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What To Find Before Seeking Alpha: Minimum Volatility Domestic Equity Allocation

Summary Minimum volatility strategies have outperformed in the U.S. markets. A minimum volatility portfolio may make a good “skeleton” for a concentrated equity allocation. USMV appears to be a good implementation of the strategy. In my last article , we looked at several types of portfolios for U.S. domestic equity. We saw that broad-based static allocations limit alpha , and tend to track the wider market in terms of returns. Nevertheless, we did see that momentum-value, minimum variance, as well as stock-based portfolio with slack had an edge over the market portfolio (as proxied by the Vanguard Total Stock Market ETF (NYSEARCA: VTI )) in terms of returns, inverse beta, drawdown, and mean-variance efficiency. The minimum variance strategy, as proxied by the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ), scored especially well. We also saw how some allocation slack in the concentrated stock portfolio allows investors to potentially capture some alpha . In this article, we expand on the minimum variance strategy within the context of U.S. domestic equity, but extend the strategy to small-cap stocks in a more concentrated stock portfolio, which should be more conducive to generating potential alpha whilst maintaining some of the structure of a quantitative strategy. Data and Methods The S&P 1500 stocks were assembled from State Street’s SPDR S&P 500 Trust (NYSEARCA: SPY ), SPDR S&P MidCap 400 Trust (NYSEARCA: MDY ), SPDR S&P 600 Small Cap (NYSEARCA: SLY ) ETFs holdings disclosures. The S&P 1500 was chosen because it’s both familiar and covers most of the market; it also weeds out many less investable parts of the market by using liquidity, float, and financial considerations. The price and return data then were obtained from the data facility of Yahoo! Finance. Only stocks with about 7.5 years of history were retained so as to include the financial crisis in 2008. This full sample requirement was to make the estimates more comparable, and left 1348 equities. The market benchmark portfolio, as proxied by VTI, was calculated for the same period, along with the ETF implementation of the strategy, USMV. The continuous logged total returns for the portfolios are computed from their split and volume-adjusted prices using the quantmod package for R . The dividends are accrued daily over the observed period. The daily return and standard deviation statistics are then made monthly using 21 trading days. The 1-year forward earnings estimates stem from Thomson Reuters fundamentals; a few missing estimates were complemented with either numbers from Yahoo or last year’s earnings. The real risk-free rate is assumed to be 1.62% comparable to some margin rates offered. The data were then imported into MATLAB in order to use the well-documented financial toolbox (The same exercise is possible in R, just much less comfortable). The minimum-variance portfolio from the sample is then computed using quadratic programming, no short-selling, no leverage, and constrained to ensure that no fewer than 10 stocks are chosen. Figure 1 gives an overview of both the assets and the minimum variance portfolio, visible in green at the nadir of the blue radial curve. Green lines emanate from the market portfolio, VTI, to the risk-free rate, minimum variance, and the mean-variance efficient portfolios. (click to enlarge) Figure 1: Risk vs. Return Efficiency Frontier for S&P 1500 Figure 1 reveals that the minimum variance portfolio has vastly outperformed the market in the last 8 years as evidenced by the upward sloping angle that connects its risk/return with that of the market portfolio in the swarm of assets. One might expect that the performance ought to be below that of the market return and above that of the risk-free rate, i.e. somewhere near the lower line segment