Via Guru Focus, a look at Sri Lanka:

Royce’s global team scours the globe looking for companies that fit our investment criteria. Sri Lanka is a country that has crossed our radar in the past and earlier this January we had the opportunity to spend time on the island nation looking for investments. As a result of our research, we found opportunities and have recently begun investing in the country.

History

For nearly half its existence as an independent nation, the island of Sri Lanka was embroiled in a civil war that pitted the minority Liberation Tigers of Tamil Eelam (the LTTE, a.k.a. Tamil Tigers) against the government and the Sinhalese, who make up close to three quarters of the population.¹ The resulting violence and instability took a heavy toll on the country from 1983 until the decisive, momentous end of the civil war in May 2009.

The LTTE had been fighting to create an independent Tamil state in the northern and eastern parts of the island nation, which was once a British colony. These two regions were their strongholds throughout the civil war, and all economic activity from these regions moved westward as it became increasingly difficult for businesses to operate there. When a group of businessmen traveled to the Tamil stronghold areas in August 2009 after the end of the civil war, they witnessed the devastation wrought by civil war—small factories that used to manufacture household products, cement plants and chemical plants were all largely dysfunctional.²

The civil war cast an enormous shadow over Sri Lanka’s positive attributes. In the late 1970s, the country became the first in South Asia to liberalize its economy.³ It possesses an enviably high literacy rate of 94%,⁴ which puts it more in line with the likes of developed Asian countries such as Singapore and Hong Kong and ahead of developing countries such as India, Pakistan, and Bangladesh.

Even during the last two decades of the civil war, when one third of the land and two thirds of its coastal belt were not integrated with the rest of the country, the Sri Lankan economy was able to grow at a real growth rate of 5.9%.⁵ Therefore, it came as no surprise to people on the ground that the Sri Lankan economy grew by 8.3% in 2011, its fastest growth rate since gaining independence from Britain in 1948.⁶

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Infrastructure

While Sri Lanka’s infrastructure ranks high by South Asian standards, it would be considered poor by western standards.⁸ The war-ravaged northern and eastern regions are in obvious need of improvements. However, even the western part of the country, where the capital Colombo lies, needs upgrades to reach international standards. The administration of President Mahinda Rajapakse has made this an issue of focus.

To attract foreign capital, the government has put policies in place such as preferential tax rates, constitutional guarantees on investment agreements, exemptions from exchange control, and 100% repatriation of profits.⁹ Chinese firms have seized the opportunity; the Sri Lankan government granted China an exclusive economic zone shortly after the end of the civil war in July 2009.¹⁰

A Chinese firm is doing maintenance work for Bandaranaike Memorial International Conventional Hall

In December 2011, Sri Lanka received its largest foreign direct investment (FDI) project to date: $500 million from China Merchants, which won the tender for the construction and operation of the Colombo South Harbor Expansion Project in collaboration with its local partner. Additionally, new hotel developments and power and infrastructure investments caused FDI in Sri Lanka to double to $1.066 billion in 2011 from $516 million in 2010. The goal of Sri Lanka’s Board of Investment is to grow FDI to $2.5 billion by 2015.¹¹

Tourism Growth

Despite Sri Lanka’s abundance of beautiful beaches and tropical weather, its tourism industry was understandably blunted by the civil war. A greater number of tourists have visited Sri Lanka each year since the end of the war in 2009. Arrivals increased by 46.1% in 2010 to 654,476 from 447,890 in 2009¹² and in 2011, tourist arrivals increased by 30.8% year-over-year to a record 855,975.¹³ Publications such as Travel + Leisure have recently heralded the country as a hot new destination.¹⁴ Sri Lanka has plenty of potential to continue to grow its tourist areas, as the volume of arrivals still pales in comparison to those of the most popular Asian tourist destinations.¹⁵

The government plans to increase tourist arrivals to 2.5mm by 2016¹⁶ through measures such as encouraging the development of new hotel rooms. The goal is to double the capacity of the current inventory to reach 45,000 rooms. Additionally, some existing hotel rooms need to be refurbished in order to be brought up to international standards.

In Colombo, we met with the capital city’s largest five-star hotel operator. The management team highlighted positive trends, including an increase in both room rates and occupancy thanks to the increased tourism. Additionally, management spoke about the opportunity to develop quality three- and four-star boutique hotels located outside of Colombo in order to attract more visitors and extend the benefits of this burgeoning sector.

The positive impact of tourist arrivals as well as record economic growth has already translated into higher disposable income for the average Sri Lankan. The country’s per capita income was $2,836 in 2011, up from $2,400 in 2010.¹⁷ To put those figures in perspective, by South Asian standards, Sri Lankans are relatively better off than the average Indian, Pakistani, or Bangladeshi— populations with GDP per capita of $1,527, $1,164 and $690 respectively.¹⁸

In Colombo we met with one of our investments, the largest alcohol company in Sri Lanka, which serves all segments of the Sri Lankan market. It also has a license for imported high-end products as well as manufactures its own premium branded domestic products that target the medium-to-higher income and mass segments of the market. Given the relatively low GDP per capita of Sri Lanka on a global standard, the largest segment of the market is the mass market, of which the company estimates it has a 25% share. The business is enjoying double-digit growth thanks to the increased disposable income of Sri Lankans. We view this company as an ideal way to play the Sri Lankan consumer growth story.

