Following is the DNH Financial’s outlook for the Colombo stock market this week and beyond.
The country’s structural story remains firmly intact and 3Q2011 corporate profits will continue to remain strong, bolstered by robust revenue growth and improving margins. While the ASPI appears to have found a healthy floor at the 7000 levels, investors may now need to make a directional call, build a quality portfolio and take advantage of what is increasingly becoming a ‘stockpickers’ market.
Game of blindfold darts…we don’t think so Contrary to the rhetoric of some that investing in the Colombo bourse can largely be equated to a game of blindfold darts, we take a markedly different view. Ours is based on the belief that the market 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 investors to now make a directional call, build a quality portfolio and take advantage of what is increasingly becoming a ‘stockpickers’ market.
Flight to Quality
Attempting to seek quality on the Sri Lanka bourse does not happen by chance, but is the effort of a careful bottom up selection process. While high-quality stocks on the bourse may always be welcome for risk management, their time to actually outperform may indeed have just begun being ideally positioned to take advantage of Sri Lanka’s 8-9% economic growth and 30% corporate EPS growth. Should the market falter, their robust balance sheets and steady earnings will provide a strong defense, conversely, should the economy and market continue to rally, their strong competitive positions should allow them to outperform. Consequently, with investors having pushed up the price of lower quality companies during the 2009/2010 bull run, an opportunity to invest in value with significant upside potential of reversing its underperformance now exists. While all stocks go through cycles of undervaluation and overvaluation, investor returns can be maximized by taking advantage of these cycles, buying stocks when they are undervalued and subsequently selling them when they are overvalued. Quality stocks are by no means an exception. Over a full market cycle high-quality stocks can not only outperform, but tend to do so with less volatility. Consequently, we advise investors to focus on high quality cash rich companies with strong balance sheets that have underperformed during periods of market over-exuberance and which have the upside potential to re-rate to their intrinsic values.
Don’t be overly dependent on PE Valuations alone
From a purely PE valuation point of view, the Sri Lanka bourse is neither expensive nor cheap; the bourse appears cheap considering its historical PE levels, but expensive relative to regional peers. However, on an all important Price to Growth (PEG) basis, the market remains highly attractive both on a historical as well as peer comparison.
4Q2011 Portfolio Construction Strategies
Given our expectation of a 4Q2011 rally where we expect the market to cross the psychologically important 9000 resistance level, we advise investors to be appropriately positioned to maximize their returns at an acceptable level of risk to generate positive and healthy risk adjusted returns. In this respect, we recommend the following portfolio construction strategy that incorporates both a core portfolio and dynamic portfolio of stocks;
- Core Allocation consisting of companies with,
- Sound fundamentals
- Both Value and Growth companies (however avoiding value traps)
- Exposure capped typically at 10% of portfolio
- Holding period 3 months – 2 years
- Reviewed quarterly, before results and on news/events
- Dynamic Allocation consisting of companies with,
- Market dynamics and strong momentum
- Holding period generally up to 1-3 months
- Capped typically at 5%
- Daily review against target sell price and stop loss levels
Inflection point close at hand
Considering the double digit earnings outlook for 3Q2011, we believe that an inflection point in the market could be closer at hand than most anticipate with the bourse breaking to the upside sooner than later. However our stance remains that current market conditions are not attractive for a short term speculative trading strategy but rather a tactical, active and aggressive stock picking strategy which should provide superior risk and reward returns over the next quarter.
Even though investors appear to be concerned over the prospect of only pedestrian returns in the stock market we believe that such concerns may be warranted if and only if their investment style is one of a short term speculative strategy. We believe however that for those whose investment horizon is beyond the immediate term can well expect to enjoy a sustainable double digit return.