that connects the risk-free rate with the market return where the equal weighted portfolio now lies (green point). I’m not versed in the financial literature on volatility, but I am skeptical whether such outperformance can continue – my pet theory is that the phenomenon is attributable to an uncompetitive bond market. Central banks have artificially lowered the discount rate by about half since the beginning of this sample period. This would approximately double the discounted present value of the company even with static earnings. Since the market return of 8.4% is essentially in line with historical averages (7-10% depending on the period and methods), I thus also suspect the momentum has drawn in participants from the other more volatile segments of the market. Beyond my empirical musings, many of you are most likely interested in the component stocks. Table 1 compares the holdings of the solution with those of the USMV. Note that the weights do not quite tally to 100% as many of the miniscule positions (i.e. < 0.5%) were omitted. Table 1 shows the weights of the solution compared with the USMV ETF. Table 1: Large/mid-Cap Minimum Volatility Portfolio (S&P1500) Symbol Company Index Index Weight Sector MinVol{SP1500} Weights USMV Weights Ratio of Portfolio Weights FW Earnings Yield JNJ Johnson & Johnson SP500 1.62% Health Care 5.1% 1.4% 3.63 5.8% PEP PepsiCo Inc. SP500 0.79% Consumer Staples 2.8% 1.4% 1.97 5.0% WMT Wal-Mart Stores Inc. SP500 0.76% Consumer Staples 5.3% 1.5% 3.47 5.9% MO Altria Group Inc. SP500 0.54% Consumer Staples 2.0% 0.8% 2.51 5.5% MCD McDonald's Corporation SP500 0.50% Consumer Discretionary 5.2% 1.4% 3.64 5.8% SO Southern Company SP500 0.25% Utilities 10.0% 1.4% 7.30 6.0% GIS General Mills Inc. SP500 0.18% Consumer Staples 10.0% 1.3% 7.67 5.2% BDX Becton Dickinson and Company SP500 0.15% Health Care 1.8% 1.6% 1.11 4.8% ED Consolidated Edison Inc. SP500 0.11% Utilities 6.9% 1.3% 5.45 6.0% CAG ConAgra Foods Inc. SP500 0.08% Consumer Staples 5.5% 0.0% - 6.3% DLTR Dollar Tree Inc. SP500 0.08% Consumer Discretionary 0.9% 0.2% 3.83 4.5% BCR C. R. Bard Inc. SP500 0.07% Health Care 3.2% 0.7% 4.81 5.4% CLX Clorox Company SP500 0.07% Consumer Staples 8.5% 0.3% 25.13 4.3% LH Laboratory Corporation of America Holdings SP500 0.05% Health Care 1.4% 0.5% 2.61 6.8% CPB Campbell Soup Company SP500 0.04% Consumer Staples 1.9% 0.3% 7.73 5.5% HRL Hormel Foods Corporation SP500 0.04% Consumer Staples 8.6% 0.3% 29.85 4.8% CHD Church & Dwight Co. Inc. SP400 0.65% Consumer Staples 5.4% 0.6% 8.59 4.2% AJG Arthur J. Gallagher & Co. SP400 0.47% Financials 1.7% 0.0% - 5.9% RGLD Royal Gold Inc. SP400 0.27% Materials 3.0% 0.0% - 2.0% TECH Bio-Techne Corporation SP400 0.21% Health Care 0.9% 0.0% - 4.2% LDOS Leidos Holdings Inc. SP400 0.16% Information Technology 1.5% 0.0% - 5.9% FCN FTI Consulting Inc. SP400 0.10% Industrials 1.9% 0.0% - 5.3% BOFI BofI HOLDING INC. SP600 0.15% Financials 2.8% - - 6.1% HSTM HealthStream Inc. SP600 0.09% Health Care 1.1% - - 1.5% SENEA Seneca Foods Corporation Class A SP600 0.03% Consumer Staples 1.8% - - 4.7% Expected Earnings Yield: 5.2% As expected, the resultant portfolio has many of the same members as USMV. It is, however, much more focused than USMV, which operates under several other sector and weight constraints. Nevertheless, this tighter collection of stocks would be more manageable for an individual investor's portfolio. The stocks are not exactly cheap trading at 19.23x forward earnings vs. about 14.67 historical average for the S&P 500. Including the small-caps does reveal some interesting small-caps like Leidos, which is a specialized IT outfit with government contracts, or Royal Gold, which owns a variety of stakes in precious metals. The latter has an interesting business model that assembles cash-flow stakes in precious metal interests, but is not exposed to the operational risk like a miner would be. In this sense, the minimum volatility