at 3 years high not just speculation but a re-rating
By NADEEM NAQVI
Head of Research, International Asset Management
Jan 24 - 30, 2000
The meteoric rise in the KSE-100 Index by 3 per cent, from 1409 on
December 31, 1999, to 1850 plus on January 21, 2000 has confounded market pundits. So far
Pakistan is the best performing market in Asia. Is this a speculative bubble driven by
easy liquidity and low 'Badla' rates or has a sustainable re-rating of the Pakistan stock
market begun? If latter is the case how much higher can the market go?
Excess liquidity in the financial system, after the withdrawal of
banks' deposit lottery schemes and low interest, have played a major role in the recent
improvement in stock valuations, and some consolidation at current levels will be healthy
for the market. At the same time there is certainly a re-rating taking place based on
reducing political uncertainty, greater transparency in policies as well as improving
corporate sector fundamentals and earnings growth outlook.
The Pakistan stock market witnessed extraordinary volatility last year.
January saw the KSE-100 Index at 945 in the aftermath of 1998 nuclear tests and subsequent
sanctions, followed by freezing of foreign currency accounts and imposition of capital
controls. After the external debt restructuring agreement with Multinational and bilateral
lenders in the second quarter of 1999, KSE-100 Index recovered to touch 1400. Immediately
thereafter, the Kargil crisis in Kashmir sent the market tumbling back to 1100 levels,
where it became range bound. Political uncertainty mounted in the second half of the year
with government focus completely removed from the economy and towards its own survival.
On the political front, the military backed technocrat government is
likely to continue operating for the foreseeable future. From an investor perspective, the
relative stability on the political front is likely to reduce uncertainty. The GoP
credibility over the coming months is critically dependent on delivering on the promises
of good governance, accountability of corrupt elements and sustained economic revival
Initial moves by the new administration have been in the right
direction. Crackdown on wilful bank loan defaulters has resulted in Rs 10 billion being
recovered and some Rs 30 billion being rescheduled within two months something not
achieved by any government in the last two decades.
On the economic front, an Economic Advisory Board (EAB) has been
constituted. It is headed by the finance minister who is a senior banker inducted from
Citibank and is well regarded in international financial circles. The EAB is composed of
eminent economists, professionals and private sector business personalities without any
political background. It has already drawn up an exhaustive blueprint for economic reform
on a sector-by-sector basis.
A senior World Bank executive has been brought in as the new governor
of the Central Bank, charged with making the financial system more market based while
improving audit and regulatory capabilities of the central bank itself. Privatization has
again been revived, with emphasis on phasing the process through domestic listing of
public sector entities on the local stock exchanges initially. This is to be followed by
induction of professional management and only then inviting strategic investors at the
It is hoped that during the restructuring phase GoP will be able to put
in place the necessary regulatory framework without which foreign investors cannot be
attracted. The first move in this direction has been the formulation and staffing of the
Gas Regulatory Authority, something that was pending for the last five years. This is a
precursor to gas sector deregulation and privatization of the gas utilities. Similar moves
are expected in the oil marketing and distribution sectors.
Signals of fiscal austerity are also emerging. Defence expenditure has
been slashed and non-essential development expenditure has been cut. Petroleum product
prices have been raised to compensate for the rise in international crude oil prices.
General sales tax has been imposed on the energy sector. These measures will help generate
revenue. In the meantime, Central Board of Revenue is undergoing a shake up and sales tax
collection is being tightened. The full year target of Rs 356 billion now appears more
Lack of progress on resolving the Independent Power Producers (IPP)
conflict and continuing informal controls on capital repatriation by foreign investors
were major causes for poor market sentiment. The new administration has taken some steps
towards resolution of these issues. The central bank has cleared most of the backlog of
portfolio funds waiting for repatriation. It has also issued a notice that it will strive
to remain current on new requests for repatriation. There are increasing signs that both
sides are being actively encouraged by the GoP to find an amicable solution and resolve
While the above moves are a step in the right direction, it remains to
be seen how quickly and effectively they are implemented. If reasonable progress becomes
visible by budget time, investor confidence should get a major boost. The re-rating of the
market by domestic investors which began in December 1999, will then likely accelerate as
confidence builds that reforms will finally get implemented and sustained economic growth
would have a greater potential of being realized.
Stock market re-rating
The re-rating of the Pakistan Stock Market has been driven by several
1. Expectation of political stability in the foreseeable future.
2. Expectation of policy transparency and consistency, with hopes for a
conducive investment environment.
3. Rising domestic liquidity, both within and outside the banking
system. After the ending of deposit lottery schemes small savers are looking at equities
again especially because dollar deposits are no longer attractive. Real estate also
4. The reduction in return on risk-free National Savings Scheme within
the last twelve months,
5. Potential for sustained increase in GDP growth led by agriculture
due to bumper cotton and wheat crops. The sharp fall in interest rates will be translated
into higher margins and profits over the next twelve months. As earnings momentum rises,
individual sectors and stocks become poised for upward re-rating.
