Sri Lanka Stock Market: gold mine or blood bath -01 - 08

Sri Lanka Stock Market: gold mine or blood bath
Clowns and villains threaten to undermine a national institution at the heart of Sri Lanka’s ambition to become a regional financial hub
Shamindra Kulamannage
LBR,Monday 24 October 2011
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Markets are often irrational and sometimes rigged. The record performance of the Colombo Stock Exchange over the last three years isn’t generally an indication of irrationality, but at its fringes, experts say, mischief-making is rampant. Its regulatory rules only bind those who care to be bound by them and enforcement doesn’t appear credible.

Even when there are rules, the line between acceptable and unacceptable conduct is often unclear among retail investors. Pumping a share price beyond any semblance of its actual worth is risky but it’s not illegal. However for a number of people to coordinate the pumping of a company’s shares up is a criminal offence under the securities law. This is not just bad for investors; it also undermines the stockmarket's broader role of channelling capital to where it can be best used. Foreign investors—the most demanding constituency as far as fair value is concerned— are leaving the market in droves. Bouts of irrationality are excusable to foreign investors but rigged markets aren’t.

Take the case of an aluminium cladding fabricating firm that is valued by the market at over Rs700 million now and at over a billion rupees in the past. It reported a Rs1.5 million profit last year following a number of years of losses. “The other day I visited the company,” says Channa De Silva who heads the US based private equity firm LR Global’s Sri Lankan office. “There are only 10 employees working in a leased out property far away from Colombo. It’s a manufacturing sector firm and none of the 10 people were wearing shoes or gloves. So its 10 people in a manufacturing firm quoted in the Colombo Stock Exchange with a market value of around a billion rupees; sounds very interesting, doesn’t it?” he asks.

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The firm’s price to earnings ratio is over 280 times and a bank has obtained a judgment against the firm concerning an outstanding loan. A case against non payment of EPF dues is also pending. Its net assets are just Rs60 million despite the market value of the firm having touched 20 times this value this year. “During the year, the directors continued to support the business in the absence of support from any of the financial institutions, in order to meet its basic financial obligations. The company managed to continue paying the accumulated overdue statutory dues of itself and even its subsidiary which were in default due to its financial weakness,” said its Chairman in the last annual report. Clearly, critics argue, investors purchasing shares of this firm are either gullible clowns or scheming villains.

Sri Lanka’s rules against market manipulation, fraud and insider dealing have been around for years, but enforcement remains patchy. SEC, which has talented staff and high profile and well connected commissioners, seems competent but is overwhelmed by the scale of the crisis. When it does prosecute wrongdoers after lengthy investigations—the cases have lost their relevance along the way.

Even by modest Asian standards Sri Lanka’s stock exchange is a midget and could be easily manipulated because of its size. With a capitalization of US $22 billion, it is smaller in relation to the economy than markets in India where market capitalization is equal to 130% of GDP and Bangladesh where it is 47%. Colombo stock exchange’s capitalization is equal to 40% of gross domestic product, lower than some South Asian markets and far below places like Hong Kong, now a global financial centre, where it tops 1,200%.

Average Sri Lankans see the stock market as an opaque place: the exclusive preserve of the elite and well connected corporate villains. As a result only a mere 0.5% of Sri Lanka’s over 20 million people have traded in listed shares. In most developed markets 40% to 70% of those old enough to invest have purchased shares. Although only a fraction of Sri Lanka’s population trade shares they accounted for 44% of last year’s Rs570 billion turnover. Foreign outflows are escalating as investors abandon the market they see as overpriced. So far this year offshore investors have sold a net of Rs10 billion after a record Rs26.4 billion last year.

Former capital market regulator Channa De Silva says high stock prices are keeping three of the four classes of investors, he identifies, out of the market. Foreign investors who were value based, looking for price to earnings multiples of 4 to 7 times no-longer find Sri Lanka’s one year forward PE of 15 times very attractive. “As a result we have no value investors coming in to Sri Lanka because our PE is too high,” argues De Silva. He says Sri Lanka could still try to attract growth based foreign investors, who may invest for one or two years.