portfolio solution might help to identify unique stocks that might otherwise pass through a standard stock screen. I suspect that many of you may already have either large-cap funds or stocks within your portfolio, so I performed the same exercise by looking at just the S&P 1000, which would complement those putative holdings. Figure 2 reveals that limiting the equity space reduces the efficiency of the portfolio as evidenced by the frontier shifting right in the (horizontal) risk space, and down in the (vertical) return space. The magenta line connects the moments of the S&P 1000 volatility portfolio to those of the market portfolio. The orange dotted line is a regression of risk, as measured by the annualized standard deviation of returns, versus annualized total returns; the negative slope counter-intuitively is telling us that more risk equates to fewer returns in the recent equity market. (click to enlarge) Figure 2: Minimum Volatility Portfolios and Risk versus Return Table 2 displays the weights and holdings of that minimum variance portfolio, we see a fair amount of overlap in the portfolios with health care, staples, and utilities playing a large role. Interestingly, we see a few more of the pro-cyclical industrials, financials, and technology firms represented. As prime example, Synopsys is a small engineering and development outfit that looks like an interesting, reasonably priced tech-play if U.S. capital expenditures pick up. Table 2: Mid/Small-cap Minimum Volatility Portfolio (S&P1000) Symbol Company Index Index Weight Sector MinVol{SP1000} Weights FW Earnings Yield CHD Church & Dwight Co. Inc. SP400 0.65% Consumer Staples 10.00% 4.2% AJG Arthur J. Gallagher & Co. SP400 0.47% Financials 7.55% 5.9% SNPS Synopsys Inc. SP400 0.41% Information Technology 2.01% 6.2% UTHR United Therapeutics Corporation SP400 0.37% Health Care 1.41% 6.9% ATO Atmos Energy Corporation SP400 0.34% Utilities 4.34% 5.5% WCN Waste Connections Inc. SP400 0.34% Industrials 1.46% 4.6% GXP Great Plains Energy Incorporated SP400 0.27% Utilities 2.85% 6.2% RGLD Royal Gold Inc. SP400 0.27% Materials 4.33% 2.0% CPRT Copart Inc. SP400 0.26% Industrials 0.56% 4.7% ATK Alliant Techsystems Inc. SP400 0.23% Industrials 2.00% 10.4% RNR RenaissanceRe Holdings Ltd. SP400 0.23% Financials 3.50% 8.8% VVC Vectren Corporation SP400 0.23% Utilities 0.54% 5.5% FLO Flowers Foods Inc. SP400 0.22% Consumer Staples 5.90% 5.1% THS TreeHouse Foods Inc. SP400 0.22% Consumer Staples 6.35% 5.1% TECH Bio-Techne Corporation SP400 0.21% Health Care 8.57% 4.2% HE Hawaiian Electric Industries Inc. SP400 0.21% Utilities 10.00% 5.1% LDOS Leidos Holdings Inc. SP400 0.16% Information Technology 6.52% 5.9% FCN FTI Consulting Inc. SP400 0.10% Industrials 3.00% 5.3% HAE Haemonetics Corporation SP600 0.28% Health Care 4.81% 4.9% MGLN Magellan Health Inc. SP600 0.24% Health Care 2.20% 3.9% ICUI ICU Medical Inc. SP600 0.16% Health Care 0.79% 3.3% BOFI BofI HOLDING INC. SP600 0.15% Financials 3.68% 6.1% HSTM HealthStream Inc. SP600 0.09% Health Care 0.91% 1.5% ANIK Anika Therapeutics Inc. SP600 0.08% Health Care 0.80% 3.9% SENEA Seneca Foods Corporation Class A SP600 0.03% Consumer Staples 3.23% 4.7% Expected Earnings Yield: 5.03% Having seen the content of the portfolios, we now compare their performance attributes. Portfolios are evaluated using: annualized returns, Sharpe ratio (return efficiency), Calmar ratio (drawdown efficiency), and inverse beta (systemic risk). These four statistics are then computed relative to the market portfolio, and their geometric mean is taken to arrive at a general score (last column). Table 3 reports the results. Table 3: Portfolios Compared PORTFOLIO* DATA (years) Portfolio Stats Benchmark Relative Stats (stat_portfolio/stat_benchmark) R SD Sharpe Calmar Beta R SD Sharpe Calmar R Sharpe Calmar Beta^-1 Score MinVolSP1500 7.4 14.4% 13% 1.141 0.353 0.648 8.4% 22.3% 0.38 0.11 1.72 3.03 3.30 1.54 2.27 