Pakistan Stock Market
A Case of Lepto-Kurtosis?
By Nadeem Naqvi
May 21 - Jun 03, 2001
The KSE-100 Index has lost 9.2% from 1507 on Dec 31,2000. Volume has also trended downward. Average Daily Volume (ADV) was US$ 51.6 mn in the period April 14 — May 14. In contrast, the 52-Week ADV has been US$ 87.1 mn. To cite a few examples, the 52-Week ADV for PTCL has been US$12.9million while its 4-Week ADV has fallen to US$6.7million i.e. literally halved. The same is true for PSO, another high volume stock that has seen its 52-Week ADV of US$40.3million reduced to a 4-Week ADV of US$21.7million.
Table 1: Comparative Market Performance
World Market Indices
Korea Composite Index
Thai SE Index
Taiwan Weighted Index
S&P 500 Index
BSE 100 Index
Straits Times Index
Kuala Lumpur Composite
It appears that activity in the market is gradually reducing as if market participants are waiting for some thing to happen... some trigger to induce them to either buy or sell. True, the news flow has been rather mixed. On the one hand the continuation of drought conditions has forced the government into public loud thinking that it may have to revise down its GDP growth targets for FY02. At the same time, there are positive signals that multilateral funds flow is likely to rise in the next fiscal year along with rising probability of external debt restructuring by the Paris Club which would considerably ease the burden on foreign exchange reserves. Furthermore, direct foreign investment is also showing signs of pick up with sharp increases ear-marked for the oil and gas sector in FY02. Politics aside, overall indicators point towards progress in the economic restructuring programs. The improvement in country risk factor is also evident by the continual rise in the price of Pakistan's sole Eurobond issue where demand now exceeds supply. And yet... the local equity market remains in doldrums.
Waiting for Lepto Kurtosis?
The world of finance these days is enamored by what may be termed as 'Lepto Kurtosis' (literally, Fat Tails). This is a statistics terminology that denotes the probability of extreme events. A high Kurtosis indicates high probability of extreme events. Traditional finance theories are mostly based on the assumption of 'rational' investor behavior and also that security prices follow a random 'Brownian' movement. This assumption allows for mathematical elegance in modeling the behavior of security prices and their variance from expected returns through the well-known Gaussian (bell-shaped) 'normal' probability distribution. Latest thinking in finance theory suggests that markets are far from being 'efficient' (at least, not strong form) investor behavior is anything but rational and that probability of extreme market events occurring is (or has become) much higher than previously assumed. If this is indeed the case then, it is argued, the Finance theorists need to explore new bodies of knowledge ranging from behavioral psychology to chaos and complex theories in order to make sense of market behavior and develop new metrics with some predictive powers. It is in the above context that we feel that Pakistan market watchers and money managers might find some insights to further their understanding of emerging market behavior.
Here is a market that is trading at (our forecast) 5.5x prospective earnings, has an estimated FY01 EPS growth of 24% (including Hubco and PTCL this rises to over 40%!) and a dividend yield — based on FY00 dividends — of over 11%. PTCL alone is showing a dividend yield (based on last year's payout) of over12% at current prices. The earnings yield gap at 6% is now nearing its historic high at the current risk-free rate (1-year T-bill) rate of 12%. Our economist expects the risk-free rate to be lower by end - CY01 as the central bank eases monetary policy to compensate for growth retardation cause by the drought.
The T+3 syndrome
The advent of T+3 settlement system has brought in with it the reality that the market volume (ADV) of US$120mn in CY00 and earlier had a huge component of speculation and much lower proportion of serious investment activity. Second, the herd mentality of domestic investors is now open to all to see. Led by die-hard opponents of the T+3 system that will curb excessive speculation, even institutional investors are reluctant to commit fresh funds to equities. (Why else would an institution let go of an opportunity to borrow at say, 14-15% and invest the proceeds in a stock with dividend yield in excess of 20% — there are more than a score of such stocks — especially when half-year results show that earnings have continues to grow). The delaying tactics of the stock exchanges are likely to allow major players to liquidate their long positions, in our opinion, and the sufferers in the immediate term are again likely to be smaller retail investors.
Event risk and volatility are high
Finally, this market has clearly demonstrated over the last several years that its big moves have little to do with changes in underlying fundamentals of listed companies. Major upside moves have invariably been linked to unexpected domestic or regional political events, while major downside moves have been triggered negative economic shocks. It is this characteristic of the Pakistan market that leads us to conclude that 'Lepto — Kurtosis' is highly likely to be in operation here (we have, to be sure, extended the interpretation to make a point rather than present a statistically rigorous analysis!). One simply has to look at the frequency of large fat-tail returns, both positive and negative, of the Pakistan market over the last few years to get a sense that this is at work here.
