Fundamentals of the listed companies have improved


By Mohammed Sohail
Dec 16 - 22, 2002

Investors feel hesitant about investing in Pakistan's stock markets when they look back at the history of the so-called benchmark KSE-100 Index. This is because since its inception in November 1991 (when it replaced the KSE-50 Index), the KSE-100 Index has ranged between 766 and 2661 points (on closing basis). An overwhelming majority (80 percent) of the time, the KSE-100 Index has moved between 1100 and 1900 points with an average of around 1530. Therefore, for a portfolio investor it is easy to decide that investing at this high level of 1900-plus may be a wrong decision. He or she believes that the Index over 1900 levels is pricey if one looks at the 11-year trend of the KSE-100 Index and that is why it creates a very strong psychological barrier for investment in equities at these levels in Pakistan.

This is quite contrary to what market fundamentals like Earnings Growth, Price-to-Earnings Ratio (PER), Price-to-Book Value (PBV), Return on Equity (ROE), Dividend Yield, etc. portray. Fundamentals of the listed companies have improved and by looking at these market ratios one can easily conclude that it's worth investing in local equities despite the KSE-100 Index being beyond 2000 points.

Thus, I feel that evaluating the worth of Pakistan's stock market by looking at the KSE-100 Index is incorrect because of an inherent weakness (discussed later in the article) in the Index methodology itself. Even the analysts and other industry experts have not taken into account this weakness and have been comparing the KSE-100 Index with share prices of individual companies even when they are not comparable.

Investors and government officials can't help but get happy when comparing the good performance of the KSE-100 Index versus other leading stock market indices of the world without realizing the fact that this comparison is flawed.

KSE-100 INDEX IS A VALUE-BASED 'TOTAL RETURN INDEX': A stock index is calculated to show an overall trend of stock prices, which is used by many as a barometer of market behavior. Generally, indices are constituted using three methods, i.e. market capitalization weighted, price weighted, and equally weighted.

During the last couple of decades, and currently also, stock indices have usually been market capitalization based, which are also termed as 'value-based indices'. Indices developed by renowned organizations like Standard & Poor's (S&P), Morgan Stanley Capital International (MSCI), and International Finance Corporation (IFC) are usually market capitalization weighted. USA's Nasdaq, India's BSE-30, and Pakistan's KSE-100 and SBP General Index are also based on this methodology.

Some of the older indices like the Dow Jones Industrial Average of USA are price weighted, which means that they do not incorporate the quantum of outstanding shares in their calculations. In this case, prices of the shares themselves are the weights rather than the market value of all listed shares as in the case of market capitalization based indices.

Within the market capitalization weighted category, indices are further classified into 'Price Only' indices and 'Total Return' indices. Worldwide, the most famous and widely tracked are 'Price Only' indices, which do not adjust for cash dividends but adjust for other changes like mergers, right issues, debt-equity swaps, etc. Even in Pakistan, the SBP General Index, not widely followed and looked at, does not adjust its divisor in case of a cash dividend.

On the other hand, 'Total Return' indices like the KSE-100 Index adjust for cash payouts, i.e. they assume reinvestment of the cash dividend which other leading indices like Nasdaq, BSE-30, etc. do not.

KSE-100 INDEX OVERSTATES THE GENERAL PRICE LEVEL: Managing any stock market index in Pakistan poses a big dilemma due to our equities' huge dividend yield. Pakistan's stock market posted a dividend yield of around 9 percent in 2001 (based on current prices), and that is why the decision to adjust or not to adjust for cash dividends creates a problem. But how?

In case, dividends are not adjusted (as in other leading stock market indices), we may see the KSE-100 Index declining when high capitalization companies like PTCL, Hubco, etc. go ex-dividend.

For instance, the day PTCL goes ex-dividend, the KSE-100 Index will fall by 45-50 points or 2.5 percent (due to PTCL's dividend of, say, Rs2.4 per share), keeping all other prices constant. Thus, the current adjustment for cash dividends in the KSE-100 Index is being carried out maybe due to this reason. But by doing this the KSE-100 Index is overstating market prices, besides making it incomparable with other indices and share prices of individual companies.

In order to judge the quantum of overstatement by the KSE-100 Index due to adjustment owing to cash dividends, we conducted a study taking the KSE-100 Index for June 30, 1996 as a base and discovered that the current KSE-100 Index level is overstated by around 400 points.

The study shows that an Index without adjusting for cash dividends should have been at around 1300-1400 points and not 1770 points as the KSE-100 Index was at June end 2002. The 400 points differential for the last 6 years is based solely on cash dividend of index companies.

