Wednesday, December 5, 2012

EPF: Time to re-enter the Sri Lanka Bourse

■DNH Financial says there is a strong case for the EPF to look at the market in a positive and objective manner

Considerable under-allocation to equities

 The Employees Provident Fund (EPF) of Sri Lanka is one of the largest portfolio investors in the country with a sizeable asset base of Rs. 1.08 trillion (US$ 8.2 b) as at June 2012, representing 78% of the superannuation industry valued at Rs. 1.31 trillion (US$ 9.9 b).

 It also accounts for 16.6%of the country’s national GDP and as such its actions or inactions have a significant impact on the Sri Lanka Bourse’s trajectory and market sentiment. In terms of investment exposure, the EPF can historically be regarded as being a highly conservative investor with an equity exposure of just 8% compared to the international average of 41% suggesting a considerable under-allocation vis-à-vis global peers.

Ninety-one per cent of the EPF’s assets are held in the form of bonds, while having the advantage of generating a steady income flow for the fund, is not without an opportunity cost when considering the long term upside potential of the Sri Lanka Bourse.

 Notwithstanding the current market consolidation, bucking the downward trend observed in many global markets, Sri Lankan equities have enjoyed a strong rise over the last couple of years fuelled by increased liquidity, positive investor sentiment together with strong macro-economic and corporate fundamentals against a stable political backdrop.

 As a responsible investor, it is suggested that the EPF take advantage of the current market conditions to increase its exposure to high growth equity investments which could maximise the effectiveness of its investment strategy as the weak-form efficiency of the Sri Lankan Bourse provides a strong opportunity to generate alpha (which is the return in excess of the benchmark index or “risk-free” investment).

Balanced approach to investing will generate optimal returns

 While the optimal asset allocation of pension funds such as the EPF is subject to considerable debate, it may differ significantly from one region to another or from one country to another based on government policies, return objectives and risk appetite.

 A high percentage of assets invested in equities could result in significant exposure of the fund to price volatility in the stock market while over-exposure to fixed income instruments however carries an opportunity cost which could affect the fund’s ability to generate optimal returns. As such a comfortable equilibrium between equities and fixed income investment may need to be achieved in order to maximise the fund’s returns while minimising its investment risks.

 We believe that a balanced approach may be the most suitable strategy to create an appropriate blend of investments with adequate exposure to fundamentally strong high growth blue-chip stocks together with sufficient investment in fixed income securities. This hybrid portfolio will allow the fund to derive the benefits associated with equities, however cushioning the fund against excessive volatility swings through exposure to stable fixed income instruments ensuring capital preservation.

Current market levels present an attractive entry point…

Shrugging off the sceptics who may still argue that the performance of the Sri Lanka Bourse is inextricably linked to the performance of global markets, we beg to differ and justifiably so. Given its reliance on largely domestic factors, the local Bourse has proven to be significantly independent of external forces and has been spared much of the contagion that has swept the majority of markets (both developed and emerging) around the world as a result of the global debt crises.

 While we do agree that the market has not delivered in the short term, we believe that the Bourse has nevertheless bottomed out at current levels presenting an attractive opportunity for long term investors such as the EPF to assume long positions.

 Despite global liquidity constraints, long term foreign institutional investors are taking advantage of the decline in Sri Lanka’s stock market valuations and utilising the current weakness as a healthy entry point to bottom fish for blue-chip stocks notwithstanding their exposure to currency risk; net foreign portfolio flows are presently at an all time high of Rs. 34 b (US$ 258 m).

…for achieving strong stable long-term returns

 Given our belief that the ASPI has bottomed out, we view the current market environment as presenting an excellent entry point for long-term investors such as the EPF who are less likely to rebalance their investment portfolios on a short term basis.

 Significant home-grown liquidity and strong corporate EPS growth will provide the necessary impetus for a gradual market re-rating while continued global fund flows should also underpin growth in the medium to longer term. Consequently, we believe that in this post consolidation stage, the window to invest is now rather than later given that market valuation yardsticks such as PE and PEG indicate compellingly attractive valuations for several blue-chip stocks.

Select stocks in line with risk appetite

 However, despite the market’s appeal at current levels, it is important to define the level of risk that the EPF can assume as attempts to maximise returns should be carried out only at the acceptable level of risk of the fund. Consequently, we believe that a careful selection of blue-chip stocks with sustainable revenue and earnings attributes should go a long way in mitigating equity investment risks.

 Peering through a ‘fundamental’ lens, not all stocks can justify their valuations, so selecting the right stocks will be essential in generating sustainable returns at an appropriate level of risk. From a technical point of view, liquidity may push the markets higher, however with the risk that some stocks could rise to unjustifiably high levels. Knowing which stocks to buy at what price levels holds the key for generating strong and consistent risk adjusted returns and we believe that an active investment management strategy should provide the right support in this respect.

Cherry-pick stocks that will outperform in a complete market cycle

 As a prudent investor in the stock markets, it is important for institutions such as the EPF to cherry pick equity investments that will generate consistent and stable returns in a complete market cycle. This may be achieved through an active investment management approach that combines both a top down and bottom up process to identify stocks with strong intrinsic values which are likely to outperform on a consistent basis (during both a market upturn and a downturn), efficient asset allocation and style rotation which together should enable alpha creation.

Flight to quality strategy advised

 It is vitally important for long term investors to look at the quality and source of earnings figures rather than just headline numbers. In this respect, we believe that sustainable top line revenue growth is the key parameter when selecting a stock using fundamental analysis. Companies could report improved earnings growth while experiencing flat or declining revenues from their core businesses as a result of cost cutting or investment gains.

 Our concern for such companies going forward is whether the source of such earnings is sustainable, and to what extent they hide the weakness in the company’s operating performance. While cost containment is a positive move, a sharp cost reduction can impact productivity and profits. Similarly, it is important to be wary of capital gains which can provide a temporary boost to earnings while concealing a decline in top revenues.

 Right investment strategy should be employed over a reasonable investment horizon
 Despite the prevailing high interest rates, our belief is that the Sri Lanka Bourse will deliver measurable and positive results provided that the right investment strategy is employed over a reasonable investment horizon.

 While the equity market has a notorious tendency to rush from one side to another in response to the ebb and flow of optimism or pessimism, we recommend long term investors such as the EPF to make a directional call, focus on building an appropriately sized quality portfolio of high quality growth stocks that will perform in a complete market cycle. This we believe will support the fund in achieving its objectives of maximising returns at an acceptable level of risk thereby generating healthy risk adjusted sustainable returns.

(Source: DNH Financial)/

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