CAPITAL MARKETS

Consolidating capital formation

By SHABBIR H KAZMI
Mar 07 - 13, 2005

The KSE-100 index gained 1,747 points during the year 2004 to close at 6,218 level. By 4th March it gained more than 2,570 points, when the KSE index closed at 8,793 level. At this juncture the market punters have two opposite opinions about the future movement of the market. Some of them believe that the index may cross the 10,000 level even before March end. Whereas, others say that the long overdue correction is knocking at the door. But no one seems to be ready to talk about the downturn.

Many analysts are of the view that during the last 20 months or so, the speculators have made so much money that no one is scared of market dropping 1,000 points in quick succession. Even if this happens, only a fraction of the money they have minted may be lost. However, erosion of such a magnitude is very difficult due to the circuit breaker mechanism being followed by the stock exchanges. Interestingly, whenever there is a dip, investors are more than keen to take new positions. Therefore, it is highly improbable that market plunges by any substantial percentage in a single day.

It is also evident that now the transactions are being made in millions of shares rather than in hundreds or thousands. The market seems to be completely in the grip of large investors, who are making a fortune and also assuming huge risk. They seems to be following an old saying, 'higher the risk, higher the return'. With each bet they hit a jackpot, gives them the courage to enhance their stake in the next transaction. This tendency is pushing up the index to new highs and there seems to be no end.

It is worth noting that the 'old lot', which has been warning about the 'bubble' and not willing to take new position once the index crossed 6,000 level has also joined the bandwagon. Now they also seems to be following the slogan, 'make as much money as you can'. No one seems to be afraid of down turn.

Any cynic may ask, are the stock exchanges managing the risk prudently? Apparently, the stock exchanges are monitoring and implementing the exposures and margins very stringently. Overflowing liquidity enables the traders to deposit additional margins without delay. And so far no one has failed in meeting the requirement. However, it is also interesting to note that bulk of the daily trading volume has remained confined to those scrips, which enjoy heavy weightage in the KSE-100 index.

Some of the critics say that investors are not making prudent decisions because at present prices buying seems imprudent. The speculators say, "We don't buy on the basis of dividend yield. We are looking at the potential trading gains only. The difference in ready and future prices is very obvious. We don't assume any risk by taking the delivery and selling in the future market." The philosophy seems to be working efficiently when one looks at the prices of ready and future market.

In the past it was often said that higher Badla volume and Badla rates were a threat for the market. This philosophy also seems to be wrong, or being ignored at least, for the time being. The Badla volume is swelling with each passing day and rates are hovering at the maximum. But neither the Badla providers nor the investors feel any fear in enhancing the stake. If the traditional Badla providers show even the slightest hesitation, the new breed is always ready to finance the transaction of any size at the prevailing rates. The number of equities eligible for COT is reducing but the Badla volume is touching mind boggling levels.

A leading player said, "The critics must stop talking about dooms day prophecy. This only discourages the small investors to take new position. Panic selling by the weak holders provides an opportunity to big and strong players to mint more money and enhance their stakes." However, he also warned, "This is not an appropriate time for the novice to enter the market. The train is moving at a very fast speed and any one trying to embark can only commit the suicide."

Some of the analysts are of the view that present rally is driven by the foreign fund managers. They say, "The share price of state-owned enterprises on the privatization list seems to be going up because interested strategic investors are accumulating the shares. These investors have a fairly good idea of the potential 'reference price', which is far higher than the presently quoted prices. Therefore, they will continue to accumulate as many shares as they can, till the quoted price gets closer to the reference price. This will enable them to enhance their bid but lower the average cost. They will also have the option to off-load the additional load at attractive price and make substantial capital gains."

Historically, bulk of the daily trading volume at the Karachi Stock Exchange has remained confined to less than two dozen companies. At present bulk of the volume pertains to less than half a dozen companies. Therefore, some of the analysts suggest that now the stock exchanges should introduce two new indices, at least. One index should comprise of five large companies, which also account for the largest share in the average daily trading volume. The second index should comprise of 25 volume leaders.

