and is also one of the largest companies listed on the Colombo Stock Exchange.  The company currently has a subscriber base of 10.9 million( up from 9.5 million in 2014), which it delivers mobile telephony and high-speed mobile broadband services ( 2.5G, 3/3.5G and 4G networks).  As of the end of 2015, Sri Lanka’s mobile subscriber base surpassed 22 million, which made its penetration rate more than 100%.

The company has been making notable strides to target the low-end segment:

  • The company also launched Sri Lanka’s lowest price android Smartphone for RS6,990 during 2015, in its efforts to capture the “bottom of the pyramid”.
  • In April of 2015, the company also launched a monthly/daily installment plan for as low as RS> 200 per month, to allow the Sri Lankan population with easy access to purchase Smartphones, tabs, and other services/products.
  • The company launched its prepaid product called “Power Play” with budget packages to cater to middle-income workers who are willing to spend Rs. 300-500/month.  Low Pay TV market penetration is still low in Sri Lanka, at less than 20%.

#8 Construction: Value and Growth

Sri Lanka’s construction industry has been through many ups and downs due to the country’s political transition that took place in 2015. While Sri Lanka’s previous political transition resulted in the delay of a large number of construction projects, things may be more favorable for the industry moving forward, and the industry also has a strong benchmark of growth prior to this, when Sri Lanka’s economic growth was also much more favorable.

 

Some catalysts for the industry’s future growth include increased home ownership affordability and notably government infrastructure projects which were previously stalled.  Two of some of the key projects that are taking place include the resumption of Port City, as well as the extension of the country’s international airport. Sri Lanka’s President of the CCI notes that the resuming of the Port City Project would be a major catalyst for local construction companies and that it could be responsible for providing about $6 billion in FDI.


Other Areas to Note 

I will also briefly note opportunities for companies which are undervalued and may be better to note when Sri Lanka’s economy/stock market outlook is more positive.  This includes the following areas tea producers, tile manufacturers, textile manufacturers, insurance companies and cable producers.

  • Investing in tea is another salient investment theme in Sri Lanka, and the consumption of tea from the population is very common, and Sri Lanka is very well known for its tea exports, although they have been on a decline.  Domestically listed Ceylon Tea Services manufacturers and exports tea under the famous name Dilmah in Sri Lanka.
  • A large number of tile manufacturing companies in Sri Lanka currently trade at low valuation, including Royal Ceramics Lanka PLC, Lanka Tiles, and Lanka Waltiles.
  • Cable manufacturers in Sri Lanka can also benefit from the rise of manufacturing in Sri Lanka.  ACL Cables is a noteworthy company in this industry, as it has an established retail channel with 250 suppliers and a 70% market share according to Asia Securities.

Frontier Benchmarks: Why Sri Lanka?

I made a list of appealing sectors in Sri Lanka, Vietnam, and Pakistan for various highly desirable sectors, as well as a quick glance of some listed options in these countries.  While the economy is certainly inferior to Vietnam’s economy, there are certainly gems to be found in the stock market, and in some ways can fill in some of the gaps of Vietnam’s market (mainly due to FOL).  I include some stocks below to show the offerings in various strategic areas of Vietnam, Pakistan, and Sri Lanka’s stock markets (top-down thematic overview, include constituents that trade at higher than desired valuation).

2
Sector Sri Lanka’s Industry Frontier Markets Sri Lanka Stocks Frontier Stocks
Alcohol Sri Lanka’s alcohol industry will have some challenges ahead of it on the back of the hike in VATs.  This, coupled with the issue of higher valuation, makes me have the strongest preference for investing in glass bottle producers to indirectly access this area. Vietnam’s beer market is easily the most appealing growth story due to the country’s demographics and existing favorable beer consumption trends. 1) Lion Breweries
2)Distilleries Company of Sri Lanka
1) Sabeco

