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
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
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.
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
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
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
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
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:
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
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
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
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
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)