Is Sri Lanka the new investment darling?

Leslie Shaffer | Writer for
Why Sri Lanka's central bank cut rates this month

Should Sri Lanka's market be on your radar after its strong start to the year bucked the downtrend in most emerging markets?

The Colombo market's All-Share Index has tacked on around 4 percent so far in January after gaining nearly 5 percent in 2013, even as many of its regional counterparts have lost ground.

Additionally, while many regional markets experienced outflows of foreign funds last year amid concerns over tighter liquidity after the U.S. Federal Reserve first broached the idea it would begin to taper its asset purchases, the Colombo market saw net foreign inflows of almost 22.9 billion Sri Lankan rupees in 2013.

(Read more: Investors to eye riskier markets in 2014: Control Risks)

Some regional markets have raised interest rates to try to prevent fund outflows, but Sri Lanka has been lowering its rates.

"We have seen inflation at the lower levels. We have been seeing the growth at the right levels. We have seen the external sector coming back to fairly robust level. So all those gave us the confidence that we were on track to having inflation at lower levels in the future," Ajit Nivard Cabraal, the governor of Sri Lanka's central bank told CNBC.

He expects the economy will grow around 8 percent in 2014, citing two major developments: the end of the civil war in 2009 and the repositioning of the economy toward services.

Colombo Stock Exchange sees more investor interest

"We have developed our infrastructure, particularly the ports and airports, which means our services have now improved quite dramatically. And we are seeing the services sector, particularly the hubs we are looking at -- maritime, aviation, knowledge, activities as well as the commercial and energy -- all now contributing a lot more to our economy than they did in the past," he said.

The stock market itself is working to attract more foreign investors, embarking on development initiatives including requiring listed companies to keep more of their shares available for trading, as well as improving broker infrastructure, strengthening regulation and developing the corporate bond market, Rajeeva Bankaranaike, the CEO of the Colombo Stock Exchange, told CNBC.

He believes his market offers a lot of value for investors.

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"It's the growth story," he said. "Some of these sectors are trading at deep discounts. Particularly in the Sri Lankan economy, we have some of the growth sectors very well represented and these are trading at deep discounts to the market P/E (price-to-earnings ratio)," he said, citing the construction, energy, property and manufacturing sectors.

Investors are responding to the lure.

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"We are positive on the outlook for equities in the current year," said John Keells Stock Brokers and CIMB in a note, citing an improved earnings outlook and expectations lower rates will spur more funds toward the stock market. They expect the All Share Index will rise at least 15 percent this year, with scope for earnings multiples to rise along with earnings growth, which it estimates at around 15 percent for the year.

Kuni Takahashi | Bloomberg | Getty Images

"As Sri Lanka comes out of its tightening cycle there is also an extremely strong pipeline of private investment into leisure and property megaprojects over the next five years, unprecedented in their scale and scope in Sri Lanka which should significantly improve sentiment."

To be sure, the view on the market isn't universally positive. HSBC only rates the market at "neutral" in its frontier market coverage.

(Read more: Frontier markets: Top opportunity or too risky?)

"Macro developments have yet to translate into improved business prospects," it said in a note.

"Sri Lanka has failed to attract much-needed FDI (foreign direct investment), and consumer spending remains sluggish. The problem appears to be delays in infrastructure projects, which are having a knock-on effect on the broader economy," it said, adding the country has a high current account deficit and overdependence on imported fuel.

While valuations look attractive, the equity market lacks liquidity, HSBC said, noting the one-month daily turnover averages only $5.2 million, the lowest among Asia's frontier markets.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1