MinVolSP1000 7.4 11.0% 14% 0.757 0.353 0.648 8.2% 22.0% 0.37 0.11 1.35 2.04 3.30 1.54 1.93 MinVolSP900 7.4 16.7% 13% 1.312 0.353 0.648 8.1% 21.9% 0.37 0.17 2.06 3.55 2.08 1.54 2.20 Mid-Cap 8.0 9.7% 25% 0.394 0.119 1.076 8.4% 22.2% 0.38 0.11 1.17 1.05 1.06 0.93 1.05 Market 8.0 8.4% 22% 0.376 0.113 1 8.4% 22.2% 0.38 0.11 1.00 1.00 1.00 1.00 1.00 S&P500 8.0 7.9% 22% 0.358 0.106 0.989 8.4% 22.2% 0.38 0.11 0.95 0.95 0.95 1.01 0.96 Dividend 8.0 8.4% 24% 0.348 0.104 1.041 8.4% 22.2% 0.38 0.11 1.01 0.93 0.92 0.96 0.95 Sectors 8.0 8.1% 23% 0.353 0.104 1.014 8.4% 22.2% 0.38 0.11 0.96 0.94 0.92 0.99 0.95 Market Cap 8.0 8.4% 24% 0.345 0.099 1.079 8.4% 22.2% 0.38 0.11 1.01 0.92 0.88 0.93 0.93 "Cramer" 8.0 8.5% 26% 0.325 0.096 1.073 8.4% 22.2% 0.38 0.11 1.02 0.86 0.85 0.93 0.91 Random Stock 7.2 1%^ 32% 0.032 -0.036 1.25 8.2% 23.0% 0.36 0.11 0.13 0.09 -0.33 0.8 NaN^ *The other portfolios are explained in my previous article . ^Due to the slight difference in how returns are calculated between the method outlined and the Calmar ratio in the performance analytics package for R, an imaginary solution is produced when the geometric mean is taken. We see that the annualized returns of the minimum variance portfolios have dominated the other domestic portfolio strategies in recent years, not only with double digit returns, but they also score much better in terms of risk-efficiency as measured by the Sharpe and Calmar ratios. Furthermore, the portfolios exhibit considerably less systematic risk as measured by beta , which implies they could be significantly leveraged to reach even higher returns without taking more aggregate systemic risk than the other portfolios. We now compare the focused do-it-yourself portfolio to the benchmark ETF USMV over a common period. Table 4: Portfolios vs. USMV Parent Index S&P 1500 S&P 900 S&P 1000 Period (years) 2.644 2.644 2.644 Portfolio Stats R 0.177 0.167 0.11 SD 0.127 0.127 0.145 Sharpe 1.396 1.312 0.757 Calmar 0.353 0.353 0.353 Beta 1.025 1.025 1.025 Benchmark R 0.191 0.191 0.191 SD 0.097 0.097 0.097 Sharpe 1.982 1.982 1.982 Calmar 3.074 3.074 3.074 Relative Stats (port/bench) R 0.923 0.873 0.574 Sharpe 0.704 0.662 0.382 Calmar 0.115 0.115 0.115 Beta^-1 0.976 0.976 0.976 Score 0.519 0.504 0.396 A bit to my own surprise, we see that USMV outperformed the other minimum variance stock portfolios. I would have thought the S&P 1500 and S&P 1000 portfolios would outperform in that the former incorporates more equities, and the latter is optimized on a class of equities, which have traditionally exhibited larger risk premia. Even optimized on a similar large and mid-cap space, USMV outperforms. Moreover, USMV has more constraints on its portfolio construction, such as turnover restrictions or an upper bound of 1.5% on any given asset. Furthermore, it has an expense ratio. It does have three advantages that spring to mind. The first is that it dynamically adjusts every 6 months, whereas the results presented here are computed as an ab initio allocation held for the entire period. The second is that as money pours into the strategy, the stocks in the ETF rise in the price - since the holdings are somewhat distinct, this might give the ETF an edge as money flows into it (but this also may run in the other direction…). Third, is the fact that the index providers may have a bit of secret sauce for how the index is constructed - this is not to say they are hiding something, merely that they may know what constraints provide a slight edge over my "dumb" optimization. That is to say, some smart quant on MSCI's index team may have a keen, but undisclosed, rationale for why no stock may be more than 20x the allocation in its parent index provides a slight edge. In this article, we have seen that minimum volatility strategies have outperformed in the recent period, but that both on a fundamental and theoretical level, this outperformance may be transitory. Nevertheless, the