In addition to the above, we also feel that the phenomenon of 'anchoring' (in the context of behavioral finance) is operative in the Pakistan market. However, it is current working in an opposite sense to what is said to be happening in the developed markets. There, the problem seems to be that people anchored themselves to the notion of ever-rising earnings, cash flows and hence valuations. Here, we believe the opposite has occurred. Domestic investors, both retail investors as well as institutional investors became anchored to negative returns since the market's historic peak of 2600 back in April 1994.
Not only has the long-term trend of the market remained negative; it has also been extremely volatile. The annual range of movement of the KSE-100 Index (between its Hi and Low) in each year since 1997 has been over 50%. In 1998 it was 127%! Rationale or not, any investor faced with such volatility is highly likely to turn extremely risk averse. Moreover, if faced with such high volatility year after year, the investor's negative anchor would only become deeper. This means that to break out from such a deep negative anchor an equally powerful 'positive' shock would become necessary.
At this point, we would like to borrow an aspect of Neuro-Linguistic Programming (NLP), which has developed tried and tested methods to breaking out from negative anchors for individuals. NLP says that the human mind is easily conditioned and certain experiences (particularly when repeated) create an auto response from the individual. As a result, the brain gets locked into (i.e. gets 'anchored' into) repeating the same strategy when faced by a similar situation. The way out suggested by NLP is first, to 'de-condition' the mind and second, to adopt a new strategy to deal with the negative experiences in such a way that the probability of success increases.
The question is of course, how can investors in the Pakistan market use any insights gained from the above discussion to make money?
Applying the theory to Investment Management
In our view excess returns are possible in the Pakistan market, keeping in view the risks involved in investing here. We believe however, that investors — both domestic and foreign — need to address their negative anchors. There are several ways to do this — we shall look at only a few factors at present.
Demand Side — or Liquidity Argument
From foreign investors perspective, Pakistan has clearly become a highly under bought market with most global or emerging market portfolios having even the miniscule benchmark weight of this market. For domestic investors, there is a short-term and longer-term situation. In the short-term, a high risk-free rate acts as a dampener for equities as an asset class. Further, with expected consolidation of the public sector financial institutions, (which traditionally were a large domestic liquidity source for the equity market) demand in the short term is at low ebb from this source. Longer term, we believe the picture is decidedly different. The restriction on institutional investment in National Savings Schemes has, in our estimate, created a situation where, over the next five years PkR250-300 billion institutional money would be seeking alternative investment venues. Current regulations governing Pension and Provident funds permit up to 30% investment in non-government securities. While the bulk will certainly go into fixed income instruments (and the limit is also likely to be increased over time, in our view) a certain minimum portion is likely to move into stocks. This should open a sustainable, long-term source of liquidity for equities, which hasn't been the case before. This leads us to conclude that now there is a definite raison d'etre for a secular rise in Pakistan's stock market over the longer-term time horizon.
Supply side argument
With the bulk of foreign holdings of Pakistan equities now mostly liquidated (in our estimate), hardly a few IPO's over the last three years and equally small volume of rights calls, the available paper will likely continue getting absorbed in longer-term portfolios with the passage of time. Thus, with domestic supply and demand imbalance tilting in favor of demand over the next two years, we expect an upward move in stock prices.
In our view, Pakistan is moving towards an inflection point in its economic management (for the better) and also in its relations with the G-8 and multilateral lenders (again for the better). The current drought notwithstanding (latest estimates by the Indus River System Authority show that water flow in all the provinces is reverting back to normal levels, as summer snow melt accelerates), in our opinion the broader economy is likely to begin exhibiting signs of growth by mid-2002. If there is a concurrent policy push towards greater development expenditure and easing of monetary conditions (as inflation remains relatively tame), the recovery could speed up.
Finally, based upon fundamental bottom-up analysis, we believe that current valuations — estimated through several approaches — indicate a cheap market with an upside potential, regardless of whether foreign portfolio investors participate in the Pakistan market or not.
In conclusion, what is needed in our view is a trigger to move the market. It could be an 'external' trigger such as the budget, Pakistan's transition into the IMF's PRGF program and associated debt restructuring, a positive surprise on the Kashmir front, or even a move towards a civilian government domestically. Or it could be an 'internal' trigger — a group of domestic institutional investors deciding that now is the time to buy and gain the first mover's advantage in the market. It could, conceivably, be such a move by one or more foreign portfolio investors. Regardless of its source, such a trigger would be the 'Lepto-Kurtosis' this market needs to break out of its current doldrums.