Current thoughts on the Colombo Stock Exchange (CSE)

As you might recall, the Central Bank of Sri Lanka (CBSL) carried out its first major rate hike back in May last year — followed by an outpouring of capital from the Colombo Stock Exchange (CSE) in favor of attractive FDs. And when the Central Bank Governor surprised markets with a whopping 250bp cut on June 1st this year, much of the 1 year FDs had matured and was sitting on the sidelines, with many expecting a rate cut— but perhaps not one that was so deep. So it’s conceivable that the market is now running on these unlocked FDs. And that’s good news if you have money invested, but as an open-minded investor, I think there’s a few points to consider before aping in;

1. It’s not a LOT of money that’s coming in. 2yr and 5yr FDs remain locked, so whatever is hitting the market now is only a fraction of what was sucked out last year.
2. While on the outset it may seem like a bull is loose, what’s different this time compared to the post-covid run is that company prices are inflating whilst profitability and productivity are declining. Some companies may record a profit in Q1 and Q2 this year, but that would be mainly led by rate cuts — not value creation. The overall trend is for companies to keep losing money; faced with low demand and crippled by high debts many took to fund investments when the going was good. Many won’t survive an economic contraction.
3. If that’s correct then a further market correction maybe on the cards. History will prove that markets which are inflated with high Ps and low Es are unsustainable. It’s a classic bubble scenario, and when exactly it could burst is anyone’s guess as it takes into account too much messy retail psychology — I personally don’t think it’s a long way away.
4. But we all know that markets work in cycles, and this is the good news for investors. A further correction — exacerbated by declining company profits and still high rates (it’s fantastical to assume that CBSL would just keep cutting rates with inflation still high and China announcing just last week that it would be injecting 1.7 trillion yuan (US$255 billion) to revive its waning economy — printers be ready), would take the market down to 6,000–6,500 levels, which would give the CSE a 100% upside just to get back to ATHs.
5. Such a valuation could certainly get the attention of foreign funds, especially those looking to cozy up to India — very likely the next economic superpower to unseat China (1.7 trillion yuan be damned).
6. India is expected to see FDIs of $450 billion (with a B) to pour in over the next 5 years. To give you some context, the top 20 foreign funds currently invested in the CSE have just $670m (with a M) invested — collectively. If just 1% of the investment slated for India finds its way here, the market could easily surpass 20,000–25,000 in the next 5 years.

So what does this mean for investors. If you lack patience or don’t mind the risk, you may make some money playing this run. But keeping some dry powder in the sidelines for the next big correction will get you in with the smart money.

Keep in mind that real smart money doesn’t buy into companies when they’re cheap. They buy in when they’re basically free. So well-grounded companies with negligible or negative price-to-book values will attract the most capital . Those with already established links in India, or could serve as a springboard across the palk strait might even go supersonic—and that’s the ride you might not want to miss.

(The above is for discussion only. I don’t wish to be branded anti-market (or even pro-market for that matter). I’ll be first to admit that I could be wrong about all of the above, and I would appreciate hearing from those who also think I’m wrong).

PS — since posting this on a few investment-related groups, I was a pointed to the fact that increasing taxes (on income as well as FDs) might mean that more people stick with tax-free equities. While this maybe true for a few retail investors with small portfolios, more sophisticated players and certainly institutions with market-moving heft will rarely take on more risk to avoid paying more taxes—they often find more creative (and far less conspicuous) ways to avoid paying them.