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“The second element missing are the institutional investors. Some of them are fully invested but others are investing in their core business, so that money isn’t coming,” De Silva adds. Another important element; high net-worth individuals are diverting their money in to real assets like real-estate and hotels. De Silva points out that, investors with a high-net-worth were significant in the market since 2009. “People who had 30 to 40 million invested in the market before the war have made a lot of money; some of them are touching 600 to 700 million and this money is also not coming as fast as we like.”

With all three of these investor classes staying away from the stock market, it’s the retailers that are dominating. “They look for ponies to ride and a few people together decide on a pony,” says De Silva who was stock market regulator until he left to set up the local office of LR Global. He says there are two elements that retail investors look for; penny stocks with a low market capitalization.

Worldwide short-term investing has been on the rise with the popularity of Hedge Funds. Use of short selling and other stock derivative instruments have reduced average holding periods dramatically in the last few decades. However in Sri Lanka, frantic trading benefits only manipulators and the middleman according to a capital market regulator who was a panelist at the LBR & LBO CFO forum on ‘The CSE: a Gold Mine or a Blood Bath’.

“You know how a gold mine works?” asks Arittha Wickramanayake the Precedent Partner of Nithya Partners and a former capital markets regulator, rhetorically. “At the top there are a few fat cats, they are few and they make the bucks and they exploit the people below them. In the middle there are the supervisors who make the commissions and the cuts and slowly put their hand in to the till and take a couple of nuggets. At the bottom you get all the people who are slaving away and they are the people who get burned in the end,” he says, applying the analogy of a goldmine to the Sri Lankan stock market.

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A cast of clowns and villains are threatening to undermine the hard won credibility of the stock exchange according to the two former regulators, both panelists at the LBR & LBO CFO Forum. “Look at the prices people are paying for these penny stocks, they are dud stocks, who are the ultimate buyers at these high prices? They are retail investors who are waiting to get burned,” says Wickramanayake, under whose leadership as capital markets regulator capacity of stakeholders like stockbrokers and mutual funds was rapidly built.

Price volatility in some stocks, mostly cheap penny stocks, is earning the ire of former regulators because volatility increases market risk, destroys credibility and can be evidence of market manipulation, reasons why foreign portfolio investors view Sri Lanka’s market as dominated by clowns and why Sri Lankan investors feel its drama is dominated by villains. They are both right according to critics.

“You can’t say that Colombo’s affluent investor and the investor from Hambantota are the same, so let the stock market determine the price. You can’t look at the US model and the Keynesian economic theory and apply that to Sri Lanka,” says De Silva who is managing LR Global’s multimillion dollar investments in Sri Lanka. “We have a fundamental responsibility of protecting our investors; we cannot have cowboys riding the ponies in the market.” Small investors can be easily swept along with the bemusing and sometimes comic behavior of stock prices.

Share price movements in liquid small cap companies have been defying logic for some time. In January stock prices of seven companies more than doubled including Guardian Capital Partners which rose 477%, in February. Prices of five companies more than doubled again including Guardian Capital Partners which was up another whopping 1,784%. In April stock prices of eight companies more than doubled including those of Paragon Ceylon which rose 533%, followed by five companies that saw share prices double in May, June and August.

Volatility however is as much about sharp declines as it is about fast increases. Guardian Capital Partner’s (which had a rights offer in February this year) share price is down 94% from its 2011 high. All the shares that doubled in price this year are now trading lower than their 2011 peak, many around 30 to 40% lower. “Some fool who has to buy those shares to keep that price up, it’s that retailer we are concerned about,” says Wickramanayake about the least informed retail investors who purchase shares at their peak.

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Detractors argue trying to protecting ignorant investors from self-inflicted harm, if any, smacks of Marxism. Markets determine prices purely by supply and demand, “it’s irrelevant who provides it, be it big people or small people,” argues Sarath Rajapakse a director at Capital Trust Securities, Sri Lanka’s largest stock brokerage by turnover.

Behavioral Finance, the concept that investors don’t always behave rationally, is being ignored in the context of the Sri Lankan market argues Rajapakse. He disagrees with the argument that small unsophisticated investors need protection. “What drives the market? Hope and expectations, some are rational and some are irrational and speculation: it’s not a mortal sin, speculation is buying with the hope that prices will go up or selling with the hope that price will fall.”

