Dividend yields provide the safest hedge against price deterioration

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.


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.