There is also a growing feeling that number of listed companies at the Karachi Stock Exchange should be reduced to one-third of the present number. All those companies having less than Rs100 million paid-up capital should be delisted at the earliest. The reason behind suggesting delisting of these companies are: 1) bulk of the shares of these companies are held by the sponsors or the associate companies, 2) there is hardly any trading in the shares of these companies, 3) most of these companies are also on 'defaulters counter' and 4) whether the quoted price is above par or below par it is of hardly any consequence for the investors. Therefore, all such companies should be asked to opt for voluntary delisting or stock exchange should delist these by amending the listing regulations.

One must ask, what could be the impact if such a large number of companies are delisted? According to various analysts the listed capital may reduce by 5 percent. After the listing of large cap companies, the listed capital is around Rs400 billion rupees. A closer look shows that the listed capital of 117 spinning units is around Rs11.5 billion, 19 textile weaving companies have a total capital of around Rs2 billion and 13 companies belonging to paper sector have a cumulative capital of Rs1.5 billion. Therefore, delisting of some of these companies would not have any adverse impact of the listed capital.

One of the objections could be, why should these companies be delisted or asked to increase the paid-up capital if they don't face any problem? In all prudence if the minimum paid-up requirement for commercial banks, leasing and insurance companies is being enhance to enable a more vital role, all other listed companies should also be asked to meet a minimum paid-up capital requirement of Rs100 million.

It is heartening to note that stock exchanges as well as Securities and Exchange Commission of Pakistan are trying to protect the interest of small/minority shareholders. However, the presence of a large number of companies on the defaulters counter is a scar on the face of stock exchanges. Names of some of the companies are on the defaulters counters for years. There could be two possible reasons: these companies are virtually dead entities but are kept alive on books to claim certain benefits and 2) these exist only on papers. Therefore, the stock exchanges and SECP should get of these. It is strongly believed that the sponsors of these companies also have interest in other businesses. Therefore, help of the central bank should also be solicited to initiate winding up proceedings for these companies.

There are some critics who still try to compares today's equities market with that of nineties. They continue to say that the present hype is creating the bubble, which has to burst one day and the fallout would be worst than that of nineties. However, the analysts and the market punters say, "There is a difference of hundred eighty degrees between the present market and that of nineties. Most of the large cap companies, also enjoying large free float were not there at that time. Most of the scrips are still trading at earnings multiples of around 10 as against an earning multiple of above 20 at that time. Therefore, the prices have not touched that alarming levels."

Some analysts say, "In nineties investors picked up shares indiscriminately, without looking at the payout history or earning potential. As against this today's investors are picking up the shares having credible track record as well as earning potential." To support their argument they refer to companies like NBP, OGDC, PTCL and some of the cement scrips. Buying in these shares is mostly due to earning potential. On top of this, corporate earnings as well as good dividend payout keep investors' interest live in these companies.

It is evident that despite increase in free float of various listed companies supply of quality scrips has remained less than the demand. One of the factors keeping supply less than the demand is increase in number of mutual funds. The nineties rally was mainly driven by foreign fund managers but present upbeat is due to local retail as well as institutional investors. As such mutual funds have emerged as the largest institutional investors. On top of this, the growing interest of small investors in the equities is keeping the market vibrant.

The growing number of mutual funds and their good payout has also attracted the attention of small investors. The total size of mutual funds in Pakistan is less than 5 percent of bank deposits. In many developed countries the size of mutual funds is double or equal to the size of bank deposits. Even in the developing countries the size of mutual funds is about half the size of bank deposits. There is tremendous growth potential for mutual funds in the country. Most of the small investors in Pakistan have already started using mutual funds as vehicle to maximize their earnings from the equities market.

