The Colombo Stock Exchange: gearing for a new age
The All Share Price Index enjoyed its best year in six years despite the coronavirus pandemic: CSE’s Chairman Dumith Fernando explains how the recovery was partly due to ongoing efforts to develop the country’s capital market as he discusses equities’ outlook for 2021.
The Colombo Stock Exchange turned 35 in 2020, a year dominated by the COVID-19 pandemic and a global economic downturn. The bourse suffered sharp losses in the first half of the year to an extended period of lockdown from March to May but rebounded impressively to close the year with the All Share Price Index gaining 10.5%, the highest annual gain since 2014.
Dumith Fernando, Chairman of the Colombo Stock Exchange, explains the reasons for the market’s stellar performance, outlook for 2021 and lays out the vision to develop the CSE as a multi-product, wealth generating platform for local and foreign investors of every hue.
Since the 1980s the exchange traded only equities and debentures, but in 2020 it introduced Real Estate Investment Trusts, or REITs, and plans to introduce gold backed trading and more. “Celebrating 35 years amidst a global pandemic and the worst recession in recent memory only served to strengthen our resolve to work towards improving taking steps necessary to transform the CSE towards a more resilient and diversified exchange,” Dumith said. Excerpts of the interview are as follows:
Can you take us through the performance of the CSE in 2020 and the factors driving that performance?
The market performance is a tale of two halves: a sharp decline before and during the lockdown, followed by an encouraging rally to end the year with positive growth. The All Share Price Index returned 10.5% in 2020, the highest annual growth since 2014 and this bounce-back was driven in the market after the lockdown. Having only operated for 209 days this year, the market bounced back 48% post-lockdown, after the All Share declined about 25% before the lockdown was lifted.
The strong recovery of the ASPI is impressive compared to several other market indices around the world: in terms of the full-year performance, we are ahead of emerging and frontier markets like Pakistan, Indonesia, Philippines and Thailand, and even bigger markets like Hong Kong and Singapore. However, some markets are way ahead of us like in Vietnam or Korea which had much stronger management of the pandemic.
The CSE’s 48% bounce back post-lockdown was possible for several reasons, and I can tell you about a few of the main ones. First, equities benefitted from the Central Bank’s monetary policy stance to reduce interest rates swiftly and significantly to stimulate the economy or contain the economic fallout from the pandemic. Equities were rendered unattractive by extremely high-interest rates over the last few years.
Now the rates have dropped to about 400 basis points and this is a big factor behind equities’ rally with local investor participation improving significantly despite the muted foreign interest. Second, the market was valued at a discount with valuations falling to a fraction of net asset value during the lockdown period. The price-to-book ratio was 0.8 times for the entire market during the peak of the pandemic but has recovered since to around 1.2 times.
Third, improving fundamentals are another factor driving equities’ resurgence as the understanding of the economic impact of the pandemic improves. During the second quarter of 2020, the economy contracted sharply due to falling exports as global value chains disintegrated and domestic productivity faltered due to the extended lockdown period which lasted for about 52 days. The economy is recovering from that dismal second quarter and this is reflected in improved corporate earnings, especially in domestic manufacturing, and the outlook seems much better now, helping to drive up valuations further.
The fourth reason for the CSE’s encouraging performance in 2020 is that we proactively took several measures to improve investor access and engagement. When foreign investors began exiting the market, we ensured that local investors took the opportunity to exploit the discounted valuations to build their portfolios, leading to a significant increase in the number of active accounts in the market. In 2019, we had an average of 43 new CDS accounts per day, and that nearly doubled to 80 new accounts per day in 2020. Going forward, we are optimistic that domestic interest will continue to grow, and this will create additional demand for equities in 2021. Our digitalization drive also enabled much easier new account opening for local individuals.
There’s reason to believe that the upward trajectory of the equities market is sustainable and will continue in 2021. The price-to-book ratio is still undervalued at 1.2 times while many mid-sized emerging and frontier markets are north 1.5 times price-to-book. The outlook for interest rates is that yields will remain low as the government attempts to revive credit growth to stimulate the economy and this is positive for equities. A oneyear bank fixed deposit yields a return of 4-4.5% on average annually, which is much lower compared to a stock that offers a decent dividend while the share price appreciates; and it does not have to be a huge appreciation to yield better than a bank deposit. Overall, the outlook for equities remains positive in 2021.
Can you give us some insights on investor behaviour during the year?
When interest rates drop there are three positive impacts for the share market: Falling deposit yields makes equities an attractive alternative and the share market becomes a destination of choice. Second, listed companies with debt on their balance sheets start reporting improved earnings because finance costs are declining due to falling interest rates,
triggering an appreciation of share prices. Third, retail investors who trade on credit will see falling borrowing costs for margin facilities so the returns they need from equity investments to cover costs is now much smaller.
