Sri Lanka was highlighted alongside the frontier markets Vietnam and Bangladesh, as being ideal investments for foreign investors with a high risk appetite seeking to diversify their equity portfolios, in an equity strategy report from HSBC.

The report cited a marked improvement in the return on equity (ROE) of Sri Lankan companies, particularly in the last two years, as being one of the factors driving foreign participation in the Colombo bourse, a market which is currently dominated by domestic investors, who accounted for approximately 89% of the market turnover last year.

Companies in the SL20 index posted an average ROE of 21.1% and 18.2% in 2011 and 2010, respectively, having previously achieved only 5.9% in 2009 and 10.6% in 2008, according to a Du Pont analysis carried out by HSBC.

“Part of this improvement can be attributed to better margins, which reflect better pricing power. While leverage has remained steady, companies have reduced their interest burden significantly, reflecting better credit terms from lenders and a big fall in policy rates,” the report stated.

The report also drew attention to strong domestic consumption levels, despite Sri Lanka’s small market size, as being another positive component in the country’s economy, in addition to increasing levels of consumer sophistication and a yet untapped market as development continues to spread to rural areas.

As with other frontier markets, Sri Lanka’s low correlation with developed markets and a tendency to be more strongly influenced by domestic factors was raised as another beneficial factor for foreign investors.

“Sri Lanka shows a low correlation with global macro factors conversely, correlation with domestic macro factors – using M2 growth as a proxy – is relatively high versus the rest of Asia.”

“Sri Lanka is a very small market so it is not surprising that both the level of foreign fund flows and the correlation with the rest of Asia and global stock markets is low. This tendency to go its own way has a benefit to investors in terms of diversification,” the report noted. The three frontier markets discussed in the report have in the last five years provided combined average returns of 21.1%.