Blood on the PSX floor offers investment opportunities
Talk to any broker on the Pakistan Stock Exchange (PSX), and the tales of woe relating to the collapse of the Pakistani equity market sound eerily similar to Galbraith’s classic description of the Wall Street crash in 1929. KSE100, the benchmark index used by many investors to measure performance, has almost halved from its peak of 53,127 in May 2017. Since then, the Pakistani Rupee has also depreciated more than 50 percent. Investors and speculators alike have seen fortunes dissipate.
The proverbial “blood on the street” appears to be flowing with remarkable ruthlessness, as low trading volumes result in closure of brokerages and mutual funds face large equity funds redemptions. The gloom in the market is painfully palpable as is often the case near the end of a bear market. However, there is enough reason to believe that the worst has already been discounted in the heavily beaten stock prices, and investors are still not incorporating the good news that is likely to follow in the coming years.
After an initial lack of clarity on economic policy in the first few months of the new government, which contributed to damaging investor confidence, Prime Minister Imran Khan’s economic team now seems firmly placed in the saddle and reforms are well underway. In July this year Pakistan entered into an agreement with the International Monetary Fund for an Extended Fund Facility (EFF) to support economic reforms being undertaken.
In order to control the burgeoning current account deficit, restore export sector competitiveness, and also bolster official reserves, the State Bank of Pakistan (SBP) adopted a flexible market-determined exchange rate, whereby a grossly overvalued Pakistani Rupee has devalued by almost 25 percent against the US dollar since the PTI government came into power. SBP estimates suggest that the currency is now slightly below fair value on a real effective exchange rate basis. In order to curb inflationary pressures that inevitably accompany such a large devaluation, and also to help stabilize the currency, the SBP has increased its policy rates over the last 12 months by 475 basis points to 13.25 percent.
Even if there are some disappointments in the economy turn-around story going forward, the Pakistan equity market has overshot valuations on the downside of worst-case scenarios.
On the fiscal deficit front, which stood at 7.3 percent of GDP for 2018, the government has eliminated many subsidies, other than those targeted to the poorest segments of society, so that corporates and household consumers pay close to actual cost for gas and electricity. The government has also eliminated numerous tax exemptions for sectors like textiles, leather, carpets, sports goods and surgical instruments. In the short term, there is the problem of debt servicing dramatically going up given the high interest rates, however it is expected to start coming down as inflation peaks towards the end of the year, and thereafter starts falling.
One of the critical long-term structural challenges is the broadening of the perennially low tax base and improving the low tax to GDP ratio. This is being addressed through greater documentation of the informal economy, which includes measures such as giving compulsory identity card details for transactions made with unregistered persons for sales tax. By implementing deeply unpopular measures, the PTI government has demonstrated that they are willing to undertake painful structural reforms that are necessary for stabilizing the economy and putting it on the path to recovery.
Despite the many difficulties faced in implementing these, corrective measures are now starting to show results, for example, the currency and interest rate adjustments resulted in contracting imports and sharply narrowing current account deficit by 32 percent during the last fiscal year. The longer-term government objective and policy measures are designed to catalyze the import substitution industries to take off, which will not only serve domestic demand but also generate much needed employment.
Even if there are some disappointments in the economy turn-around story going forward, the Pakistan equity market has overshot valuations on the downside of worst-case scenarios. Bloomberg estimates put the market at around 4.4 times the earnings for year-end 2020 with an expected dividend yield of 9 percent. To put this in perspective between 2005-2018 the corresponding averages were 10.4 times and 5.5 percent respectively. The Pakistan equity market is trading at a 65 percent discount to the regional average. Pakistan equity market is also trading at a ten year low Price-to-Book ratio close to one, and again at a significant discount to regional peers.
All these factors should make Pakistani equity particularly attractive for value investors with a three to five year investment horizon. While it’s impossible to predict with absolute certainty the direction of equity market movements, the extreme valuations suggest that the probability of significant positive returns in dollar terms are much higher than that of further losses.
– Javed Hassan is a graduate of Imperial College London and an MBA from London Business School. He is an investment banker who has worked in London, Hong Kong, and Karachi.