Real potential of the Colombo stock market

By an Analyst
There is no doubt and there is near unanimity that overregulation by the previous Securities and Exchange Commission arising from inexperience, lack of knowledge and lack of correct strategies was the prime cause for the market collapse witnessed today.

The SEC without any foresight and professionalism has introduced ad hoc legislation detrimental to the market and naturally stakeholders, investors and brokers have insisted these be amended for good reasons

A short review of series of mistakes made by SEC is useful to the investor public, brokers and the Government. Since 1994 after a bull run due to foreign inflows our stock market witnessed a very long period of bearish trend for 14 years up to 2008 except for brief recovery for nearly two years from 2002. Terrorism, with a very adverse impact on the economy, was the main reason for the unusual prolonged bearish market.
With the defeat of the LTTE, the country witnessed an unprecedented economic development and accordingly, the stock market too witnessed remarkable growth during 2009 and 2010. Thousands of investors flocked to the stock market and lakhs of small investors earned substantial profits, which also contributed to the economy through right issues and IPOs, etc., apart from substantial contribution to popularise the Government.
At the time the retail market was very active and small investors were earning good profits. Without prior notice suddenly eight share and warrants, e.g. Touchwood, Dankotuwa, Blue Diamond, Greg warrants, were suspended from trading and thereafter imposed restriction on movements for 15 days, thereby killing the sentiment of these shares/warrants.
It was widely rumoured that certain high net worth company/companies influenced this decision since one of the affected companies threatened to become the highest cap company due to price appreciation. This was the beginning of the attack on midcap and speculative shares popular among small investors.
Suddenly in September 2011, the SEC decided to completely ban broker credit by giving short notice up to 31 December to complete the exercise. The SEC failed to realise such major reversal of policy needed at least two to three years to avoid seriously damaging the market.
This decision invited serious criticism and SEC extended the deadline to 30 June. This was further extended to 31 December 2011 for the final 25% balance to be paid by that date.
Bank guarantees
When the IPOs were attractive up to 2010, the rich class resorted to apply for substantial portion backed by bank guarantees without committing cash. Small investors invariably applied for shares with 100% cash, thereby substantially restricting the quantities requested.
Some who apply for 10,000 shares were given only 100 shares and naturally they were compelled to apply for additional shares far above the offer price, ensuring huge profits to the rich class. Ultimately the small investors who were the victims incurred massive losses.
Despite public protects, SEC waited for a long period prior to introducing restrictions when IPOs became unattractive.
Private placements
This was another method the rich class found to make huge profits. The modus operandi has been to issue substantial quantities of share to the directors, friends and relatives within a short period prior to an IPO so that these would be unloaded after trading commenced. It was the small investors who bought such shares, ultimately incurring huge losses.
What is more tragic is that such shares have been issued even below the IPO offer price, which helped to increase the profit substantially. There were several such cases and the return on an annual basis may rise up to even 150% to 200%.
For example, Expo Lanka has issued 300 million shares at a price of Rs. 6 per share prior to the IPO and had priced 176 million shares at Rs. 14 as offer price. The poor small investors who purchased at the opening day were not aware that they were giving over 100% return to the privileged class who purchased them at Rs. 6.
As to why SEC waited over one year despite protest by investor public and newsprint, it is rumoured that some connected to the SEC and CSC were also the beneficiaries of this share issue with conflict of interest. Investment under nominees was also widely suspected.
Sell down of shares of directors
Due to the restrictions on IPOs, the rich class resorted to selling down shares prior to IPOs, bringing down cost per share far below the IPO price and consequently enabling the rich class to make huge profits again.
There are other rules and regulations introduced by the SEC which damaged the stock market but due to lack of space it is not possible to give details.
There is widespread belief among investors/brokers that rules and regulations were detrimental to the retail sector, which included small investors and designed to please some blue chip companies and the rich class. The Government, which owned SEC, never intended for this objective and sadly some high officials of the Ministry of Finance too contributed to this trend.
Other contributory factors
The campaign was launched by the Opposition party that the upward movement of the market was due to manipulation by high net worth investors connected to the Government. Some MPs even compared it to a casino.
Naturally the Opposition was worried lakhs of investors were making profits which would be politically damaging during an election, hence it was necessary to ensure the collapse of the market and make the Government unpopular.
Certain SEC officials and commissioners and some opposition members with a view to please blue chip companies campaigned through newsprint/electronic media that midcap and speculative shares have been manipulated and hundreds of investors and brokers were called by SEC and threatened with severe repercussions if they continued to trade with such shares. The blue chip companies too found the retail sector was not favouring blue chips and consequently remained inactive.
