Investment Outlook

The Case for Equities

Editorial Comments: Farrukh Karim Khan, CFA Tel: 92-21-35292650 research@nextcapital.com.pk

August 2010

A Bad Time to Hate Equities

Valuations of the Pakistani stock market and particularly of specic stocks are quite attractive at the moment. Dividend yield in some cases are in the double-digits, providing investors with the safety of dividends to match xed income returns, in addition to the prospect of earnings growth and capital gains. As shown below, on a P/E, P/B, and market capitalization as % of GDP basis, the KSE-100 trades well below historical averages. Compared to target prices, many stocks are signicantly undervalued. As we will highlight in this Investment Outlook, history indicates that this is a great time to buy stocks. And yet investor interest in equities is waning!!
Figure 1: KSE-100 P/E
14.0 12.0
Price / Earnings

A Skeptical Nation = Risk Averse Investors

Most Pakistanis have never quite embraced equities as an attractive asset class. NSS, real estate, bank deposits, dollars and gold (not to mention real estate in Dubai!) are all preferred as investments by most individuals. Domestically held free oat of the KSE is a mere 9.1% of M2, 11.5% of banking deposits and 31.8% of NSS stock. In terms of the overall wealth stock of the nation, equities represent a very small proportion. The Pakistani stock market has a few hundred active UIN s amongst a population of 170 million people. What is the reason for this underrepresentation of equities in the average Pakistani portfolio? We identify two major reasons: Firstly, stocks are seen by many of the saving public as an extremely risky investment; a form of Russian roulette in which the house always wins. Many of the saving public believe that the Pakistani stock market is controlled by a few power brokers, where small investors are lambs to the slaughter. In their opinion the odds are stacked against them and the risk of losing money is high. Granted, many individuals have lost a lot of money making speculative bets on leverage. This misconception arises primarily because most people in practical life fail to distinguish between investing and speculation . Benjamin Graham did a masterful job in highlighting the distinction in Security Analysis, published in 1934. For Graham, An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator s primary interest lies in anticipating and proting from market uctuations. The investor s primary interest lies in acquiring and holding suitable securities at suitable prices. Market movements are important to him in a practical sense, because they alternately create low price levels at which he would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell. Warrent Buett added some more clarity to the words of his mentor, and said that If you re an investor, you re looking at what the asset -- in our case, business -- will do. If you re a speculator, you re primarily forecasting on what the price will do independent of the business.

The Pakistani stock market has a few hundred active UINs amongst a population of 170 million people

10.0 8.0 6.0 4.0 2.0 0.0 FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08
FY08

KSE-100 P/E
Source: Next Capital Research, KSE

Average

Figure 2: KSE-100 P/B

3.5

...most people in practical life fail to distinguish between investing and speculation

3.0 2.5 2.0 1.5 1.0 0.5 0.0 FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY09

KSE-100 P/B
Source: Next Capital Research, KSE

Average

Figure 3: Market Cap as a % of GDP

45.0% 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10

Market cap as % of GDP

Source: Next Capital Research, KSE, SBP

Average

FY09

Think back to all the times that market participants have been burned by equities in Pakistan, suering a signicant and permanent decline in capital. In most such instances, they have been speculating, not investingpaying more for something than it was actually worth, in the expectation of a short term price increase. In a speculative endeavor, particularly an unintelligent one, there is always the risk of losing money. Such activities should never be confused with investing.

Let us consider the return from a hypothetical PKR 1 million invested in various asset classes for the 10 year period ending June 2010. The results are shown graphically in Figure 4 above. Invested in the KSE-100, the initial grubstake would have grown to PKR 6.4 million. In the 6 month T-bill (rolled over at every maturity), it would have become PKR 2.2 million. Invested in DSC s, it would have grown to PKR 3.7 million. In gold, the initial million would have grown to PKR 6.1 million. If kept as plain and simple US dollars, it would have become PKR 1.6 million. The return from equities was superior to the other asset classes, with only gold coming close to matching the return from Pakistani stocks. A strong case can be made for gold currently being in a bubble, but for fear of digressing, we will not get into that discussion at the moment.