Rajapakse points out, that basic instincts like lust, greed, jealousy, urge to dominate and rivalry, also drive the market. “If everybody is rich we are not happy but if we are richer than our neighbor we are very happy,” he says of dynamics that drive the market. “If you believe that market players are saints and they don’t have these basic instincts then you are misleading yourself.”

Capital Market regulator SEC imposed an opaque price band which limited the price movement on any stock it was imposed on to 10% up or down. In the year since its introduction the band was used 78 times; multiple times on some companies. The band was initially applied for 15 market days and subsequently reduced to 5 days and was applied on 52 listed firms in the first year. Wickramanayake opposed the imposition of price bands on stocks to stem volatility. They instead argue the regulator should prosecute market manipulators because the outcome of all this will decide whether the exchange will become a serious institution, able to offer firms the opportunity to raise equity competitively and establish the island as a financial hub, or remain a slapstick drama.

“It’s the responsibility of the SEC to maintain a fair and orderly market and protect the interest of investors and that has not happened,” charges Arittha Wickramanayake of Nithya Partners, one of the island’s most sought-after corporate law practices. “We are now racing to the bottom of the mountain; if nothing is done to correct this we are not going to be able to resurrect the Colombo stock exchange, so you can forget about being a financial hub, which will never happen.”

Channa De Silva, who has a master’s degree from Harvard University’s Kennedy School of Government, argues that promoting stock market investment to rural Sri Lankans is fraught with danger because of the nepotistic small club that is dominating the market. To say that tougher stock market regulations would drive the Sri Lankan market further along the road to where the North Korean one is, misses the point. The argument is about where to draw the line now and the ability to shift that line when next needed. It can go back and forth in a process of trial and error.

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Rules are not broken when an investor chooses to corner the limited supply of shares of an illiquid stock like happens often at the CSE. “By pumping a share up he is taking a massive risk, what if nobody buys? He will be left holding it. For taking that additional risk he gets an additional return. Is that a sin?” asks Rajapakse. However there is a fine line between cornering the limited supply of a share and expecting its price to rise and manipulating a share price as a group working together to later dump the stock on unsuspecting retail investors. This practice is rife according to one of Sri Lanka’s largest retail investors.

If stock traders earn huge profits and brokers huge commissions, only because of widespread market manipulation, that becomes a legitimate matter of public concern because the stock market is a national institution and not a private fiefdom. Chief Executive of Royal Ceramics deleted Perera, one of the largest traders of listed stocks at the Colombo Stock Exchange says stockbrokers are manipulating the market for their own gain. “Ninety percent of our investment advisors and brokers are also investors themselves,” he says.

Recommending or hyping a stock in which a broker already owns to drive its price up and profit, is wholesale flouting securities laws broker ethics. However the practice is widespread,” I don’t trust brokers and I don’t take their advice, most of the brokers are incapable of advising, they have no qualification.”

“These brokers, they have 6 or 7 dud accounts which they trade through, and who gets played out at the end? It’s the stupid retailer,” points out Arittha Wickramanayake. Since there are no capital gains taxes brokers can use dud accounts with impunity.

“When the retail investor is staring at disaster it’s important that the SEC brings in regulation or at least educates the retail investor on their plight, and that has not happened.” The rot started years ago but became an epidemic in 2009 after the war ended. Investors are taking comfort in the practice of working like a herd and are completely disregarding due diligence. “Most investors don’t look at research. I have never read any research in my life, this is the reality,” claims deleted Perera about some of the 35,000 or so retail investors who have trading accounts at the CSE.

Detractors point out that the long predicted Armageddon hasn’t happened. They claim a tougher regulatory regime would be a mistake: forcing out retail investors and robbing the market of its vitality and global chart topping performance. “When we trade by accident we may make some mistake and that may lead to an investigation,” says Perera. “When that kind of thing happens you should not try to take maximum revenge and then put us in to jail.” Instead he advises SEC to impose fines on wrongdoers who admit their offenses. “A person like me, if you try to put me in to jail for a small mistake is it reasonable?” asks Perera who accounted for Rs1.2 billion of the Rs6.3 billion record market turnover on August 18th when broker credit rules were relaxed.

Perera, who recently acquired a 21% stake in George Steuart to control the firm together with deleted deleted who also acquired a 21% stake in the 175 year old trading firm, says his trading has been ‘critically analysed’ by the SEC on a number of occasions. “If we have committed a criminal act like manipulation, or insider trading purposely then of course you can take action,” says Perera without spelling out what he means by ‘small mistake’.