We have seen a lot more optimism about investing in listed shares for these reasons. Also, people seem to be confident about the policy stability after the 2020 elections and are optimistic about stable government. Another factor driving the positive sentiment in stocks is that business activity continues uninterrupted despite the second coronavirus wave; there is a strong indicator that the government will not impose a permanent nationwide lockdown to control the pandemic.
To be frank, the foreign exodus from the CSE was largely due to a general exit by foreigners of emerging market investment and the temporary closure of the stock exchange from March 20th to May 11th. While such a shutdown is very much unlikely now, we have taken measures to digitalise the exchange so that trading can now continue without anyone having to be onsite. During a period of curfew, the exchange operated seamlessly without anyone having to come into the office, so I believe we have proved that the market does not have to shut down again even during a lockdown or curfew and that has generated positive investor confidence.
Investors have been coming back to the CSE for all those reasons and about 70% of all new CDS accounts opened since May are by investors in the 18-35 years age category; so, we are seeing a new segment of investors coming into the market and this is very encouraging for equities outlook going forward.
Perhaps the only dampener to all this is the muted foreign interest not only in Sri Lanka’s equities but most other emerging and frontier markets as well due to the global uncertainty around the pandemic. The recent sovereign credit rating downgrade could have an impact on foreign investor sentiment, but one hopes the government will address this issue so that CSE will be in a position to attract foreign investors once the global economy gains some clarity in 2021.
You mentioned that the market sees a lot of interest among people that have not invested in equities before. It is a new experience for them so what is your advice to them?
Our efforts on investor awareness and education have been stepped up significantly. Investor education is a priority for us, and we are helping them to understand the fundamentals of investing in equities so they can make better and insightful investment decisions – and that includes learning where to get the information. We are also making them aware of the risks and how long-term returns could probably outweigh the risks and warning them against insider trading and market manipulations.
What is the outlook for equities in 2021?
Market capitalisation is just under 20% of GDP and this is quite low compared to other emerging markets who are in the 40-60% range while in developed economies market caps are well over 75% of GDP. In the near term, I would like to see our capital market get up to the 40-60% range and this requires a lot more new listings not just in equities but debentures as well. Increasing the market cap will require more investor participation too, and they need to be both domestic and foreign retail and specialised institutional investors.
While foreign investor sentiment is not very encouraging right now, I hope to see an improvement in 2021 given the interest rate outlook and macroeconomic factors that will lead to better valuations. I feel the stock market should continue to perform well both in terms of high volumes driven by individual investors as well as valuations because we still have a big price-to-book gap compared to some peer markets.
The CSE took several measures to attract new investors in 2020. Can you take us through some of these initiatives?
One of our major developments this year was digitalization. Together with the capital market regulator, the Securities and Exchange Commission (SEC) of Sri Lanka, we introduced an app so that people open and access their CDS accounts completely online, whereas previously the process required a lot of physical documentation and visits to broker branches. Investors can now use this CSE app to select a broker of their choice and open a new account within an hour.
The number of app downloads is very encouraging, and the trend will continue well into 2021. The CSE has been able to conduct online investor forums and financial literacy programmes for a much larger audience whereas in the past we had been limited by the number of people we can physically reach and accommodate at any given event.
We are also working with the SEC on developing curricula on capital markets and financial literacy for school kids. We have big plans for 2021 because we cannot be silent and expect people to get excited about the stock market, so market awareness initiatives will be ramped up. On the marketing front, currently, investors need access to a broker to open a CDS account, but we are exploring the possibilities of streamlining this further. For example, telco companies are present across the country and they could act as a feeder or introducer system to opening a CDS account and these are some of the possibilities that we are exploring.
The bourse introduced REITs in 2020, can you tell us why this is a significant move?
We have been working on a proposal for a Real Estate Investment Trusts (REITs) for many years, but the current SEC helped expedite its implementation during the year and this will benefit both real estate developers and investors looking for a share of the property market without having to make outright purchases of land or apartments. A REIT can raise money from a pool of investors and buy real estate from property developers who can then develop other sites, so this is an essential intermediary function that supports capital flows into property development whether it is residential, commercial, or retail space.
From an investor perspective, you can invest in a REIT and take a smaller share to a property without having to incur a heavy capital expenditure especially amidst spiralling property prices. This will allow you to partake in property price appreciations and real estate booms. REITs have a requirement to have assets in their property portfolios that generates a yield or an income regularly, which should be much more stable than a dividend on a listed share.
In other words, an investor is getting access to property-backed securities that offer regular returns and allows you to access that property asset class without having the full amount of money. The government has reduced taxes on REITs to encourage its uptake. The first transfer of property into a REIT had a stamp tax of 4% which the government reduced to 0.75%, so I expect this will generate a lot of interest and expect multiple REITs to be listed and come to the market in 2021.
What are your plans to attract and expedite new listings on the Colombo Stock Exchange?
This is a particularly important aspect of what we need to do, and we will certainly intensify a marketing program to encourage private companies to list which will be the primary responsibility of a new division that will be
created at the CSE. We are also engaging companies and telling them about the benefits of listing and helping them to address obstacles that they may encounter when they try to go public.
