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Investing in Sri Lanka offers opportunities and pitfalls

After the end of a long-running civil war and the beginning of a fresh government, Sri Lanka's market offers both opportunities and pitfalls for investors.

The market certainly has its boosters. Dumith Fernando, executive chairman at Sri Lanka brokerage Asia Securities, highlighted the positives.

"You're talking about 5-6 percent economic growth, fairly robust earnings growth and in that context, right now the forward price-to-earnings multiples are under 10 times," he says. "That's cheaper than most of the frontier markets in Asia and emerging markets in Asia."

The market has had a tough year - the Colombo Stock Exchange All-Share index is down more than 7 percent so far this year, although it's tacked on around 5 percent so far this month.

On a one-year horizon, Fernando expects some of his top picks could garner total returns ranging from 25 percent to 60 percent. Fernando is particularly positive on the outlook for the construction sector, noting one of his top picks is Access Engineering.

"There's a big push from the government on construction across the country. That had stalled over the last year while the government was relooking at all their projects but most of those projects will start again this year," he says, adding that that's also why he likes the cement sector.

In a January 2015 election, Mithraipala Sirisensa ousted his former mentor and then-president Mahinda Rajapaksa. Then in August's parliamentary elections, the United National Party defeated Rajapakse's United People's Freedom Alliance (UPFA) party, a defeat that blocked the former president's chances of a comeback.

During Rajapakse's decade-long tenure, he encouraged Chinese infrastructure investment in the country, but the new government put on hold many contracts signed by the previous administration, including deals to build as many as three casinos and a port, amid allegations of corruption. However, the huge port project has since gotten the go-ahead again.

Meanwhile, others point to the tourist sector as getting a big fillip since the country's civil war with the Tamil Tigers ended in 2009 after 26 years of fighting.

"The entire country is really a tourist haven," Mark Mobius, Templeton Emerging Markets' executive chairman, says. "It has history, it has beautiful beaches, it has nice people and it's small enough so you can see everything in a week or less."

Templeton is overweight on Sri Lanka, Mobius says, but notes that the index weighting for the country is very low.

Mobius is hopeful that the government will reinstate the casino licenses as they will draw in tourists, particularly from nearby India.

"The casinos are a very good thing to have because they will attract a lot more Indian investments and Indian tourism, which will balance the infrastructure spending that the Chinese are doing," he says.

A trader on the floor of the Colombo Stock Exchange in the capital's CBD; a lack of liquidity is one of the potential complications of investing in Sri Lankan stocks.
Kuni Takahashi | Bloomberg | Getty Images
A trader on the floor of the Colombo Stock Exchange in the capital's CBD; a lack of liquidity is one of the potential complications of investing in Sri Lankan stocks.

Tourist arrivals in 2015 climbed nearly 18 percent from 2014, reaching more than 1.8 million arrivals, nearly quadruple the level a decade ago, according to government data. About 316,000 of those arrivals were from India, up 30 percent from a year earlier.

But even if the casinos don't get back on track, Ajit Gunewardene, deputy chairman of Sri Lankan conglomerate John Keells, says his company is proceeding with building the waterfront integrated resort, including convention space, that was meant to accompany an on-hold casino.

John Keells had expected to lease the casino space to the licensed operator, Gunewardene said. But the full project proceeded because John Keells is eyeing tourist arrivals from India.

"The great opportunity for us is the subcontinent right next door and we think that that's going to play a big role in terms of what will drive growth in Sri Lanka," he says, noting Indian arrivals make up the largest segment of inbound tourists. "That will grow exponentially over the next few years."

John Keells' hotel chain is the conglomerate's largest net asset exposure, with two of its hotels in the capital Colombo offering 40 percent of the five-star room capacity in the city, according to its website. The company also owns a network of tour operators in the country. Gunewardene noted that the company's hotels run at about 80 percent occupancy year-round.

There are drawbacks to investing in the country, however. Both Mobius and Fernando cite liquidity issues.

"Liquidity is limited, and certainly getting out of stocks can be harder than getting into stocks, so you need to manage your exit strategy carefully," Fernando warns.

Mobius also notes that the types of companies available on the exchange can be difficult to parse.

"The biggest companies are diversified companies that are involved in any number of things: Plantations, beverages, retail, whatever," Mobius said. "For the analysts globally, it is very difficult for them to analyze. Usually conglomerates are not favored by analysts [because] they find it very difficult to get a handle on what they are doing."

But there are expectations that the variety of companies available for investment will improve as the government begins to privatize some state-owned enterprises.

At the same time, fresh requirements for maintaining free floats may make existing listings more attractive to investors.

Rajeeva Bandaranaike, CEO of the Colombo Stock Exchange, says he expects the government will initially list non-strategic enterprises first, with about five companies lined up. Bandaranaike also expects the government will divest a hospital and a hotel.

There's another risk investors need to watch for: the currency. The dollar has climbed more than 10 percent against Sri Lanka's rupee since the start of 2015, going from 131.10 rupees to around 145.30 rupees currently.

That's why it's so important for the new government to proceed with its efforts to rein in spending, John Keells' Gunewardene said, adding that will give foreign investors "a level of comfort."

Amid expectations that the U.S. Federal Reserve will increase interest rates this year, which would be expected to strengthen the dollar and might spur outflows from emerging markets, keeping government spending on the straight and narrow is likely to help Sri Lanka appear to be a better destination for foreign investment.

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