2)Habeco

3) Other UPCoM subsidiaries of Sabeco and Habeco

Cigarettes Consumers in Sri Lanka may switch to beedi ( continuing on this trend).  The introduction of pictorial warnings is a minor threat, as other markets have fared well after these additions, and because most products in Sri Lanka are sold loose. According to the World Bank, some other markets that are more prevalent in terms of smoking include Vietnam (48%) and Indonesia (72%). 1) Ceylon Tobacco 1) Vietnam: Cat Loi JSC ( printing, filters, and accessories)

2) Pakistan: Philip Morris Pakistan

Conglomerates Sri Lanka has a flurry of conglomerates which operate in diverse areas of retail, FMCG, and healthcare.  Further appeals of these companies include the ability to outperform lackluster market movement, and the strong market shares for these companies. Retail, FMCG, and healthcare are three of the most highly desired areas for foreign investors in Vietnam, yet foreign room for many of these stocks is not available. Mobile World Investment Corporation operates in some of the similar areas as Singer PLC, but there is no foreign room for this company. 1 Hemas Holdings
2) Soft Logic

3) Singer PLC

1) Vietnam: Masan Group

2) Pakistan: Engro Group

Banks Sri Lanka’s banking industry has some appeals due to the industry’s slight recovery in NPLs, the high banked population, and general low valuation of the sector.  Some banks in this industry can consequently be considered for value investing. Vietnamese banks have been in the spotlight in recent months and may open up to foreign investors. However, this process is still not straightforward, and the issue of NPLs is still not fully resolved.  Banks will also be preparing for Basel 11.  A downturn in the real estate sector, which could be approaching its peak, would also not bode well for Vietnam’s banking sector.

My favorite frontier bank is actually in Pakistan, namely Bank Alfalah.  It is most notable for its extremely low valuation, lower level of NPLs, and specifically its decision to target SMEs.

1) Hatton National Bank 1) Pakistan:Bank Alfalah

2) Military Bank and VietcomBank

Healthcare Sri Lanka offers the opportunity for investors to directly invest in listed private hospitals ( Lanka Hospitals). Moreover, some conglomerates also operate private hospitals or distribute pharmaceutical products, including Hemas Holdings and Soft Logic PLC. The majority of Vietnam’s large pharmaceutical companies ( IMP, DHG, TRA) are still not fully open to foreign investors, and there is currently not a pure play for healthcare.  Pakistan’s healthcare industry is also worth noting due to the country’ low healthcare spending per capita and rising middle class. 1) Lanka Hospitals and other private hospitals

2) Hemas Holdings

1) Vietnam: Various Vietnamese small-cap Pharmaceutical Stocks, as there is no room for major pharmaceutical companies.
2) Pakistan: Shifa International Hospitals and Searle Company Ltd.
Construction The resumption of previously delayed projects driven by the country’s recent political transition can continue to benefit the future growth of Sri Lanka’s construction industry. The China-Pakistan Economic Corridor will be a major catalyst for the growth of construction in Pakistan, and domestic cement producers are particularly poised to benefit from this.

Vietnam’s construction industry is continuing to deliver strong growth due to increased demand for real estate projects and infrastructure projects.

1) Access Engineering
2) Tokyo Cement
1) Pakistan: Lucky Cement ( one of several domestically listed cement producers)
2) Vietnam: Some major listed companies involved in infrastructure projects include Cuong Thuan Idico and Tasco JSC.
Telecommunications Sri Lanka’s telecommunications industry has an extremely high penetration, and domestically listed Dialog Axiata serves 10.9 million of the country’s population of approximately 21 million. Vietnam: 52.7 internet users per 100 people and 131 mobile cellular subscribers per 100 people.

Pakistan: 18 internet users per 100 people and 67 mobile subscribers per 100 people.

1) Dialog Axiata 1) Vietnam: Mobifone ( watch for potential state divestment)
2) Pakistan Telecommunications
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