6. Increasing signs of serious moves towards implementing
long-postponed economic reforms that focus on better governance, higher tax collection,
greater accountability of public servants, accelerated restructuring of the banking system
and revitalization of the privatization process.
A historical focus helps in understanding how domestic investor
perceptions are changing for the positive leading to reduced equity risk premium and
consequent valuation expansions.
The economic indicators are broadly in line with the forecasts for the
current financial year and clearly point towards a bottoming out of the economic cycle.
Brokerage industry's consensus earnings forecasts for KSE-100 companies currently range
from 9 to 13 per cent mainly due to income tax imposition on PTCL for the first time and
earnings uncertainty in Hubco. In full year 2001, earnings growth estimates range from 20
to 28 per cent. These are robust numbers and show that the market re-rating is not based
simply on speculative liquidity but expectations of real improvement in corporate sector
performance. The important point to note here is that unlike most other Asian emerging
markets where markets rises have been driven mainly by foreign liquidity inflows focused
initially on the technology sector, Pakistan market's rise is driven purely by domestic
liquidity. Thus even if foreign funds flow to Asia slows down or reverses, it is unlikely
to have a major negative impact on the Pakistan market. In fact most of the stocks are
still trading at a significant discount to Asian markets. Any improvement in country risk
perception would open up the possibility of foreign fund flow to Pakistan pushing local
equities even higher.
Potential risk factors
Despite positive developments in macro economic policy, sector dynamics
and consequent corporate earnings outlook, there are several risks that need to be kept in
Although, exports were up by 9 per cent in the first half of current
financial year, imports rose faster by 13 per cent. The inflow of expatriate
remittances also remained low resulting in higher current account deficit. The rise in
petroleum prices and upturn in other commodity prices means that the current account is
likely to remain under pressure.
The question that will become increasingly pressing is, how will
Pakistan fund its 2001 debt servicing requirements once the present breathing space
created by rescheduling ends. The optimistic scenario is that if the GoP follows its
reform policies and meets IMF targets, there may be a possibility of a more comprehensive
external debt rescheduling in 2001. Pakistan may be required to sign the Comprehensive
Test Ban Treaty (CTBT) in return for a larger and longer term debt restructuring. If such
a scenario unfolds, sovereign credit ratings could rise as the risk perception for
The pessimistic scenario is that the present administration gets mired
in the politics of pleasing various competing constituencies in order to legitimize its
stay in power. This would lead to loss of momentum on the economic reform front and likely
failure to meet the benchmarks agreed with the IMF. If this happens, and further, if
Pakistan takes a hard-line towards signing the CTBT. A second rescheduling of external
debt would be put in jeopardy. Such a turn of events would inevitably raise alarm bells in
the investor community. While foreign direct investment potential is limited in the
short-term, such a development would inhibit FDI inflows even in the medium term which is
likely to inhibit economic growth.
Domestic political unrest
Although the probability of general public dissent appears limited in
the immediate future. If some form of representation arrangements are not in place by
2000, public resentment against the government might surface. This could occur especially
if the economy is not put back on an even keel by the end of year 2000.
With the market already up more than 30 per cent in the first three
weeks of the year, and leading stocks having risen even higher, it is valid to ask where
should investment funds be deployed? The answer depends on the type of investor and their
objectives, constraints and risk tolerance. For institutional investors who have already
invested and have profited from the recent bull run, tactical top slicing of the best
performing stocks followed by sector rotation, based on fundamental earnings growth, is
perhaps the best option at the moment. One way to gauge longer term prospects for price
performance is to look at the adjusted high-low price levels for major stocks in 1995 and
1996. These price ranges should then be compared to current prices. Based on the
investor's capital market and fundamental expectations, it can then be determined whether
there is any more steam left in specific top performing stocks or not. This exercise will
also identify under performing stocks. If the investor believes that the under-performance
is due to neglect rather than any adverse fundamental reason, then such stocks can be
earmarked for entry when the market corrects from its present over-bought levels.
For retail and individual investors the game is different. It is
critically important for them to avoid the temptation of jumping into the stock market on
the basis of tips and rumours at this stage. Otherwise they are likely to get burned as
happened in the past. The first step for individual investors is to take proper
professional advise rather than trying to out-guess the market. This should begin by
clearly setting out their investment objectives within the context of a well thought-out
long term wealth accumulation plan. This plan must define their risk taking capacity, how
much surplus is available for investing in the stock market on a regular basis after
taking account of necessary financial commitments and keeping a reasonable sum aside for
contingencies. Once the above has been done a proper asset allocation mix should be
decided in consultation with their investment advisor between stocks, cash holdings and
fixed income instruments. Only then stock picks should be focused upon. Despite the
checkered history of many local sponsors in terms of corporate governance and dividend
payouts, there are pockets of good examples available. The individual investor must be
willing to expend time and effort to conduct proper research. Focus should be on
historical and future earnings growth trends, sector dynamics, leverage, return on equity,
expansion plans, pricing power of companies, profit margin management both at the gross
and operating levels and cash flow trends. In a low inflation environment companies that
run cost effective operations tend to be margin maximizers that produce highest returns.