This created a situation where the rich class was unable to dispose of these shares and therefore it was necessary to damage the retail sector preferred shares by ensuring substantial downward moves, resulting in huge losses to the small investors. It should be noted that nearly 200 out of 275 shares are in this category.
Unconfirmed reports indicate that in order to damage such shares, attempts are being made to permit only blue chip companies to be provided with margin facilities, which would be a death knell to nearly 200 shares.
Interest rate hike
The latter stages of 2011 have seen a deterioration of the balance of payments with the value of imports almost doubling and exports with a BOP deficit of US$ 1 billion. In order to discourage imports and divert from consumption to savings, the CB has been increasing Treasury bill rates in the past with 12 months TB attracting over 12% on 9 May 2012. It is possible that the upward movement of TB rates would come to a saturation point very soon.
Since the CB has imposed a credit ceiling of 18% without foreign inflow for commercial banks, incentive attempts to increase rates would not be attractive. This would also affect margins of commercial banks. Even reputed old finance companies such as Central Finance are cautious with regard to unnecessary rate hikes. Accordingly we don’t expect diversion of funds from the stock market to commercial banks/finance companies. In fact a shrewd investor may, on the contrary, considering the present market prices, shift funds from others to the stock market.
Similarly it should be noted that unlike interest from bank deposit, income from the stock market is tax free. Those involved with the stock market, i.e. the investor public, stock brokers and stock brokering companies, should realise the TB rates similar to prime rate and libor should not be considered in isolation and instead considered comparatively for any investment decision. For instance, if the return from the stock market for a period of 12 months is 6%, there is logic in diverting funds from stock market to TB at 12% and bank deposits. However, on 11 May 2012, midcap and speculative shares have dramatically dropped to 85% to 95% in several cases compared to highest price in the recent past. Consequently at current level it would be prudent and advisable to divert from TB and other fixed income instruments to the stock market for a comparatively higher profits. The table confirms the above position.
It could be argued that it would not justify the highest prices reached on above shares. However, it should be noted that the price of a share as in any other market in the world would not solely depend on EPS and net asset value. Prices of some blue chip companies would confirm this position. For instance price of John Keells at Rs. 202 with a PE 22.50 (overall PE 13.1 on 11 May 2012) and NAV of Rs. 76.40 is highly overpriced.
Rupee depreciation
The rupee, which devalued to Rs. 133, has now settled around Rs. 27 in 28 due to several steps taken such as increased taxes on vehicles, price increase of petroleum products, etc. CB now expects official reserves as at end of 2012 up to US$ 7.9 and official rate to be around Rs. 120.
Unfounded fear among investor public/brokers and brokering companies
The country is presently undergoing unprecedented development having recorded over 8% growth in the past two years. This is very remarkable considering the fact that the majority of European countries are already officially in recession.
In addition most of the countries such as Spain, Portugal, Greece, North Ireland, etc., face sovereign debt problems where the governments are unable to repay their debts. It is possible this may even affect powerful economics such as Italy and France.
What is inexplicable is that the stock markets in those countries have recorded upward movements from time to time in contrast to ours having remained dormant for several months, moving within a very narrow band with occasional sharp downwards. For instance the ASI has been continuously declining for nine consecutive days up to 11 May 2012, which is considered abnormal.
Wrong interpretation of net capital
Originally prior to the crisis, granting of broker credit was permitted on a very liberalised basis and this has been removed by SEC. Later the companies were permitted granting credit against zero capital, which proved totally ineffective due to the basis of computation of net capital. It is due to the personal intervention of the President that the SEC was compelled to introduce three times capital. However, further obstacles were placed on the determination of the net capita by subtracting T+14 to T+30 transactions value with 50% and above T+30 with 100%. The net result has been instead of credit expansion by three times, the companies were even unable to provide zero capital, resulting in daily forced selling. This is turn created pressure on margin trading further. An investor with a comfortable 10% margin may have found this rising to 70% to 80% with forced selling.
We observe that the investor public and majority of brokers are sadly not briefed regarding the country’s macroeconomic situation and many positive aspects of the stock market. It would appear that all those connected to the market are groping in the dark without knowing what action should be taken to revive the stock market. Majority of CEOs and senior brokers lack the leadership qualities to provide correct leadership in motivating their subordinates and investors.
