Is the Pak­istani Stock Mar­ket still at­trac­tive to buy?

The Pak Banker - - FRONT PAGE -

LO­CAL eq­uity mar­kets have de­liv­ered phe­nom­e­nal re­turns over the last few years. The bench­mark KSE 100 In­dex has in­creased by more than sev­en­fold to 36,000 points from the trough level of 4,815 hit in Jan­uary 2009. With the KSE 100 In­dex hit­ting record highs, many in­vestors pon­der whether the stock mar­ket would con­tinue to post hand­some re­turns go­ing for­ward.

We high­light that sim­ply look­ing at the In­dex level in iso­la­tion could be mis­lead­ing with­out tak­ing into ac­count key stock mar­ket driv­ers such as cor­po­rate earn­ings growth, val­u­a­tions (Price to Earn­ing, Price to Book Value, div­i­dend yield, etc.), key macroe­co­nomic in­di­ca­tors ( GDP growth trend, in­ter­est rates, ex­ter­nal ac­count po­si­tion, etc.), and geopo­lit­i­cal & se­cu­rity sit­u­a­tion. Cor­po­rate earn­ings and div­i­dends have re­mained ro­bust, ris­ing at a Com­pounded An­nual Growth Rate (CAGR) of around 14% dur­ing the last six years. The KSE-100 In­dex has largely tracked the growth in corpo- rate earn­ings and div­i­dends. Our anal­y­sis shows that al­most three-fourth of the mar­ket per­for­mance dur­ing the last six years (June 2009-June 2015) is ex­plained by cor­po­rate earn­ings growth and div­i­dend yield. Dur­ing this pe­riod Price to Earn­ings ra­tio of the mar­ket has rerated from 6.4 times to 9.5 times.

Sig­nif­i­cant im­prove­ment in macroe­co­nomic in­di­ca­tors as man­i­fested in multi-year low In­fla­tion, ris­ing GDP growth rate, be­nign bal­ance of pay­ments po­si­tion and im­prov­ing po­lit­i­cal & se­cu­rity sit­u­a­tion is the key rea­son of the mar­ket re-rat­ing. We have used Jus­ti­fied PE frame­work to as­sess the up­side in the stock mar­ket from the cur­rent lev­els. The jus­ti­fied.

PE method­ol­ogy is a sim­ple yet in­tu­itive val­u­a­tion tech­nique that uses macro in­puts like in­ter­est rates, cor­po­rate earn­ings, div­i­dend pay­out and as­so­ci­ated risks to cal­cu­late a jus­ti­fied PE ra­tio for the mar­ket. The jus­ti­fied PE ra­tio for­mula takes into ac­count es­ti­mated earn­ings/div­i­dends growth rate (g), cost of eq­uity ®, and div­i­dend pol­icy (pay-out ra­tio) to get a jus­ti­fied PE level for the mar­ket.

Pay­out ra­tio is the pro­por­tion of earn­ings that is paid out as div­i­dends, while growth rep­re­sents ex­pected ag­gre­gate earn­ings growth of the com­pa­nies listed on the stock mar­ket. Re­quired Rate of Re­turn takes into ac­count the risk free in­ter­est rate and the eq­uity mar­ket risk pre­mium re­quired by the in­vestors to carry the eq­uity risk.

Math­e­mat­i­cally, the jus­ti­fied PE mul­ti­ple of the stock mar­ket de­pends upon; (i) the re­quired rate of re­turn of in­vestors; (ii) pay-out ra­tio and; (iii) the ex­pected growth in earn­ings.

Based on this, we pro­ject in­fla­tion to re­main at around 7% p.a. in the near fu­ture. Thus, medium-term risk free rate is ex­pected to re­main at around 9% p.a. The risk pre­mium is based on volatil­ity (risk) of the stock mar­ket. A his­tor­i­cal anal­y­sis of daily In­dex move­ments re­veals that stock mar­ket volatil­ity has no­tably di­min­ished over the last few years. In or­der to quan­tify the re­duced volatil­ity, we have taken daily volatil­ity as mea­sured by stan­dard de­vi­a­tion from FY10-FY15 (6 years af­ter the mar­ket freeze in FY09) and com­pared it with daily volatil­ity from FY03FY08 (6 years be­fore the mar­ket freeze in FY09). We have ex­cluded FY09 as an out­lier as the mar­ket re­mained frozen for a sev­eral months dur­ing the year and crashed dra­mat­i­cally post freeze pe­riod, re­sult­ing in the su­per­nor­mal volatil­ity dur­ing the year. The re­sults show 840bps re­duc­tion in volatil­ity. The sharp re­duc­tion in volatil­ity can be at­trib­uted to lower lever­age po­si­tion in the mar­ket, higher par­tic­i­pa­tion of more in­formed in­vestors in­clud­ing in­sti­tu­tional in­vestors, at­trac­tive val­u­a­tions post 2008 mar­ket crash, and im­proved macroe­co­nomic in­di­ca­tors. The his­tor­i­cal (last 30 years) risk pre­mium of the stock mar­ket is 7%. This is based on an av­er­age re­turn of 16% p.a. on the stock mar­ket and an av­er­age risk free rate of re­turn of 9% p.a. over the last 30 years. Re­duced stock mar­ket volatil­ity, along with strength­en­ing macroe­co­nomic in­di­ca­tors and im­prov­ing po­lit­i­cal and se­cu­rity sit­u­a­tion war­rants a lower eq­uity risk pre­mium go­ing for­ward.

How­ever, based on pru­dence we con- tinue to as­sume a 7% p.a. eq­uity risk pre­mium in the com­ing years. We ex­pect cor­po­rate earn­ings and div­i­dends to grow in line with nom­i­nal GDP growth in the medium-term. Our es­ti­mate for this nom­i­nal growth rate is 12%.

Real GDP growth hit an eight year high of 4.2% in FY15. Over the medium term we ex­pect eco­nomic growth of 5% driven by greater macroe­co­nomic sta­bil­ity, ame­lio­rat­ing se­cu­rity and law and or­der con­di­tion, im­prov­ing po­lit­i­cal cli­mate, be­nign in­ter­est rate en­vi­ron­ment, higher de­vel­op­ment spend­ing, im­ple­men­ta­tion of in­fra­struc­ture projects un­der the Chi­naPak­istan Eco­nomic Cor­ri­dor (CPEC), and res­o­lu­tion of struc­tural bot­tle­necks, es­pe­cially the energy short­ages.

A sur­vey con­ducted by OICCI which en­com­passes the job mar­ket, man­u­fac­tur­ing ac­tiv­i­ties, and in­vest­ments ex­plains the im­prove­ment in busi­ness. The re­sults of the sur­vey in­di­cate con­sid­er­able im­prove­ment in all the three ar­eas. This fur­ther strength­ens our belief in the econ­omy grow­ing by 5% p.a. or more in the com­ing years.

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