Dividend yields provide the
safest hedge against price deterioration
By AQIB ELAHI MEHBOOB
The writer is Head of Research at
Khadim Ali Shah Bukhari & Co.
May 20 -June 02, 2002
Watching the aftermath of the terrorist attack on the
World Trade Center in New York live on television, few investors would
have predicted the performance of the KSE-100, especially as ominous
references to Osama Bin Laden were already being made. The KSE-100 Index
is up 31.12 per cent since the market reopened after 9/11 and 29.38 per
cent year-to-date.
The 9/11 has had many unfortunate effects on Pakistan
from war in neighbouring Afghanistan, to the physical disruption of
trade with the outside world and allowing India the high moral ground
while it deployed troops on the Line of Control (LoC). Add to that the
deepening of the global recession caused by the attacks, and you begin
to wonder whether the market is sane! How could a "sane"
market drive up valuations whilst political and event risk is so high,
when corporate profitability really hasn't been anything to talk about
and investor concerns about corporate governance (taking on a new
vehemence after the Enron fiasco) are yet to be properly satisfied? Let
us explain.
First and foremost, it is very important to
understand that the KSE-100 index is not driven much by sentiment or
even fundamentals. Nor is it completely manipulated by big brokers,
people who have lost money in the market would like you to believe that,
its never our own fault, right? As our good friend Shabbir Kazmi is oft
quoted as saying, "As long as there are fools, the intelligent will
never go hungry." The market may be susceptible to manipulation in
the short run, but in the medium term this is usually corrected. It is
our belief, that an investor (this does not apply to day traders or
margin traders) who bases his investment decision on a fundamental
evaluation of the market, sector and company will not lose money in the
market due to manipulation. Coming back to the topic at hand, we believe
that the primary driver of the market is the liquidity conditions in the
market.
Fundamentally this is easy to explain. When valuing
any company you apply the rate of return that you require from that
investment. The required rate of return is the summation of the
risk-free rate (return available on a government security of similar
maturity), market (equity) risk premium (the extra return required
because you do not have a fixed rate of return — as opposed to fixed
income instruments), sector risk and company risk (including management
risk). So if the State Bank of Pakistan (SBP) follows a loose monetary
policy reducing interest rates on benchmark government securities, then
the risk-free rate falls correspondingly hence raising the fair value of
the investment/scrip. Why is that? You may be willing to accept a lower
yield on your investment because the yields on the entire domestic
universe of investible assets is lower. Remember, yields and prices are
negatively correlated. As prices go up yields fall and vice versa.
OUTLOOK
The additional liquidity in the market was driven by
two events. The inflow of foreign aid (as a result of cooperation in the
'War on Terror') and the increased inflow of remittances through
official channels as a result of greater scrutiny worldwide (there was
also an element of one-time inflows of capital invested aboard). These
events allowed the SBP room to cut interest rates without an adverse
impact on the Pakistani Rupee. We believe that these interest rates have
now bottomed out, which means that liquidity is unlikely to raise the
market's value further in the intermediate term. We believe that the
market will probably move sideways between 1800-1910 over the period,
with downside limited to 1740.
There is room for a breakout above 1910, which is
best looked at in the context of required rate of return framework
described above. The Risk-free rate, which we bracket country risk,
could come down after the election in October or if the Indian
government pulls its troops off the LoC. Or company risk could come down
as a result of more stringent formulation and implementation of
corporate governance regulations, or in specific cases from the
privatization of these units (as profit maximization would become the
primary objective of these concerns). So there are opportunities for
investment in the equities market, but remember do your homework first.
Dividend yields usually provide the safest hedge against price
deterioration so rank that high on your investment criterion. After all
that money can't have been that easy to earn and save.
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