July 13 (Bloomberg) -- Without a whiff of good news supporting them, stocks in Sri Lanka, the teardrop island off India's southern coast, are the world's fifth-best performers this year.
There's no apparent reason for the 22 percent surge in the Colombo All-Share Index in U.S. dollar terms, a gain exceeded only by Colombian, Austrian, Egyptian and Hungarian equities. The increase is all the more puzzling because it follows a 30 percent spurt in shares last year and a 26 percent jump in 2002.
The exuberance ``is difficult to explain,'' says S. Jeyavarman, chief executive officer of National Asset Management Ltd., the country's largest unit trust company. ``It's a surprise to everyone in the market.''
If anything, there's plenty of bad news in the nation of 19 million people wracked by two decades of civil war. The Tamil guerillas, who have honored a cease-fire since February 2002, are threatening to resume fighting even as a three-month-old, Marxist- supported government consolidates power. The Marxists oppose regional autonomy for the minority Tamils, lowering the chances of a peace accord that looked in sight even a year ago.
A woman suicide bomber killed herself and four police officers in the capital of Colombo last week. Incidents like that could cripple tourism, which, along with tea and garment exports, supports the $18 billion economy. In June, 30,000 tourists were drawn to the sandy beaches and Buddhist temples of this former British colony, a 6 percent drop from a year ago. The full-year target of 600,000 tourists is becoming unattainable.
Best in Asia
Share prices have risen in Sri Lanka even as they have slumped elsewhere in Asia amid concerns high fuel prices will stoke inflation, and interest-rate increases by the U.S. Federal Reserve may pull investment dollars away from local bourses. Thai, Indian, Chinese and South Korean stocks are among the world's 10 worst-performing benchmarks this year.
And all these economies, with the exception of Korea, are forecast to grow faster than the 5.5 percent pace at which the Sri Lankan economy may expand in 2004.
So if you haven't already invested in the island's top shares, like John Keells Holdings Ltd., which runs hotels and a sea port, and makes foodstuff, are you missing out on a juicy market?
Too Bullish
One may look at Sri Lanka's surging stocks as evidence that investors are ruling out a return to civil war, interpreting the government's landslide win in Saturday's provincial polls as a sign that the United People's Freedom Alliance will attract some opposition lawmakers to switch sides, giving the coalition more stability and a better chance to take the peace process forward.
There's also a view that Western supporters of the Tamil Tigers have started investing in the island's north and east, another indication that fighting may not resume.
Investors, however, may be expecting too much too soon. In reality, the economy, which expanded 5.9 percent last year, is already slowing and local investors are putting up a brave face only because they have nowhere else to go.
Foreigners are largely staying out. On Friday, when the Colombo index rose 0.7 percent, purchases by overseas investors made up 6 percent of total stocks traded. That's a far cry from last year, when foreigners accounted for 23 percent of turnover.
No Choice
For local investors, parking money in government bonds isn't an option because inflation is quickening and may shoot up if global fuel prices remain high. The yield on a government bond maturing in August 2013 has risen more than a quarter percentage point in the past six months.
The Sri Lankan government borrowed 137 billion Sri Lankan rupees ($1.33 billion) by selling bonds in the local market last year. Total outstanding government debt was 1.86 trillion rupees at the end of last year, more than the country's annual gross domestic product.
Since the government restricts outflow of domestic capital, investors don't have too many options. If bombs start going off in Colombo like they used to with frightening regularity until three years ago -- the central bank was bombed in 1996, the business district in 1997 and the only international airport in 2001 -- real estate prices may not hold.
Nor does it make much sense to hold cash at a time when the benchmark interest rate is 7 percent, the lowest since 1997.
Jeyavarman of National Asset says he has kept 60 percent of his funds in stocks and the remaining in debt.
``The rise in the stock market may or may not sustain,'' he says, ``but it's been too big to ignore.''
Correction Due?
And Sri Lankan stocks are indeed cheap. The price-to-earnings ratio of Colombo-listed shares is 10.3, compared with 12.5 for the top 100 shares in India and 20.6 for Singapore. Brokers are advising investors to buy more.
``We renew our recommendation to accumulate fundamentally sound counters,'' researchers Inthi Mohammed and Ineka Dunuwille at Ceylinco Stock Brokers Pvt. in Colombo said in a note to clients yesterday. ``We expect the market to show upward movement although a correction is due anytime soon.''
Yet, bear in mind that Sri Lanka is also an illiquid market. In 2003, trading turnover was 28 percent of market capitalization. In neighboring India, the turnover-to-capitalization ratio was more than 50 percent last year.
For foreigners to bet on the island's fragile peace may not be such a good idea. True, there may be exceptional opportunities. Returns, however, are shrouded by a shadow of looming risks and are best left for local investors to savor.
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