Various seminars are conducted almost every other day regarding manipulation and insider trading, which has become a boring subject today, and investors are now suspicious whether this is an attempt to divert attention from many other adverse factors linked to SEC referred to above and use it as a smokescreen to save the SEC from public anger.
SEC Chairman’s press comments
Certain comments need critical analysis:
“Credit rules having been relaxed since it was not hurting the market.” In reality credit should go to the President and not due to the change of heart of the SEC. In addition wrong interpretation has been given to the net capital; ultimately today brokers instead of three times are unable to grant even zero capital. Many now consider this is an attempt to undermine the authority of the President. In fact the Stock Brokers Association was scheduled to meet the SEC regarding this matter.
While we totally agree with the Chairman that the investor public and brokers have lost faith in the SEC, it is not due to amendments to the rules introduced consequent to pressure from investors/brokers.
The SEC without any foresight and professionalism has introduced ad hoc legislation detrimental to the market and naturally stakeholders, investors and brokers have insisted these be amended for good reasons. Naturally, the SEC was compelled to amend the rules; maybe they too later discovered their mistakes. It should be remembered that it is the investors’ funds that are at stake. Therefore, the credibility of the SEC has been lost due to the passing of flawed decisions; e.g. removal of broker credit within four months.
Even an ordinary investor/broker knows what has gone up should come down. What is relevant is as shown in the above schedule, many prices have come down drastically to 85% to 95% level and no investors could survive under these circumstances. The Chairman should clearly state whether he wishes to see a drop to a level of zero value. The stock market, especially small and mid cap shares, has dropped drastically and could be termed free fall, but sadly no comments have been made by the Chairman at least to explain that our market has tremendous potential for a substantial upward movement.
Recomm-endation
(1) As in the past the President should call an immediate meeting of all stock brokering companies and important investors with a view to ascertain the factors presently affecting the market such as wrong interpretation of net capital, etc., if satisfactory response is not received from SEC.
(2) Major Government funds such as EPF, ETF, insurance, Bank of Ceylon, People’s Bank, NSB etc., should be requested to commence buying of mid cap, speculative shares from the market in a small way on a daily basis without resorting to buying large parcels, which would only help the rich class and would not in any way help the market to improve. It could be the small buying of a share that may even last few months. It is common knowledge that immediately after a large parcel is done, the price drops.
Initially such funds could target 50 shares and on the basis of three million shares with an average price of Rs. 25, it would cost Rs. 3,750 million. It we are to increase it to 100 company shares, it would generally cost Rs. 7,500 million by averaging only Rs. 1,250 million per fund, which in relation to their fund base is small.
Similarly there are over 27 unit trusts and over 10 private insurance companies and if each invests Rs. 200 m, nearly Rs. 7,400 m could be invested in another 100 company shares in the manner outlined above. We are of the opinion that within the period of one year, companies would be in a position to realise a minimum 100% gain in profits. It should be mentioned that investing in blue chipsw would not give even a 50% gain since prices have not dropped much. John Keells is one example.
(3) A Presidential commission should be appointed ideally consisting of judges who are independent and with no connection to blue chip companies to report on the workings of SEC and CSE on wrong decisions taken and why early action was not taken to impose restrictions on IPOs, private placements, sell down of shares and wrong interpretation to net capital, etc.
 Summary
Today the first, second and third priorities should be on how the market can be revived. We emphasise in the first place that there should be a market to regulate. Nearly 500,000 small investors are today beggars having lost their entire savings.
The rich privileged class, having earned billions, must be still counting profits from shady IPOs, private placements and sell down of shares thanks to inaction on the part of the SEC. The above inaction, broker credit and other regulations of SEC are 90% responsible for the present plight of poor investors; the impact of manipulation and insider trading is minimal and may account for the remaining 10% only.
Stock brokering companies should set aside their cutthroat differences and unite to revive the market, which is very attractive. Sadly today Board members of SEC and CSE and officials are unconcerned about reviving the market. Their confrontational attitude towards small investors, brokers and brokering companies is immensely damaging the market and this should be immediately stopped by the Government. If necessary the Government should not hesitate to introduce drastic changes to the SEC Board and the top management to save the stock market. The present state of the market is not good for the Government politically and economically. Ours is considered the worst in Asia, when ironically the country recorded the second best growth of 8.3% in 2011. It shows the immaturity of the stakeholders.
Foreigners are net buyers to the tune of almost Rs. 22 billion, which is a record when locals are selling.
CB expects this to rise to Rs. 60 billion by 2012 year-end. It is high time for investors and brokers to realise that huge profits could be gained by investing at current levels.