Whats up with the

Pakistan Stock Market

Karachi Stock Exchange
Limited

Nadeem Naqvi, Managing Director, KSE

This article was published in the

Investment & Marketing Magazines Special Report on

Demutualization (in Issue # 586, published in March 2013)
The Pakistan Stock Market is in record high territory, with
the KSE-100 Index closing above 18,000 level for the first
time on February 22, 2013. This is a significant event in the
64 year history of the Karachi Stock Exchange. It is even
more eye catching because, judging by news headlines, the
risk profile of the country appears to have deteriorated in
the last quarter or so in socio-political and economic terms.
On the socio-political front, the war-on-terror has become
more inward and sectarian/ethnic focused with some of the
worst atrocities witnessed against ethnic & religious minorities
in the first two months of 2013. The political scene has also
become more fluid with elections on the horizon. On the
economic front, the picture remains mixed with the external
sector just managing to stay afloat due to improvement in
inward remittances by overseas Pakistanis. Yet, foreign debt
repayments, especially to the IMF, have put downward
pressure on the Rupee with Rs/$ exchange rate witnessing
100 for the first time. This has intensified speculation against
the Rupee and created a vicious downward cycle for the
exchange rate.
The official domestic economy has shown mediocre growth,
helped only by the agricultural sector and its knock on effect
on manufacturing and service industries. While some of this
can be accounted for by continuing robust soft commodity
prices globally, much of the economic activity is consumption
oriented, driven by massive federal budgetary deficit that
was 8% in gross terms in FY11-12. In the first half of FY1213, ended Dec 31, 2012, the lower deficit was primarily due
to inflow of NATO's Coalition Support Funds which are likely
to be absent in the second half of this fiscal year ending in
June 30, 2013. Consistently high budget deficits have taken
domestic borrowing by the public sector to record level of
over 90% of all borrowing which is not sustainable and has
crowded out private sector credit off-take. While lower
inflation levels have allowed the central bank to reduce
interest rates, real sector activity has yet to respond.
.
Given the above dynamics, the rise in stock market indices
is surprising to many. Should not the stock market be
reflecting the real economy and the uncertainties facing the
country? Why is there such a disconnect between the sociopolitical and economic conditions on the one hand and stock

market performance on the other hand? Do stock market

participants know something about the future that the rest
of us do not know? Is the market stupid or are the rest of us
stupid? What is going on here? These and many such
questions occupy observers and laymen about the current
dynamics of Pakistan's Stock Market.
At this point, it may be instructive to revisit what are the key
drivers of equity (stock) prices and valuations. In simplest
terms, there are three fundamental factors that drive stock
and market prices & valuations:
Dividend payout
Earnings growth
Valuation expansion or contraction
The first two factors are straight forward. When dividend
payouts and yields (Dividends per share divided by Earnings
per share) are above historical average, investors find the
market attractive and bullish behavior results. Similarly, above
average earnings growth (or above expectations earnings
growth) raises the likelihood of better earnings growth in
the future and makes the market attractive to investors.
These two drivers have been shown empirically to be the
most important factors in determining the stock market's
performance over the medium to long term (i.e. over three
year or more time horizon).
The third factor, VALUATION CHANGE, reflects a combination
of sub-factors that affect market performance - these subfactors can be both subjective (or behavioral) and relative.
An example of behavioral / subjective factor can be that
many investors start believing that in an election year the
government will spend more money to attract votes via
increased provision of subsides, low cost or sector specific
loans, tax relief, etc. and broad groups of industries will do
well. This "expectation" can make investors take "buy"
positions in the market, thus propelling the market higher.
An example of a relative factor can be that interest rates
come down significantly (such as the 450 basis point reduction
in discount rate over the last 18 months). This makes the
expected or potential return on stocks look "relatively" more
attractive than return on other assets taking into account