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Securities regulation and supervision in Sri Lanka is chaotic, with few prosecutions despite an ex-regulator’s belief that market manipulation is rampant. Representatives from the regulator’s office and the Stock Exchange declined to join the panel at the LBR & LBO CFO Forum. A new market supervision IT system, procured from London Stock Exchange subsidiary MillenniumIT, which was claimed to be fool proof is still to show results. “It was a very sophisticated system which will flag anyone including trading by relations. Data was partially fed during my time,” claims Channa De Silva the former securities regulator. He says the system is ‘robust’, “you can have the best of systems but it depends on how that is applied.”

Securities regulators seek to protect investors. In the process they may be able to project the stock market as a viable option for companies under the high interest rate stranglehold of banks and a lacklustre bond market. Channa De Silva observes that price volatility is a direct component of risk which all analysts internationally observe. The volatility levels in this market are too risky for them.

Smart regulators around the world have shown that it takes more than mere market pressure to bring discipline to comic and self destructive behaviour. Regulators have to cajole stakeholders, use the threat of embarrassment when necessary and bully chronic rule breakers into submission. Without the full arsenal of moral powers the prime regulatory objective of protecting investors whittles down to imposing fines and prosecution.

“It’s important that the regulators realize there is a crisis,” points out Arittha Wickramanayake. “You have to understand that the market is always ahead in this game and it’s important that you get all participants together and create a market that is fair and orderly. It must be done fast,” he says. Following a conference of stakeholders in June, the SEC announced the setting up of a ‘Capital Market Industry Consultative Committee’ in September to take into account the views of various stakeholders. SEC says the committee will be able to recommend policy and aid inclusive development of the capital market.

SEC’s pronouncements of tougher action against manipulators were met initially with shrieks of joy from the financial press, but after the regulator failed to carefully pick a few villains for big fights, the positive zeal among stakeholders watching the freak show in horror, died. “You need to shake the tree, you need to pluck the biggest branches by taking bold decisions, that is how you discipline a market,” claims former capital market regulator Channa De Silva who during his time as head of the SEC however treaded rather carefully because there was little trading in the market. Recently the SEC filed action against one broker and censured others while employees of a finance company also had charges filed against them for insider trading.

“Ultimately it’s your will to prosecute or will to enforce the law. Unfortunately there seems to be uncertainty on what the laws are and about the proper way of going about it. That has given the people who are committing those wrongs a lot of confidence, they think that they can get away with anything,” says Wickramanayake.

The regulator also fined Rs10 million and compounded a case against listed ERI and three of its directors for providing misleading information and not revealing material information about the firm in time. “I don’t think a person who has had a case compounded against them can ever be in the securities industry and I don’t think such a person is fit to even be a director of a company,” Wickramanayake adds. “Unfortunately people tend to trivialize this aspect of compounding though it has very serious consequences.”

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The SEC may prefer to compound offences of securities law violations because of the difficulties involved in taking these criminal cases to court. Criminal cases have to be tried in Magistrates Courts, which is the lowest level as far as the hierarchy of courts are concerned and where the judges are the least experienced and may not readily understand the complexities of a securities fraud case.

The rot runs deep among stockbrokers. “Brokers are talking to investors and asking what to buy. Every day I get 10 to 15 calls from brokers,” confides deleted Perera without revealing if he passes on buying tips. However Perera does say that stockbrokers are ‘a very important component of this investor community’.

Rich investors don’t need brokers, its small investors who seek their advice. Industry watchers say brokers then recommend stocks to retail investors in which they and other rich people have already built up sizable positions. “‘Brokers miss-sell they front run using several accounts, people know what is going on here, you think we are all fools,” said parliamentarian Harsha De Silva who joined the discussion as an audience member during the CFO forum.

“The way to tackle a problem like that is to create greater awareness and have greater professionalism among the broking community. The broking community has failed miserably, they are openly saying nobody listens to us, why are they here? To trade for themselves?” asks Wickramanayake who has been outspoken on governance related issues even after leaving his job as the securities regulator.