...a disaster proof portfolio is impossible to construct

...an investor would need to grow PKR 1 million to PKR 2.2 million to just maintain purchasing power...

The second issue is that many people are unwilling to invest in equities due to their bleak outlook on Pakistan s socio-economic future. For those who are skeptical regarding the long-term future of the country it is important to understand that a disaster proof portfolio is impossible to construct. If Pakistan becomes the next Afghanistan or Iraq, value of all investments in Pakistani currency will plummet. This will include NSS, bank deposits, and real estate, along with equities. Investors with such a harsh long term view on the country s long-term future would do well to switch their entire wealth into assets denominated in foreign currencies. Removing Pakistani equities from their portfolio (whilst keeping much larger Pakistan exposure in the form of real estate, bank deposits, and NSS, not to mention personal businesses and jobs) will be an extremely imperfect hedge if such a doomsday scenario comes to pass. It s akin to insuring just your bathroom for fear of a re in the whole house- from a portfolio point of view, it doesn t make sense! The statistical reality is that over the long term, equities have outperformed other asset classes in Pakistan.

Equities Serve as a Real Ination Hedge

Above we calculated nominal returns from various asset classes in Pakistan. However, with double-digit ination, a Pakistani investors top priority is to nd an investment vehicle which maintains purchasing power. In real terms, an investor would need to grow PKR 1 million to PKR 2.2 million to just maintain purchasing power in the 10 year period ending in FY10.
Figure 5: Real Returns FY01-FY10
12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0%
-2.0% -4.0%
Source: Next Capital Research, SBP

10.7%

...over the long term, equities have outperformed other asset classes in Pakistan

10.2%

Equities Have Been the Best Bet in the Long Run

In the last 10 years (FY01-FY10), the KSE-100 has averaged a 20.4% annual return. Over the last 20 years (FY91-FY10), the average annual return from the KSE-100 has been 15.3%. This compares favorably with other asset classes, which are preferred by most Pakistani investors. .Figure 4: Value of PKR 1 mn over last 10 years
7.0 6.0 5.0 PKR in Millions 4.0 3.0 2.0 1.0 0.0 Equities
T-bill

4.2%

0.0% Equities
T-bill

USD DSC
-3.2%

Gold

As depicted in Figure 5, an investment in T-bills earned a zero real return in the last decade. In bank deposits and US dollars, the real return has been negative. Equities, meanwhile, gave a real (ination adjusted) return of 10.65% during the period, whilst that of DSC s was 4.2%, and gold 10.17%. This impressive return from equities has been achieved through both bull and bear markets, in periods of relative prosperity and utter chaos, in times of dictatorship and democracy, with investor sentiment alternating between greed and fear. In short, this is the average result, smoothing out the impact of business cycles and investor psychology. It highlights

DSC

USD

Gold

Source: Next Capital Research, SBP

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the proven role of equities as a return enhancing asset class, and underscores that equities has been a winning game for the long term investor. Why than do savers in Pakistan hold such a small proportion of their wealth in equities? Often in life, perception is more important than reality. Many see equity trading as risky due to its daily uctuations and short term gyrations. For a long term investor however, risk should be seen as a permanent loss of principal. We believe the inability to disregard the short-term noise emanating from price uctuations is one of the chief reasons for equity market skepticism in the country.

By the end of the bear run, the market P/E had fallen well below historical averages in both instances. Part of the decline in valuations was due to a signicant increase in interest rates during the period. Corporate protability, as measured by ROE s, also fell during both bear markets. In symmetric contrast, the boom period identied (FY99-FY07) started o with the market P/E well below the long-term average, and ended signicantly above the historical average. Part of the increase in valuations was due to a signicant decline in interest rates during the period. Corporate protability, as measured by ROE s, also improved markedly during the period. As such, we identify two primary reasons for this periodic underpriced and overpriced history of equity markets in Pakistan; 1. The oscillating nature of the business cycle and 2. Investor psychology. Let us discuss each in turn.

...two primary reasons for this periodic underpriced and overpriced history of equity markets in Pakistan...

