Bullish investors looking at the phenomenal rally in the Sri Lankan equity market have been offering a range of arguments as to why this state of affairs will continue well in to the future.
While some argument can be refuted outright as simple faith, others take analysis to see if they are merited. Perhaps the most controversial of all the bullish assumptions is the one bsed on the notion that high GDP growth over the next decade would lead to higher equity returns to investors.
The debate about the close nexus between GDP growth and high stock market returns isn’t something limited to Sri Lanka and is currently raging in about all developing nations. While it makes intuitive sense that domestic growth should benefit domestic equity markets, the connection is much weaker than what appears. In fact, considerable academic research is coming around to proving the exact opposite to be true.
Academics at the London School of Business, led by Professor Paul Marsh have been updating an annual yearbook of global asset class returns spanning more than a century, and have concluded that returns from emerging markets are inversely related to GDP growth. The same conclusion was reached by Jay Ritter, a Professor of Finance at the University of Florida.
There is little doubt about the strong future economic growth of Sri Lanka in the medium to long term. With favourable demographic dynamics, rising wealth in Asia and the end of the conflict, only a global disaster or epidemic will have a material impact on the healthy rise in GDP. Return from stocks however have very little to do with any of this, especially if the companies do most of their business with non-Sri Lankans and are exposed to the fortunes of other countries.
The US expanded faster in the 19th century than in the 20th, but equity returns were no higher. Over the past decade, Asia has had faster economic growth than Latin America, but Latin American shares have performed three times better.
The reason for this counter-intuitive finding is that you can’t buy shares in the statistical construct known as GDP. You buy the shares of real world companies. Sri Lankan companies that end up winning the struggle for survival may not even exist yet. That was certainly so in the case of Japan’s economic miracle. In the 1950s there were more than one hundred motorbike companies. The market leader, Tohatsu, was driven out of business by the cut-throat pricing of a flaky upstart called Honda.
Secondly, companies in Sri Lanka will likely finance their growth by repeatedly raising large amounts of new capital. This is of no benefit to shareholders without an overall improvement in return on capital.
Thirdly, Sri Lanka has large reserves of under-utilised savings and human resources. Mobilising them is both the key to our success and the guarantor of mediocre investment returns. Why waste time attempting to raise returns on your existing capital when you can easily access more?
There is only a limited amount of free-float shares to choose from in Colombo Stock Exchange. The free float of a public company is an estimate of the proportion of shares that are not held by large owners and that are not shares with sales restrictions. The vast majority of shares in Sri Lanka are either held by large family interests, cross-holdings or increasingly now, indirectly by the government (through the large pension funds such as the EPF). This illiquidity should come at a price that is used in discounting the value of any company.
Another obstacle for many investors is that some of the best run and most profitable firms in the country are not listed for the public to invest, but remain in private hands. Take for instance the successful apparel manufacturers and niche manufacturers of soft commodities with very strong growth over a decade, which are all beyond the reach of investors.
The best way to take advantage of the growth in GDP is to understand where this growth comes from. Studying the development trends of other countries going back millennia, the first major transition occurs in personal consumption.
Any company that has significant pricing power in basic consumption goods followed by services, which can be purchased at a reasonable price, is a good starting point. Unfortunately, most companies who benefit from this growth are global multinationals (Unilever, Procter & Gamble, etc.) listed in overseas markets. Similarly, firms that significantly export consumption goods and services to other developing nations which are listed in Sri Lanka will also allow you to participate in the GDP growth story.
What should be important to you as an investor are the returns you can make by investing in companies, and the kind of exposure those firms have to domestic consumption growth.
(Kajanga is an Investment Specialist based in Sydney, Australia. You can write to him at