risk factors. On a global level, if global money flow into risky

assets (such as emerging market equities & bonds) rises,
than a particular market with relatively lower valuations in
key sectors such as energy, food, FMCG's, etc. may start
looking attractive to foreign investors even on a risk adjusted
basis. So, even if nothing may have changed significantly
from a domestic perspective, global money flow dynamics
can result in changing valuations in particular markets.
.
It should be noted, however, that of the three fundamental
factors that drive market performance, the third factor (i.e.
valuation change) is usually a shorter-term phenomenon.
Over longer term, especially beyond five years, the impact
of valuation change has been found to be limited and over
even long-term (say, 10 years) the impact of this factor is
even less. In the U.S. for example, studies based on 85 year
data (1926-2010) show that the average annual return for
stocks was approximately 10% per annum. Of this, 4.7% was
due to earnings growth, 4.3% was due to dividend yield and
a mere 1.0% was due to valuation (P/E) change.
.
Thus, the longer the investment time horizon, the more
important dividend payout and earnings growth become.
However, keeping in mind John Maynard Keynes' famous
phrase, "In the long run, we are all dead", or the local
equivalent, "kon jeetaa hay teri zulf kay sar honay tak",
investors can ill afford to ignore the valuation change aspect
in seeking superior asset class return from stocks.
.
It is in the above context that Pakistan Stock Market's current
dynamics should be viewed. In 2012, the KSE-100 Index
depicted a return of 49% in Rupee terms and 38% in US
Dollar terms. Behind this was the solid corporate earnings
growth (using KSE-100 non-financial companies as a
representative sample) of over 25% per annum for 2010,
2011 and 2012. Secondly, Pakistan equities offered a dividend
yield of over 8% in both 2011 and 2012. Thus, the first two
key factors were already in place providing a solid base for
the market to move upwards.
The valuation change factor weighed in with a significant
decline in interest rates which made equities relatively more
attractive than competing financial asset classes. Additionally,
developed country central banks firmly kept pumping liquidity
into the global financial system though multiple rounds of
quantitative easing (equivalent to printing money). This
forced global investors to seek higher returns which emerging
markets provided, including Pakistan. Thus we saw net foreign
portfolio investment flow of US$160million in the second
half (Jul-Dec) of 2012 versus an outflow of US$157million

in the second half of 2011. In the first two months of 2013

calendar year, net foreign funds inflows into Pakistan stock
market have already topped US$30million. Financial
institutions, under pressure of tightening interest spreads,
are also re-entering the market, followed by gradual build
up of interest from the hitherto reluctant retail investors. It
is the combination of these factors that is bringing liquidity
into the market and driving share prices and market valuations
higher. What is interesting is that despite the recent run up
in the market, a key gauge of whether the stock market is
overvalued or not, the Market Capitalization-to-GDP ratio
(also known as the Equitization ratio) is still around 22%. This
ratio touched a high of 46% in 2008 when the KSE-100 Index
touched its previous high of 15676 in April of 2008.
.
So what is the outlook for the stock market in 2013 and is
there any potential upside left? Further, are expected returns
commensurate with potential risks facing investors? That is
for each class of investor to decide depending on their
particular profile, investment return objectives, risk tolerance,
etc. What is important for investors is to set specific
quantitative return targets, assess potential downside for
their equity portfolio as a whole and conduct vigorous
research into sectors and companies which present
opportunities from fundamental earnings growth and
dividend yield potential as well as relative valuation perspective
in terms of peer group, previous market cycle and specific
sector or company triggers for large price moves. As an
example, consider that in 2012, while KSE-100 Index rose by
49%, the top 25 performing companies in KSE-100 showed
returns ranging from 100% to 570%! Similarly, in the first
seven weeks of 2013, although the KSE-100 Index has risen
by 6%, top 25 performing companies have provided returns
ranging from 11% to 37%.
In conclusion, while the future remains unknown,
investors who make the effort to conduct thorough
research and analysis, use independent thinking rather
than naively follow the crowd and have the mental
fortitude and discipline to stick to their targets and sell
once target returns have been achieved, are likely to
achieve superior returns on their equity investment
portfolios - not just in 2013 but more often than not. In
the end it is useful to keep in mind that stock market is
like the sea. Some take out pearls, some take out fish,
some come out simply wet!
Disclaimer: Investing in stocks & shares carries various risks, including loss
of the principal amount. Investors are advised to conduct their own research
before investing or take advice from professional investment advisors.

Karachi Stock Exchange Limited

Stock Exchange Building, Stock Exchange Road,
Karachi - 74000. Tel: 111-001-122, E-mail: info@kse.com.pk