Is the Pakistani Stock Market still attractive to buy?

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.