strategy does have some conceptual merit, and might be a good initial skeleton for retail investors who are known to choose riskier higher beta and smaller cap stocks. Beyond a basic industry diversification, retail investors are unlikely to be in a position to exploit the covariance amongst the assets. Some of these correlations are not immediately obvious - for example, my miner, Vale (NYSE: VALE ), is linked to my utility by virtue of the fact that they are both Brazilian. My Australian stocks seem subservient to the whims of Chinese GDP reports, and my gold miner tracks my iron stock. In short, unless you have done the work ahead of time it is fairly easy to inadvertently put together a very volatile portfolio that looks on paper to be very diversified, but trades very wonky. As we saw in Figures 1 and 2, the advantage of the minimum volatility approach is that it at least should keep your equity portfolio somewhere in the triangle between the risk-free-rate, risk-optimal return, and the market portfolio; staying out of the dangerous southern hemisphere and wild eastern reaches of the risk-return chart should prevent your portfolio from getting totally wracked on the low-return high-variance shoals of the equity markets. If you are less-risk averse and do not want to use margin, the strategy at least leaves you with some risk-budget to squander, err.., "deploy" on high-octane biotechs or Internet IPOs. For those who do not seek the venerated alpha or who do not want to do-it-yourself, USMV looks like a good implementation of the allocation strategy where its expense ratio vs. VTI might be just good value, rather than a wealth-destroying violation of the Bogleheads' sacred low-fee doctrine.

Investing In Africa: A Long-Term Growth Opportunity?

Summary Certain indicators point to an overvalued S&P 500. Prudent investors should consider more attractively valued indexes. Despite headwinds, Africa’s improving fundamentals suggest long term growth opportunities. As the new year begins to take shape, most investors have their attention squarely focused on the United States as the oasis of growth in a desert of underperforming national economies. Nevertheless, when we take a closer look at the key American stock market index, the S&P 500 (NYSEARCA: SPY ), it would appear that many market observers consider it to be overvalued. Some suggest that its blended P/E ratio of 17 is on the upper end of its historical normal valuation range since 2001, others warn that it is historically expensive relative to GDP and finally most point to the Shiller P/E which currently sits at 26.4, which is 59% higher than the historical mean of 16.6. Although it is difficult to make accurate broad valuation forecasts for a large collection of companies such as the S&P 500, such forecasts can be useful to the prudent investor. If we are willing to accept that many companies trading on the S&P 500 are trading at or above their fair value we may at minimum need to consider the possibility of a slowdown in broad index growth over the coming year. As such, the prudent investor may want to start contemplating other more attractively valued indexes. It would appear that such opportunities lie in Africa. Despite several headwinds such as the effects of the Ebola virus, civil unrest (Boko Harem), the slowdown in the global economy and the drop in the price of oil, Africa remains a resilient continent poised to record around +5% economic growth. In a recent report Yogesh Gokool, head of the AfrAsia Bank explains that this growth will be primarily driven by more foreign direct investments and remittances from non-OECD (Organization for Economic Co-operation and Development) countries that will continue to pour money into corporate acquisitions and large-scale infrastructure projects. Resource rich countries will continue to attract the lion share of FDIs into Africa yet with the drop in the price of oil and rising wages