The SEC is working with us to make the listing rules and easier to fulfil and approvals process easier and seamless so a broader range of companies can raise capital with a public offering. We have plans to create a single-window concept where there is an issue relations manager that each listed company will have. There will be an online platform, so companies would be able to track the progress of their listing application at any given point of time.
Another initiative in the pipeline to improve the number of new listings is to open up the multicurrency board to local companies who may otherwise raise private equity capital overseas. The CSE is focusing on early-stage FDI projects including those linked with the Colombo Port City in a bid to attract new listings, and we would also like to initiate a sensible conversation with the government on listing some of the well-managed and profitable state-owned enterprises. This is an important step in further developing the stock market by increasing its depth and breadth and will give investors more options and reduce the burden on the Treasury of providing the ongoing capital needs of SOEs
How can such listings benefit investors and the SOEs themselves?
A state-owned enterprise is like any other company, and like any other business, they will require fresh capital to remain competitive and build market share. Given the constraints and fiscal limitation the Treasury is under, a listing of a non-controlling stake may be a better alternative for these enterprises to raise capital for growth. This will also allow people to reap the returns from investing in a well-managed state-controlled entity. The government will benefit because it will get a bigger financial return by way of dividends from SOEs that are engineering their own growth.
The President made it clear that he intends to improve the management of state-owned enterprises by attracting and recruiting experienced professional managers, and this is something that can naturally happen when an entity is listed. Listed companies are required to follow guidelines that cover among other things governance and the need to be run by professional managers, and this is a good thing. It keeps companies disciplined and honest, and on their toes to deliver financial value.
Employees at state-owned enterprises tend to oppose any listing because they wrongly assume it is the same as privatisation, and they have very vocal unions, but we are talking about listing small non-controlling stakes. If shares are listed, it opens up the opportunity to reward SOE employees with share options so that they can then work towards the growth of the company and partake in its success when the share price appreciates over time. This is a good way to align the aspirations of employees with those of the company. This will help remove the stigma of listing SOEs and can be done in a way without the government losing its control.
Are there any new listings of private companies or SOEs in the pipeline?
There are some but they cannot be disclosed at this stage, but we do expect a lot more listings in 2021 partly encouraged by the recent accommodations provided in the budget where the corporate tax rate would be halved for companies listing before the end of the year.
Why is the exchange opting for DVP settlement system and how will it impact the market?
We have slightly modernized the settlement infrastructure of the market with the DVP. That may create more inflow because more investors may be confident about trading in this market. After all, we have DVP and it reduces their risk of settlement and tells them we have built the capacity to handle larger volumes and introduce new products.
DVP is delivery versus payment, and what it does is, it makes sure that there is more certainty in the settlement and the simultaneous settlement of the buy-side and the sell-side. The sellers receive cash and buyers get their shares on a simultaneous basis, and the DVP has other ways to further guarantee settlement. The CSE has never had a settlement failure but this new system brings us on par with more advanced exchanges of the world and will also ensure that our track record stays intact as we introduce new products and services, which are important next steps for us, such as stock borrowing and lending which by itself will generate multiples of additional liquidity and trading volumes
What are your plans to improve market infrastructure and the regulatory framework for a more efficient and vibrant stock exchange?
As mentioned before, we are taking measures to relax some of the rules so that the listing process can be streamlined. We are keen to make sure the market is moving in the right direction so we will be proactive to make sure that the rules and
regulations align with our strategic goals while we focus on maintaining a well-regulated and safe market for investors. In that context, we are not going to liberalize anything that does not make sense right now but only focus on areas that will make the CSE relevant in a digital world, and a lot of this is around making things easier for investors and listed companies.
A new SEC Act will soon be in place which will allow it to regulate a much broader range of financial instruments as well as market participants. This will create a more dynamic and safer capital market for investors. We are also looking forward to another major development which is the demutualization of the stock exchange. Demutualization will separate the ownership from the governance and running of the exchange. At the moment, the members of the CSE board are elected from among the 15 full members of the exchange. When the exchange is demutualized, the appointment of the majority of the board is shifted away from those members or shareholders. The reason this is important is that allows the exchange to slightly shift their focus towards building a robust, successful standalone exchange that thrives on investor confidence and trust.
The CSE as part of a joint Central Bank initiative plans to develop and introduce a central counterparty system, which is known as a CCP. The CCP will effectively extend our DVP to a point where the settlement risk is taken away even further so market participants can operate in full confidence that their transactions will not be exposed to any intermediaries. This is something that will take a couple of years to finalise because it involves the entire financial system including the banks. If Sri Lanka can link its different financial markets with a CCP, the knock-on impact of that, apart from obviously even more heightened trust in the market and its settlement process, is the ability for us to introduce even further products such as derivatives, which will be a step in the right direction towards a more developed and robust capital market and stock exchange.
In the near term, I would like to see our capital market get up to the 40-60% range and this requires a lot more new listings not just in equities but debentures as well.