Broker responsibilities are not inconsequential gobbledygook. Brokers or investment advisors, who permit or advice their clients to buy shares at prices which are hugely out of proportion with the worth of the company may be held liable for subsequent losses suffered by a client. “In a situation like that brokers have a responsibility to advise clients against investing in such a company and there is enough case law in the US where brokers allowed unsophisticated clients to trade and they can be held liable to pay damages to the client when the price drops. I hope that happens here,” says Wickramanayake. Heads of broking houses may also find it difficult to blame the inadequacy of their compliance systems to keep in check screwball brokers profiteering off unsuspecting clients.

“What really makes one mad is that we tend to trivialize what is happening, nobody gives a damn and that is the dangerous trend!” points out Wickramanayake. “In my profession I see what’s happening and I hear stories and it scares me that nobody wants to do anything about this.”

Ravi Abeysuriya who heads the local office of Heraymila Investments, a UAE based leading international asset management company, says the small size of the CSE has made it possible for a few local high net worth investors and institutional investors to support the market at current levels without a major correction.

He says in comparison with MSCI Markets Index which includes India, China and Brazil which have a PE multiple of 13 times, or with frontier markets – the category to which Sri Lanka belongs to – where the PE multiple is only 10 times, Sri Lanka’s PE multiple at 17 times stands out. “Hence one can argue our market is still relatively overvalued,” Abeysuriya says.

The current state of affairs at the CSE is not without international precedent. In the 1930s US securities regulators had to deal with similar challenges. “The difference there was regulations were introduced and enforced,” Wickramanayake says.

deleted Perera is one of the new billionaires of surging stock prices of relatively illiquid and small firms. Perera who is from the village of Pinnawela has a simple investment philosophy which has worked fantastically in the years since the war ended. “Our market isn’t a developed market, you should not do long term investment, you should trade day to day.

This is what I’m doing and that is why I’m so successful. I have no long term portfolio and I have no segregation of good shares and bad shares, all shares are just shares, this is how I do my trading”. Perera purchased two prime properties alongside Colombo’s Horton Place and Gower Street each extending to around 40 perches and costing him Rs6 million a perch at both places. “This market was dominated by Colombo 7 high class people all these years. Today we have taken over that position from these so called Colombo 7 high class people,” he says.

A meritocratic model, which affords opportunities for ambitious individuals like deleted Perera who came from a rural village to also succeed despite the circumstances of their birth, is the surest way to ensure wider economic success. Sri Lanka is far from being a land of opportunity barring the few exceptions. But any sign that the few opportunities that exist here because of a framework of laws and regulations are being destroyed requires serious consideration. To say that tightening regulatory screws now denies an opportunity for a new class of investors to emerge is as fatuous as claiming that the circumstances of one’s birth are irrelevant for success in Sri Lanka.

“The fact is that you protect what brought you here that’s important, pass it on to the next generation, life does not end with you all,” Wickramanayake said addressing Perera who was seated at the same panel at the LBR & LBO CFO Forum.

Although stock prices have risen, many aspects of the market remain unchanged from one and a half decades ago when Wickramanayake was director general of the SEC and Lanka Tiles Managing Director Mahendra Jayasekera was a stockbroker. In the intervening 15 years around 40 companies have listed which isn’t in tandem with economic growth in the period. “Our market is still very small, it lacks the width and the depth, so it’s possible to create a wave in the market with a relatively small amount of money,” says Jayasekera who was also a participant at the LBR & LBO forum about the future of the stock market.

“The conclusion is that we all ride on the same companies, in 1994 if we had 50 research analysts researching the market and today we have maybe 100 analysts, and I think that the market is fairly well researched then there is no way prices can move up and down the way they are moving,” he says.

In fact the stock market is still the preserve of an exclusive class; a fiefdom of a few hundred investors. Of course share-price movements don’t always fit as closely with financial results and a regulator is not equipped to decide pricing. However rebuking or filing action against a few wrongdoers may no longer be enough at the CSE.

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"“There
are only 10 employees working in a
leased out property far away from Colombo. It’s a manufacturing sector
firm and none of the 10 people were
wearing shoes or gloves. So its 10
people in a manufacturing firm quoted
in the Colombo Stock Exchange with a
market value of around a billion rupees; sounds very interesting,
doesn’t it?” he asks."
LOL