in Asia, manufacturing will also be a significant recipient. The other main driver of growth will be private consumption. In a recent report by the United Nations Economic Commission for Africa entitled African Economic Outlook 2015 it was found that private consumption in Africa is expected to accelerate by 0.5 percentage points to 3.8 percent in 2015 due to consumer confidence and the expanding middle class. Private Consumption and gross capital formation are expected to be key drivers of growth (click to enlarge) Data Source: UN-DESA, 2014 In addition, inflation should remain under control by 0.4 percentage points to 0.7 in 2015. Subdued inflation across economic groupings (click to enlarge) Data Source: UN-DESA, 2014 As for fiscal deficits, the current account balance is expected to decline but remain positive for oil exporting countries while the current account deficit may rise less than expected due to lower oil prices for oil importing countries. Moderating fiscal deficits expected in 2015 among country groupings (click to enlarge) Data Source: EIU, 2014 As mentioned above, certain downside risks could slow economic growth in Africa such as the effects of the Ebola virus, civil unrest (Boko Harem), the drop in oil and commodity prices and a global growth slowdown. Based on early assessments , the economies of Guinea, Liberia, Sierra Leone are experiencing significant hardship as public finances are strained and household incomes are dropping. Nevertheless, the economic impact is not as bad as some feared as the World Bank estimated that Ebola could cost the region as much as $32 billion and the real cost appears to only be a tenth of that figure. In fact, a positive impact of the outbreak seems to be the renewed urgency to reinforce basic public health systems in vulnerable regions. As for lower commodity prices, the negative impact on the continent’s growth may be offset as lower prices will help ease balance of payments pressures in food and energy importing countries while commodity exporting countries face lower export earnings. Furthermore, these commodity declines will serve to reaffirm the benefits of more diversified national economies. Finally, in the face of a potential global slowdown Africa should remain attractive as its economic fundamentals remain sound . Governance and macroeconomic management have improved. Investment in infrastructure, human and physical capital are increasing. Productivity, the middle class and diversified trade are all growing and finally a culture of entrepreneurship is being created. Conclusions Given the risks outlined above and my belief that stable growth in Africa is still a long way off, it may be better to describe investing in Africa as an opportunity for the enterprising investor rather than the prudent investor. Nevertheless, if you remain patient and take a long-term view of an investment in Africa, you may be interested in several ETFs which have African exposure and are currently trading near their 52 week lows. The first is the Market Vectors Africa Index ETF (NYSEARCA: AFK ), which allocates just over a quarter of its weight to developed market countries that do business in Africa. This allocation serves to reduce some of the fund’s exposure to the volatility of local African markets. The fund is heavily weighted to South Africa, Egypt and Nigeria with financials accounting for around 40% of the fund while materials and energy account for around 30%. The other ETF of note is the Guggenheim Frontier Markets ETF (NYSEARCA: FRN ). This fund invests in a collection of small, illiquid and risky markets with great growth potential known as frontier markets . These often high yielding markets have become an asset class in their own right and the fund’s exposure to Africa is only about 13%, with the rest allocated to other markets in Latin America.

Sri Lanka – Do The Elections Represent A Green Or Red Light To Investors?