Commercial banks and insurance companies have also emerged as big institutional investors. In the past these entities used to invest heavily in the government securities as well as various products offered under the National Savings Schemes. However, imposition of restriction on investment in these instruments and substantial cut in the rate of return has forced them to look for new options. The investment in blue chips offers them regular dividend income as well as opportunities to maximize capital gains. These institutions, enjoying ample liquidity normally buy at dips and sell when the time is ripe. This is evident from huge investment portfolios maintained by these institutions. Their active participation has also helped in containing the market volatility.

Two factors encouraging the small investors to invest in the equities market are presence of the Central Depository Company (CDC) and growing number of online trading facility. Establishment of CDC has made instant transfer possible. Online trading allows investors to make on the spot decision regarding buying and selling, at his/her own convenience. The investor does not have to call the broker to know the prevailing price and then wait for the confirmation of trade. Availability of real time data allows the investors to make on the spot decision and the automatic 'match making system' confirms the trade in a few seconds.

The policy of offering shares of state-owned enterprises to the general public has also helped in broadening the small investors' base. Preference for small investors in public offerings has increased the inflow of funds to the equities market. One may say that most of the small investors sell their holding, which is bought by large investors ultimately. However, it is also true that handsome gains made also encourage them to keep on submitting applications for the new offering and the funds remain in the equities market.

WAY FORWARD

If the investors are bullish there should be no room for those who are propagating doomsday prophecy. Keeping in view the risk management system being followed by the stock exchanges, the probability of market taking a nosedive seems highly unlikely. Looking at daily high and low levels of the KSE-100 it is certain that intra-day correction is common. The circuit breakers provide ample breathing space and with every dip the index continues its upward journey. News records are being created just to be broken in the following days.

However, it is also necessary to keep in mind the recovery plan, in case of a fall out. Analysts say, "We keep on reminding the investors about the fall out to keep the factor bright. Though, there may not be any massive correction in the near future, but they must hedge the risk. It may be true that there are huge trading gains but one should also keep in mind, the possible losses in case the market goes through a massive correction."

Some of the analysts say, "We raise alarm for the small investors, who are often carried away by the market behavior. They usually suffer from herd mentality. They often enter the market at a time, others are taking exit. That is the reason most of them lose their money. No novice should try to enter the market at this time."

Lately, the central bank asked the commercial banks to comply with Prudential Regulations regarding their investment in equities. At the same time the SBP also raised the minimum paid-up capital requirement for the commercial banks. It is believed that the central bank is also considering hiking the paid-up capital of commercial banks to Rs6 billion. If this happens, even 20% of the equity would be more than enough to double their stake in the equities.

Capital market reforms and proactive approach of regulators have improved the level of compliance to listing regulations. Brokers' conduct is also being watched. But, there are still some lapses. The first and the most disturbing factor is that some of the entities offering online trading facility allow short selling. As such short selling is a bad practice and once it is also termed a violation, no one should be allowed to indulge in such activity.

The other factor being that some of the brokers are not asking the buyers to deposit margin, particularly for the future trade. It is assumed that such trades would be settled without any problem. It may be true that there has been no problem. It is only because the share prices are moving up. However, not demanding margin may lead to serious problems in case the prices go down substantially.

Though, the management of stock exchanges may not be keen in reducing the number of listed companies, the SECP must consider this seriously. If bulk of the daily trading is confined to less than two dozen companies, why should the stock exchanges allowed to carry the load of more than 650 companies? The reduction in number of listed companies will allow the regulators to oversee the affairs of remaining companies in a better manner.

It is also suggested that all the state-owned companies should be listed at the stock exchanges and part of their shares should be offered to general public. The recent public offering has received tremendous response. It has helped the government in divesting part of its investment in these entities at attractive price and also expanding the shareholders' base. Government must also ensure that recently privatized entities are also listed at the stock exchanges and part of their shares should be offered to general public.