Opportunities and Risks

The inflow of tourist money has reached Sri Lanka’s food and beverage industry, which has seen robust growth since 2009. Private sector companies have seized the opportunity to sell into the previously off-limits northern and eastern regions. During 2010, the industry grew by 6.8%, with first-half growth being 7.2%.¹⁹ According to market research by AC Nielsen, based on their retail audit, Sri Lanka recorded nominal growth of 21% and volume growth of 11.7%, the highest rates recorded in both categories in the FMCG category within the Asia-Pacific region for the period January 2011 to September 2011.²⁰

Sri Lanka clearly has a lot going for it following nearly three decades of civil war. Yet the country also faces potential growing pains and lingering issues that investors need to recognize, including the small size of the country’s GDP, its trade deficit, corruption, and the strong-arm tactics politicians employ to maintain power.

Sri Lanka is not on many global investors’ radars because the overall size of the country’s GDP at $50 billion ranks it 73rd on a global basis.²¹ Unlike the powerhouses of China and India, which have the largest and second largest populations in the world, respectively, Sri Lanka’s population of 21 million ranks 56th among the world’s nations.²² Therefore, if and when an economic slowdown occurs, the country is likely to fall in the pecking order of importance, as multi-national companies would presumably concentrate their investments in larger emerging markets.

Sri Lanka’s trade deficit also widened to nearly US$10 billion last year²³ —a figure that represents nearly 20% of GDP—putting a strain on its dwindling foreign reserves that could eventually hurt its credit rating. Sri Lanka needs to borrow heavily to finance the trade deficit and in a downturn that could drive the country into a vicious cycle were it required to repay the debt quickly. As part of its effort to reduce this trade deficit, the government has raised fuel prices by up to 49% and electricity by 40%.²⁴ However, these actions come at a price of likely lowering the overall growth rate.

Sadly and predictably, Sri Lanka also suffers from the kind of corruption that plagues most developing countries. It ranks 86th on Transparency Internationals’ Corruption Perceptions Index for 2011.²⁵ Property rights are undermined by an inefficient judicial system that remains susceptible to substantial corruption and political influence.²⁶ The South Asian Corruption Barometer released by Transparency International Secretariat in December 2011 stated that 49% of Sri Lankans believed that corruption was on the rise.²⁷ The government will need to address this issue head-on in order to give investors comfort with the sustainability of longer-term growth.

Mahinda Rajapaksa was elected the President of Sri Lanka on November 19, 2005 by a razor-thin margin of 180,000 votes; then was re-elected on January 27, 2010 in a resounding victory of more than 1.8 million votes²⁸ as his party rode the mood of optimism that came with the end of the civil war. However, despite the economic growth that the country has enjoyed under Rajapaksa, there have been strikes, riots, and protests by students and public workers in recent months.²⁹ Some believe the protests have been motivated partially by the increasingly extensive reach of the President’s family: his brother Basil Rajapaksa was appointed the economy minister and another brother, Gotabaya Rajapaksa, was appointed the defense secretary. Foreign investors will become skittish if the current government falls in popularity to the point that they believe future administrations may renege on its agreements.

Sri Lankan companies need to make significant advances in corporate governance and management focus if they want to improve their attractiveness to foreign investors. For example, in some of our meetings with Sri Lankan companies we were dismayed to find that insiders largely dominated the Boards of companies. However, the country has made some advances, notably in 2007, when new legislation made it compulsory for a company to constitute a remuneration committee and an audit committee, and mandated that both should be comprised of two independent, non-executive directors.³⁰

We also discovered in our meetings that Sri Lankan management teams like to diversify their businesses into areas with no obvious synergies. For instance, there are companies that have operations in disparate areas such as telecommunications and plantations. The largest listed company in Sri Lanka, John Keells Holdings PLC, has operations in several industries including food and beverage, transportation, and tea and rubber. Other companies look to replicate this “conglomerate” model as they grow rather than staying more focused, which is what public investors would generally prefer.

Royce and Sri Lanka

After nearly three decades of civil war, Sri Lanka is enjoying its highest growth rate since independence from the British in 1948. The country is on a growth path driven by a recovery in consumer demand, infrastructure spending, and foreign investment. To sustain its high growth rate, Sri Lanka will need to keep its trade deficit under control while also implementing reforms that will entice outsiders to invest in this island nation. The global team members at Royce will continue to monitor developments on the island as well as look for new opportunities that meet our investment criteria.