Summary 2-term President Rajapksa loses despite calling election 2 years early. President Sirisena calls for National Government in ‘Rainbow Coalition’. China’s Economic Influsence likely to be reduced, but any shortfall likely to be made up from elsewhere. India likely to play a more prominent role in economic activity. The election is a milestone in Sri Lanka’s maturing democracy and may well represent a milestone in its economic progression. Background On Thursday January 8th 2015, Sri Lanka went to the polls in a Presidential election. This election had been called 2 years early by President Rajapaksa following evidence of declining support for a President that had once been hailed as a national hero . Indeed, his party’s previous dominance had allowed him to change the constitution and permit his seeking a third term. However, despite this wavering support, few expected him to actually lose the election. In the event, Maithripala Sirisena, a former health minister in Mr. Rajapaksa’s cabinet, won the election and was immediately installed as President. Whilst polls had shown the 2 candidates to be level pegging, this result remained shocking. It is thus necessary to consider whether this is evidence of a maturity in Sri Lankan politics or a dangerous change of course following a period of solid economic advance. The Election Despite rumors that elements of the police and army were intimidating anti-Government supporters prior to the election, the poll went ahead in a relatively peaceful fashion. Around lunchtime on the 9th, President Rajapaksa conceded defeat and left the Presidential Residence. That evening, President Sirisena was inaugurated as President and congratulations poured in on a smooth transition from the country’s neighbours and indeed from US Secretary of State Kerry . However, on January 11th, news emerged that the transition may not have been as smooth after all. An aide to President Sirisena announced that President Rajapaksa had approached the police and military seeking support to remain in office. An attempted coup was claimed . However, even if this is correct, the police and military refused to support Mr. Rajapaksa and a peaceful transition has been effected. It seems highly unlikely that Mr. Rajapaksa will make any further attempt to unseat his successor following his rejection by the security forces. Moreover, it is likely that this initiative will be used by President Sirisena and his supporters led by the United National Party (‘UNP’), as a way of pressuring Mr. Rajapaksa’s Sri Lankan Freedom Party (‘SLFP’) ahead of April’s parliamentary elections. From this perspective, it seems likely that the Rajapaksa family’s dominance of Sri Lankan politics (and indeed business life) is at an end. Winners and Losers The principle losers from this election are the Rajapaksa family and China. It was no secret that members of the Rajapaksa family had benefited from their family connection to the President. Whether by holding official office or by their involvement in business deals, the ‘first family’ had clearly benefited. One of the first questions private equity or strategic investors made was which part of the family would be involved and what their expectations would be. Their involvement in the country’s business life cannot be removed overnight. A comparison may be made with some of the business associates of President Suharto of Indonesia whose influence certainly waned following his removal from office, but didn’t disappear. However, it is equally clear that Mr. Rajapaksa’s loss was at least partially owing to discontent with the nepotism that had marked his rule. Many of the transactions in which they had been involved were with Chinese investors . Indeed, a simple overview of Sri Lanka’s international relations during President Rajapaksa’s rule involves China supplying the armaments and finance required to extinguish the LTTE and in return being given a prominent role in the country’s economic expansion. Whilst this certainly involved providing access to money and equipment that has propelled the rebuilding of Sri Lanka’s infrastructure at a rapid rate, critics pointed to the Chinese investment as being a quid pro quo for securing a naval base in the Indian Ocean. Such Chinese involvement naturally put pressure on Sri Lanka’s relationship with neighbouring India. President Sirisena has already talked about China being a good friend to Sri Lanka but warned about not being behoven to any one nation. Additionally, his election manifesto included the cancellation of the Colombo Port City project, a US$1.3 billion project to reclaim land and build everything from high rise offices and apartments to a Formula 1 Grand Prix track. If he carries out these promises, it is clear to annoy China on both economic and strategic grounds. Indeed some have hailed the defeat of President Rajapaksa as destroying China’s overall Indian Ocean Foreign Policy and placing a dent in its ambitions to build a global network of ports. This is likely to be exaggerating things a little, at least at this stage. It is easy to point to India as being the strategic winner from this election. It understandably held concerns about China’s influence both economically and militarily in Sri Lanka. Additionally, the economic policies of the ruling BJP are more in line with the UNP in Sri Lanka than they were with the more left wing Rajapaksa administration. Additionally, the religious minorities of Sri Lanka were solidly behind President Sirisena, and polls indicate that the size of their turn out was a major influence in his victory. Whilst President Sirisena and his key supporters are Sinhalese, it is likely that their policies will be more accommodative of minorities than had been the case with the previous administration. Hence his call for a ‘rainbow coalition’ Invest or Wait? Let’s consider the key questions at this time: · Will President Sirisena change economic course in Sri Lanka to the detriment of investors? o Highly unlikely. His key supporters (UNP) have a more pro-business posture than the SLFP and have been critical of policies (such as the land reform bill) that were deterring to foreign investors. · What will the impact be of cancelling the Colombo Port City project and the planned integrated resorts (casinos)? o The Port City was certainly a massive project and the construction and engineering would certainly have added to the local economy. However, there were major doubts about its ambition and viability. o Given recent revenue contraction in casinos from Macau to Singapore and the planned launch of casino based projects in many other East Asian countries, it is questionable whether building such projects in Colombo would have had a big impact on tourist arrivals and expenditure. Sri Lanka has a wealth of attractions for tourists and many would argue that it can continue to accelerate its tourism industry without resorting to gambling. · Are the upcoming Parliamentary Elections important? o President Sirisena has pledged to reverse the trend of increasingly centralized Presidential power that evolved during President Rajakasa’s terms and strengthen parliament. However, this may be the largest uncertainty given the composition of the coalition which supported his candidacy. o There is little doubt that this coalition was more ‘anti-Rajapaksa’ than it was ‘pro-Sirisena’. Equally, that Sirisena comes from the left-leaning SLFP but now is supported by the right-leaning UNP creates uncertainty. He talks of a “rainbow cabinet’ but this may turn out to be a more effective sound bite with echoes of Mandela than a sustainable coming together of previous enemies. o President Sirisena now has 3 months during which he must bring together elements of multiple parties into a coalition which will support him and demonstrate leadership prior to the election. This will require an impressive level of political maneuvering and only time will tell whether he can pull this off to create a balanced but effective government. The worst case scenario is for the coalition to fracture and leave him without a power base. o His Prime Minister, Ranil Wickremsinghe, was the driving force behind the selection of Mr. Sirisena and is the leader of the UNP. The day to day relationship between these two gentlemen is going to be critical as if Sirisena is regarded as being a puppet of the UNP, then the coalition could fracture rather easily. · Should we be concerned about China being annoyed? o In a word…’No’. Whilst there is little doubt that a return of Rajapaksa would have been China’s preference, they will not want to endanger their access to this strategically important island. Whilst the military benefits of Sri Lanka were often focused upon, the economic benefits of having a trans-shipment option that is lower cost and arguably more convenient to Singapore or Malaysia is also key to Chinese interests. o As mentioned above, this may also allow India and Sri Lanka to become friendlier, particularly given the friendship of Messrs Modi and Wickremsinghe. It would be no surprise if Mr. Modi was one of the first visitors to Sri Lanka, bringing with him promises of additional trade and support. · What about the response of other Countries? o The removal of Mr. Rajapaksa who was the architect of the crushing of the Tamils may bring Sri Lanka closer to its Commonwealth brethren as well as the US. This may well translate directly into expanded financial support as well as giving the country the ability to face the events that accompanied the ending of the civil war without being punished for retaining as President the architect of these events. o It is likely that international relations will improve under Mr. Sirisena and Sri Lanka may once again focus on promoting its many strengths rather than defend its recent history. Conclusion Whilst there are reasonable uncertainties about President Sirisena’s political leadership and his ability to build a sustainable coalition, the positives from this election exceed the doubts. International investment will be more balanced and strategic investors are less likely to be frozen out by preference for ‘first family’ initiatives or Chinese investment. Despite this, credit has to be given to President Rajapaksa for the great strides that Sri Lanka has made over recent years. The country now has a solid foundation of infrastructure including power generation and transportation from which it can build. In m y previous article , I argued that there were many reasons to be positive about Sri Lanka over the coming decade. I see no reason for concern that these reasons have been diluted and indeed believe that stronger growth can now be achieved. Today, Pope Francis arrives in Sri Lanka on an official Papal visit. The timing is appropriate as he will be being greeted by a President who has made reconciliation between religions a key issue. From this perspective, it is an effective ‘Christening’ of the new administration. Only time will tell whether President Sirisena will reward the electorate’s confidence, but the signs are positive and assuming that he can harness the spirit of co-operation and renewal that Pope Francis is certain to preach, the country is set for strong further growth. Investment options for prospective investors in Sri Lanka remain limited. The Ceylon Stock Exchange is small, illiquid and volatile. In essence, it is more of a private equity market for the time being. However, we believe that this will change over coming months as Sri Lanka focused investment vehicles emerge. To this end, emerging market investors should keep at least one eye on Sri Lanka given its strong potential.