Interestingly, if this methodology of adjustment continues in the future, then after three years we may see the KSE-100 Index somewhere around 2300-2400 points assuming no change in share prices of the 100 Index companies. Similarly, if we keep the KSE-100 Index constant at current levels of, say, 1975 points then after three years, share prices of most of the 100 companies will be understated. For instance in that case, PTCL will be around Rs12-13 and Hubco Rs15-16, in line with the expected dividends these two stocks will distribute in the next three years.

This cash dividend adjustment also gives rise to another controversy of maintenance of the Index's history. As observed for the KSE-100 Index, there is a need to adjust the base divisor whenever an Index company distributes cash to its shareholders. This is very normal and regular in Pakistan. Thus by regularly doing this (i.e. revising the divisor) one is disconnecting oneself from the past and from the base date, besides making the index more volatile. This may not be an issue in case of right share announcements, mergers, etc. as these things are not very common.

NEED FOR ANOTHER INDEX: Normally, indices worldwide are not replaced if there are any weaknesses, as they lose their previous history. The Dow Jones Industrial Average, though based on an old methodology (price-weighted) is still looked at as it is one of the oldest indices in USA. Therefore, there is an urgent need for developing another index based on market capitalization and turnover as trading is concentrated in few scrips in Pakistan, which should not be adjusted for cash dividends. This new index should run parallel to the existing KSE Indices (KSE-100 Index and KSE All-Share Index), which adjust their divisors for cash dividends.

Moreover, as it has been observed in Pakistan that a limited number of scrips catch investors' attention and a majority of the transactions relate to these limited stocks, a smaller sample of, say, 20-30 stocks will be ideal for the new index.

Also, with regulators now focussing on the development of the Stock Futures market, introducing a new value-based 'Price Only' Index will help in the introduction of Index Futures trading. Interestingly in Pakistan Stock Futures have been introduced before Index Futures.

The new index, hopefully, is likely to portray a better and comparable picture of prevailing stock prices and can help in generating more portfolio investment in local capital markets. This would be in line with the market's fundamentals and valuation ratios that, by the way, are still at attractive levels, whereas the KSE-100 Index is not.

30 COMPANIES 'PRICE ONLY' INDEX SUPPORTS THE ARGUMENT: In order to justify our argument that adjustments for dividends should not be made so as to portray a better picture, we have carried out a study. We, at InvestCap, have done an exercise by creating the InvestCap-30 Index. These 30 companies were selected purely on the basis of market capitalization with no sectoral representation concerns as done by the KSE-100 Index.

We found out that during FY02 (July 2001 to June 2002), the InvestCap-30 Index rose by 12 percent compared to a 29 percent increase in the KSE-100 Index, and a 19 percent increase in the SBP General Index.

As is obvious that the change in the SBP Index and InvestCap-30 Index is relatively closer, whereas the KSE-100 Index overstates the growth by 10 percent over the SBP General Index and 17 percent over the InvestCap-30 Index mainly on account of its 'Total Return' methodology of adjusting its divisor for cash dividends.

LEVEL OF ADVANCEMENT FAR AHEAD OF LOCAL INDICES: The calculation methodologies for indices worldwide have reached quite an advanced level these days. There are several options, which have been considered in order to get as true a picture of market behaviour as possible.

The introduction of market capitalization weighted indices with certain restrictions currently caters to such investor needs. One method of getting a true picture is to take only the portion of a stock's market capitalization that is available in free float. This means that outstanding shares used for the Index are adjusted for those shares that are not freely available for trading like shares held by sponsors and the government.

Another modification that has been made in recent times by index managers is to put a limit on the weightage that a single company can command in the index. This exercise is usually done to limit the influence of the largest stocks in the index, which otherwise would dominate the entire basket.

In case of Pakistan, PTCL's 20 percent weightage currently (that has come down from a high of 35 per cent) creates a hurdle as a Re1 change in PTCL's price affects the Index by 20 points. Going forward, it is expected that due to KESC's (Karachi Electric Supply Corporation) debt-equity swap, KESC's weightage in the KSE-100 Index will increase from 3 percent currently to over 10 percent. If that adjustment is made, then a Re1 change in KESC's share price will change the KSE-100 by a mammoth 40-45 points. Looking at this how can one say that the KSE-100 Index reflects the correct price level of the equity market?

But in Pakistan we have to go a long way before joining the race of these advancements made on the index methodology front. We first have to create, as discussed before, a new stock market index that should run parallel to the existing KSE-100 Index. This new index will overcome the weakness of cash dividend adjustment, which overstates the existing KSE-100 index. Moreover, as investors in Pakistan focus on limited stocks (as is obvious by share turnover), the new index should be based on a limited sample rather than 100 companies. Moving to the new advancements in index structuring will be the second step.

In the second step one must also focus on the issue of free float (though very difficult to define) and putting a cap on the weight of individual scrips in the index.

(The writer is 'Head of Research' at Invest Capital & Securities)