Short Term Performance is Volatile: Bull follows Bear

If shorter time periods are considered, equity returns follow an alternating pattern of weak followed by strong performance. We have identied three distinct time periods spanning from FY94 to FY10, in which the market has alternated between weak and strong performance. The four year period from FY95-FY98 was a crushing bear market, with the KSE-100 losing 62% of its value, and posting an average annual decline of 22%. This was followed by a nine year bull market FY99 to FY07, in which the KSE-100 went up by 1465%, an average annual return of 35.8%. What followed is too recent for anyone to forget! The KSE-100 came o by 48% from FY07 to FY09, an annual average decline of 28%. In FY09 alone, the KSE-100 fell by 41.7%!
Figure 6: CAGR of Bull and Bear Markets
40.0% 30.0% 20.0% 10.0% 0.0% -10.0% -20.0% -30.0% -40.0%
Source: Next Capital Research, KSE

The Eect of Business Cycles on Equity Markets

The economic and business cycle in Pakistan oscillates; rising than falling. Although there are numerous inter-related macro-economic variables that impact the business cycle, the two most important factors from the point of view of equity valuations are interest rates and corporate protability. Boom periods in Pakistan s economy have been typied as having low interest rates and strong corporate protability. This combination of factors provides a double impetus to stock prices. First you had an improved rate of protability, as higher ROE s earned by rms results in higher earnings. Additionally, lower interest rates make a rupee of future prots more valuable, resulting in higher valuation multiples such as P/E and P/B. In terms of the bull-run identied from FY99 to FY07, the period saw a sharp fall in interest rates, which started the period at 15.9% and ended at 8.9%, a 44% decline. Corporate protability as measured by the ROE of all KSE-100 companies (excluding outliers) averaged 24.2% during the period, as compared to 15.7% in the preceding bear cycle. Starting from a very low P/E of 5.80x at the end of FY98, the KSE-100 ended FY07 at a P/E of 13.2x.

...the two most important factors from the point of view of equity valuations are interest rates and corporate profitability

35.8%

FY95 - FY98 FY99 -FY07

FY08 -FY09

-21.6%

-27.9%

A Method to the Madness

Are these market gyrations following a random walk, or can they be intelligently predicted and proted from? Analyzing the alternating bear and bull runs on the KSE, some striking results come forth. Market P/E at the start of both bear periods was well above the historical average of 9.0x.

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As economic weakness sets in, so does investor depression

Table 1: Bull Market FY99-FY07

Starting Level Ending Level % chg FY95-FY09 Avg 6 month T-bill (%) 15.9 8.9 -44% 10.0 P/E of KSE-100 5.8 13.2 126% 9.0 Avg ROE of KSE-100 (%) 24.2 21.4
Source: Next Capital Research, SBP, KSE

The two bear periods identied saw interest rates rising above historical averages, and corporate protability declining. In such a scenario, stock prices decline not only due to depressed protability, but also because higher interest rates reduce valuation multipliers such as P/E and P/B. Interest rates moved up signicantly (by 41%) during the bear market of FY95-FY98, from 11.3% at the beginning of the period to 15.90% by the end of it. Corporate protability also showed a declining trend during the period, with average ROE s of the KSE-100 companies being 15.7%, as compared to the historical average of 21.4%. Starting P/E of the market (at the end of FY94) was extremely high at 21.7x, which fell to an abnormally low level of 5.8x in FY98.
Table 2: Bear Market FY95-FY98
Starting Level Ending Level % chg FY95-FY09 Avg 6 month T-bill (%) 11.3 15.9 41% 10.0 P/E of KSE-100 21.7 5.8 -73% 9.0 Avg ROE of KSE-100 (%) 15.7 21.4
Source: Next Capital Research, SBP, KSE

As economic weakness sets in, so does investor depression. At such times, most investors are unwilling to project anything but the prevailing abysmal economic conditions into the future, expecting high interest rates and falling protability to continue. In short, investors are gripped by a combination of fear and depression. Extrapolating such a hostile environment into the future manifests itself in the form of single digit P/E s and low P/B multiples. Near the trough of the two bear markets identied, P/E ratios have fallen to unjustiably low levels, even if the high interest rates and low corporate protability were taken into account. The fear factor accounts for that.

