Whither equity markets?

It has been heartening to observe the seemingly inexorable rise in the stock markets this year. With the Colombo Stock Exchange’s market capitalization having peaked at US$ 7.38 billion, the obvious question is: Where do we go from here?

Despite the feel-good effect of this milestone, one must admit that the equity culture has not yet really caught on in Sri Lanka. There seem to be factors that result in savings finding their way into real estate and bank deposits rather than into the equity market.

A vibrant and liquid capital market is imperative for the balanced growth of any economy. As business entities gradually move up the continuum from family-controlled enterprises to professionally-managed corporations, it is necessary that they have access to equity markets. However, the dearth of public issues – Initial Public Offerings (IPOs) or otherwise – suggests that not enough is being invested in equity by the general public.

The two essential ingredients for a flourishing stock market are safety and liquidity. While Sri Lanka’s financial markets have a fair degree of systemic safety, the lack of liquidity in the equity markets appears to be a significant impediment.The Colombo Stock Exchange’s market capitalization is US$ 7.38 billion and the average daily turnover is US$ 3.69 million – or merely 0.05% of market capitalization. If one was to take the Indian equity markets as a benchmark, the average daily trading is about US$ 2.34 billion, which works out to 0.32% on the market capitalization of US$ 730 billion. Hence, even taking India as an example of what is possible, there is ample scope for a six-fold increase in traded volumes on the Colombo Stock Exchange.

To develop the equity markets in this country, we need more robust institutions – mutual funds and depositories, for instance. The average person, with discretionary funds to deploy, would not invest in equity unless he is educated about and aware of the risks and rewards of equities as an asset class. There is a need for pioneering institutions (like Merrill Lynch and Franklin Templeton) to play this role.

The growth of equity markets typically has the effect of a ‘virtuous cycle’ – Economies of scale result in reduced transaction charges that intermediaries charge. This lowering of such costs would draw more people to the market. The business press and other media can also play a responsible lead role in this connection.

As markets mature, investors tend to value companies based on expected future performance, rather than on ‘historical’ measures like net asset value or dividend yield. Despite the low liquidity of most shares and the general mood of pessimism that prevails in this country, share prices are at an all-time high today. That is a good sign.

Theoretically, the market capitalization of a company is the discounted value of all future cash flows of the company. If that is the case, persons investing in equities today believe that the future is brighter than it has ever been before.