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Case for Investment in Stock Funds – Valuations Now Near Decade Lows
October 28, 2019 Posted By MCB Funds

The bearish spell at Pakistan Stock Exchange continues unabated and has taken over the nerves of investors. The stock market is down by nearly ~45% from the peak level it witnessed in May’17 and currently is trading at its 5-year low. Certainly, we share the concern, as it has been nearly 800 days since KSE100 index formed its peak and we are yet to find the bottom. Even during the last financial crisis (FY09) which was one of its kind, it took only 283 days for the KSE100 Index to form a trough from its peak.

The legendary investor Warren Buffet points; “The stock market is a device for transferring money from the impatient to the patient.” Perhaps, this is the period to relate the famous phrase that markets can remain irrational for a period of time, and patience will remain a key virtue for successful investing for the long term investors. Back in December 2018, we presented a strategy report, where we highlighted that market has the potential to produce double digit returns exceeding 15% for the next year. Our premise was based on the fact that valuations have priced in most of the negatives, therefore, stock market should have formed the bottom. We presented a table with major valuation indicators and provided how average returns fared based on those indicators based on history. To make it easy for our audience, we will read out a sample from the table. Based on the table provided below, the Price to Earnings ratio on the last date of calendar year 2018 was 7.6 x, and based on the 20 years history, if an investor had invested in the market near such ratio, the expected 1-Year return would have been 26.3%.

However, contrary to our expectations, the market took a nosedive and has yielded a loss of nearly ~20% (As of 19th Aug 2019). While our outlook on most of the important economic variables have been in line with our expectations, we however did underestimate the impact of deep hit on confidence of investors due to prevailing uncertainty on interest rates and exchange rate. Strain in Indo Pak tensions amid escalation of Kashmir Issue also added to the worries.

Let us first discuss how the major economic indicators have fared over the period. Pakistan’s major crisis was concerned with its balance of payment, where by an unsustainable current account deficit along with near term financial obligations brought in Pakistan on the verge of default. Vigilant policy actions by the central bank (devaluing the currency by ~50% and increasing the interest rates by 600 bps) led to the arrest of current account deficit which we expected. Alongside, Pakistan was able to fetch material flows from its friendly allies (USD ~10 billion) which averted default on its obligation. Most importantly, Pakistan signed up for an IMF program providing it the crucial USD 6 billion financing, alongside providing it access to the international financial markets for funding it needs. Pakistan now is on the path to achieve a sustainable current account deficit which we are projecting at 2.0%-2.5% of GDP.

The headline CPI inflation jumped to 10.3% in the first month of FY20. Although, much higher than the last year average of 7.3%, it was still within the manageable range. Our expectation is that inflation will peak out near 12.0%. As a result of anticipated higher inflation, the central bank increased the policy rate to 13.25%. Importance of expected inflation grew much higher post SBP Governors explicit emphasis on the forward looking approach for monetary policy guidance. Nevertheless, the increase in interest rates was slightly higher than our expectations as we expected the policy rate to peak at 12.5%. Hence, some of the deterioration in PSX returns was driven from much higher hike in interest rates compared to our expectations.

The most important reason that we were not able to decipher was the crisis of confidence, perhaps, the one which was the most difficult to forecast. We all know that government implemented contractionary policies by the virtue of situation it inherited. However, the uncertainty associated with the policies, marred the investor confidence. Take the example of exchange rate, which continued to depreciate throughout the period even after attaining the status of undervalued (Below 100 REER). Similarly, the hike in interest rates continued till the last monetary policy, creating an atmosphere of uncertainty with regards to the inflection point. The higher interest rates caused local investors with lower risk ability to shun stocks through mutual funds deepening the fall in prices. Banks, Insurance and Other Investors were also overwhelmed against the selling from Mutual Funds which sold USD 166 million of stocks during the last 6 months. Therefore, we saw a massive outflow and resultantly de-rating in Price to Earnings Ratio of the index, which de-rated from 7.6 x to 5.5 x.

Nevertheless, a silver lining can be drawn from the buying pattern, that foreigners whom were the largest seller in the Pakistani market in the last 3 years (Sold USD 1,384 million of equities), turned out to be surprise buyers, accumulating USD 78 million of equities this year. Albeit slow but accumulation of stocks by foreigners in the local market should be viewed as a strong sign of potential equity market returns.

It is difficult to gauge the bottom of the market but comparing it to even the worst of the times shows us that bottom might not be far from us. We have provided a table below which compares what would be the bottom of the market if valuations reach at the level seen at the bottom of financial crisis witnessed during Feb’09.

We want to highlight to our investors that once the market hit the bottom in Feb’09, it rebounded sharply and posted a return of 69% in the next 12 months. Perhaps if we emulate the same situation here, the market should rebound from the bottom to a target of ~46,000 in the next 12 months assuming there is not a massive deterioration in economic fundamentals, which we believe are moving toward the right direction (A brief macroeconomic snapshot is provided at the end of the document). Our balance of payment worries are over as current account deficit is expected to reach at a sustainable level. We believe PKR has attained its equilibrium level and with the expected recovery in FX reserves, the expectations should gradually move towards a normalized exchange rate depreciation of 5 – 7% per annum going forward. Similarly, SBP has hinted that interest rates have peaked and only modest hikes will be considered if any adverse situation arises. In our view, interest rates are close to peak and current valuations fare adequate return potential against risk free returns.

While at the time of sheer pessimism, it becomes difficult for our minds to accept the potential of equity returns, but it has remained a historical fact that over the longer horizon, equities as an asset class has outperformed all other asset classes. A fundamental illustration of what our market has to offer over the long run is worth highlighting. The long term equity returns are generally a function of nominal earnings growth plus the dividend yields. Currently, the dividend yield of the market is close to ~9%. Similarly, Pakistan’s average inflation has been close to 8% over the course of its history. Even assuming a 2% real growth over the long run which we believe is utmost conservative, will yield nominal earnings growth of 10% over the long run. This theoretically implies that long term returns should be close to at least ~19% (9% yield + 10% earnings growth), which is a staggering number. The power of compounding further highlights what investor will lose if they don’t invest in equity markets now. If you compound 19% (expected equity returns) over the course of next 20 years, your wealth will grow ~31 x from the current levels, while if you invest same in cash fund (Assuming 10% expected return), your wealth will grow ~6 x from the current level. If you understand the difference, you will never dare to miss the boat.

We have updated the table that we presented in our last strategy report. Our return expectations have now drastically improved based on the current valuation levels.

Moreover, not only the return expectations have improved, the probability of beating FI income returns have been ascertained, as if you invest in equity market now there is a 100% probability now (based on last 20 years’ history) that you will beat the Fixed income returns over the 3-year and 5-year horizon. The last time we published the strategy report (31st Dec 2018), the probability was 90.7%.


Based on our view of relative stability in key economic fundamentals and sharp correction in stock prices, we consider the returns for long term investors shall be considerably higher than other investments. Given the higher absolute returns in Money Market and Fixed Income Funds, a diversified portfolio with an overweight stance on equities is appropriate in our view. We see strong return potential in equities however, a 3 to 5-year period looks best aligned with expected outlook on economic recovery.

Macroeconomic Snapshot

By Muhammad Asim, CFA
Chief Investment Officer

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