The Reality of Mean Reversion

The historical reality is that economic variables and stock market valuation multiples are mean reverting over longer time periods. Human nature does not change either, suering from periodic bouts of greed and fear. Over the course of the last 16 years, mean reversion can be seen in economic variables such as interest rates, business variables such as ROE s, and valuation measures such as P/E s. Every time these variables have been above their historical mean, they have come back down. And in the instances when they have been below the historical mean, they have gone back up. Often, they overshoot in the process, which is a part and parcel of the process of mean reversion. We identify 6 years in the last 16 years where the KSE-100 has traded at a P/E below the historical mean of 9X. In each of the six instances instance, the subsequent 5 year return from equities has been outstanding. This is strong evidence that value investing in Pakistan has been richly rewarded in the past. The years in which the KSE-100 P/E was below mean were FY98, FY99, FY01, FY02, FY03, and FY09. The annual average 5 year stock market return for each year was 31%, 38%, 49%, 51%, 29%, and 34% respectively (for FY09, a 1 year return has been calculated).
Figure 7: Subsequent 5 yr CAGR of KSE-100
60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% FY 98 FY 99 FY01 FY 02 FY 03 FY 09 Years with below average P/E

Historical reality is that economic variables and stock market valuation multiples are mean reverting over longer time periods.

...value investing in Pakistan has been richly rewarded in the past.

In the FY07-FY09 bear market, interest rates moved up from the level of 8.9% at the start to 11.4% at the end, a 28% increase. Corporate protability, as measured by the ROE of the KSE-100 companies, averaged 19.9% in the two years, falling from the average level of 24.2% in the preceding bull cycle. From a P/E of 13.2x in FY07, the KSE-100 came down to a P/E of 7.8x times in FY09.
Table 3: Bear Market FY08-FY09
Starting Level Ending Level % chg FY95-FY09 Avg 6 month T-bill (%) 8.9 11.4 28% 10.0 P/E of KSE-100 13.2 7.8 -41% 9.0 Avg ROE of KSE-100 (%) 19.9 21.4
Source: Next Capital Research, SBP, KSE

Investor Psychology Amplies the Impact of Business Cycles

The fundamental valuation changes brought upon by changing interest rates and corporate protability is amplied by investor sentiment. In boom times, most investors are happy to project sanguine economic conditions into the future, expecting high prot margins and low interest rates to sustain indenitely. At the peak of the FY99-FY07 bull period, P/E ratios were not only well above the historical average, but higher even the levels justied by the low interest rates and strong protability. This unjustied premium can be put down to the greed factor in human nature.

Source: Next Capital Research, KSE

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For all the variables mentioned above, it would make sense to understand what the mean reverting levels are, to which forward looking valuations can be anchored. The average level of the 6 month T-bill rate from FY95 to FY09 has been 10%. The average ROE for KSE-100 companies from FY95 to FY09 is 21.4%. The P/E multiple of the KSE-100 has averaged 9x in the FY95-FY09 period.
Table 4: Mean Reverting Levels
6 month T-bill (%) P/E of KSE-100 ROE of KSE-100 (%) FY95-FY09 Avg 10.0 9.0 21.4 Current Levels 12.5 8.0 17.0 Difference -20% 12% 25%

portfolio which is not budgeted for expenditure in the next 3-5 years should be allocated to equities. Most ideally placed to invest for the long haul are pension and provident funds, along with life insurance companies. Their liabilities are long-term in nature, and thus they can match them by buying long-term assets. General insurance companies can also keep a high percentage of equity investment in their portfolio. Individuals can and should invest a percentage of their long term saving in equities. Within mutual funds, closed end funds are in a good position to be fully invested and reap the signicant benets of long term investing, as they do not face the pressure of redemptions. Banks, who are in a comfortable position with regards to MCR and capital adequacy, can also aord to take a long-term outlook and increase allocation to equities as well.

Source: Next Capital Research, SBP, KSE

Mean Reversion Implies a Signicant Upside in Equities

Where do we stand today, and what implications does that have for the valuation of the KSE-100? If looked at from the point of view of P/E ratios, the current level is approximately 8X. A reversion to the mean P/E of 9X would imply a 12% upside in KSE-100 valuations. Add to that a 25% increase in earnings as ROE reverts to the mean, and the overall undervaluation of the KSE-100 on the basis of mean reversion is 40% This has important asset allocation implications for long term investors. It indicates that the KSE-100 is currently undervalued by 40% on the basis of mean reversion. Reversion to the mean may not happen in Pakistan over the course of FY11 alone. However, investors willing and able to take a long term view should place their condence in the innite wisdom of history.

Knowing yourself is Even More Important!

Having the ability to invest for the long term is not enough to make one a successful investor. Emotional discipline is also of critical importance, and this has to be supplied by the investor himself. If achieving short term results is critical to your psyche, long term investing is not suitable for you. The timeless wisdom of Benjamin Graham when he said that the stock market is a voting machine in the short-term and a weighing machine in the long-term is well worth remembering. Within the context of the current Pakistani market, fair values may not be reached in the short-term but they will be in the long-term. An investor who realizes and internalizes this will be less frustrated than one who does not.

Fair values may not be reached in the short-term but they will be in the long-term. The KSE-100 is currently undervalued by 40% on the basis of mean reversion

Understanding Portfolio Constraints is Key

In terms of stock selection, we recommend four criteria to select superior investments...
Investors who are omitting or under-invested in equities as an asset class should realize that equities currently have the potential to signicantly improve overall portfolio returns over the next few years. Admittedly, stocks are not the basement bargains they were in Jan 2009, but many are long-term bargains nonetheless. Investing for the long-term at current levels will be a winning game, and investors with the willingness and ability to commit capital intelligently for the long-term stand to gain signicantly. There is no free lunch however; equity returns can be volatile, and mean reversion can take longer than expected. Before investing in equities, an investor should have a strong understanding of potential liabilities and liquidity requirements from their portfolio. In our opinion, only the percentage of the overall

Devising a Long Term Investment Strategy

If an investor is convinced on the merits of mean reversion, and has the ability and willingness to take a long term view on stocks, what is the correct portfolio strategy to employ? In terms of asset allocation, we have already mentioned that such investors should currently be overweight equities. In terms of stock selection, we recommend four value investing criteria to select superior investments. Put succinctly, investments should be made in companies which have the potential for strong earnings growth in the coming few years (usually taking the form of favorable industry dynamics and a competitive advantage), an ability to withstand economic and business shocks (manageable levels of debt to equity and operating leverage), an able and trustworthy management (a subjective call; track record is critical), and a cheap valuation.

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The companies that measure up to the four investment criteria outlined above promise strong returns in the future. In due course, we will provide investors with specic investment ideas to match the investment philosophy being proposed.

Road Map for Investors with a Shorter Time Horizon

...many investors cannot afford the luxury of investing solely for the long-term
We understand that many investors cannot aord the luxury of investing solely for the long-term. Examples of such investors are individuals with short to medium term liability considerations and open end funds (who have to focus on short term performance for sales and redemption purposes). Other investors may not have portfolio constraints, but expect a quick return from their investments. For such investors, medium term performance considerations are also critical. Next month s Investment Outlook will outline asset allocation and stock selection strategies for them.

Equity Research Farrukh Karim Khan, CFA Head of Research Dir: 92-21-35292650 UAN: 92-21-111-639-825 Ext 113 Shehzad Ashfaq UAN: 92-21-111-639-825 Ext 114 Raza Hamdani UAN: 92-21-111-639-825 Ext 114

Equity Sales Zulqarnain Khan Head of Sales Dir: 021-35292629-31 UAN: 92-21-111-639-825 Ext 421 Fahad Muhammad Ali Dir: 92-21-35292630-35-38 UAN: 92-21-111-639-825 Ext 105 Taimur Khan Dir: 92-21-35292640-41 UAN: 92-21-111-639-825 Ext 108

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