September 15, 2003	Monday	Rajab 17, 1424

The record-breaking, liquidity-driven Pakistani stock market rally continues. The KSE-100 Index, has gained in excess of 250 per cent, inclusive of dividends, since the beginning of the calendar year 2002.

The bullish trend that began with the gleaming high dividend yields, has now shifted to the price-earnings (PE) multiple and growth, thanks to the central bank’s policy of keeping the market liquid, with the inflation well under control.

The article dissects the performance of the stocks in the ongoing rally. For the purpose of better evaluation, the rally has been divided into two parts i.e., 2002 (covering 12 months of the calendar year), and 2003 (incorporating the increase witnessed between January-July of the current year).

Small ruled the large: After the detailed analysis, it has been observed that the second and third tier stocks combined have posted capital (price) gains of 174 per cent in this bull-run as compared to 142 per cent increase posted by large cap, the first tier stocks.

In fact, this trend was evident even more so during the 2003 rally, where uptill July these medium and small stocks have gained 60 per cent and 68 per cent, respectively while the large cap stock prices are up by 28 per cent only.

These gains are exclusive of the dividend payouts which the KSE-100 share index incorporates, and that is why the index always overstates the average prices of the 100-stock basket.

There is no hard and fast definition of first, second, and third tier stocks. Usually, by blue chip companies, investors refer to first tier or large companies that are well established and have demonstrated ability to pay dividends both in good and bad times.

In the light of the fact that there is no clear categorization of first, second, and third tiers, definitions of different tiers of stocks have been devised.

First tier stocks (large cap stocks) have been taken as those accounting for at least 2 per cent of total market capitalization of all listed companies. This yielded a list of 10 companies based on the data for July 31, 2003.

This list includes the PTCL, the Hubco, the PSO, the FFC, etc. Categorization of the second tier stocks (medium cap stocks) resulted in a list of 73 companies. These are those listed stocks whose market capitalization falls between 0.2 per cent and 2 per cent of the total market capitalization of the KSE.

The remainder have been categorized as the third tier stocks (small cap stocks), i.e., those stocks that have capitalization level of less than 0.2 per cent of the total market cap. This method may seem arbitrary at the first glance; however, in the absence of any set criteria in the local market, liberty has been taken in assigning stocks to different categories, based on our understanding.

Why small is beautiful: There are various reasons why small and medium sized companies provide above average returns to investors.

First of all, the big financial institutions and mutual funds have some restrictions that limit them from buying the second and third tier stocks, aggressively. Since the big players cannot buy such stocks, they usually remain undervalued. Secondly, the large funds have liquidity considerations also, as they believe that the stocks should be equipped with an easy exit strategy. And as the second and third tier shares have relatively less average daily volume, they are ignored by the large funds.

Finally, such stocks remain neglected due to the fact that the fund managers try to design a small and manageable portfolio so that they can focus on a few shares in a better manner. It is then easier for the fund to track the benchmark index, which in many countries is based on a few selected stocks.

Due to these reasons, the medium and small stocks remain ignored. Smart investors availing this opportunity dig out such cheap scrips, especially those whose prices have hit rock bottom in the downward part of the economic cycle and make good capital gains.

Moreover, these smart investors believe that at some point in time in the future, these shares will see an increase in the value and share liquidity, which will eventually lead them into the first tier category, thus automatically eliciting interest from the bigger players.

Sectors that led the way: The ongoing rally has seen a few non-traditional sectors taking the lead as far as appreciation in market value is concerned.

The sectors that have seen the most gains, e.g., cement, auto, and mutual funds comprise of stocks that fall into the second and third-tier categories owing to their lower capitalization.

A reason for each of these sectors’ excellent performance seems to be that all these sectors comprise of the second and third tier stocks, which has caused increased investor interest.

Ibbotson Associates’ findings: The trend of excellent returns of the second and third tier stocks is not at all unique for Pakistan. A famous study conducted by the Ibbotson Associates Inc that was published in its 1998 Yearbook concluded that in the US on an average, small firms’ stocks performed far better than the comparable investment options.

According to that study, which analyzed rates of return for each year from 1926 to 1997, the average annual nominal return from investing in small stocks was 17.7 per cent, compared to investing in large cap stocks constituting the S&P 500, which resulted in an average annual return of 13 per cent.

Small caps, big confidence: During the course of this current stock market rally, Pakistan’s economic performance has taken a significant turn for the better.

Numbers pertaining to almost all facets of the economy have depicted a significant change in Pakistan’s fortunes. This economic improvement has played a major role in lifting the values of equities to where they are today.

It has been observed globally in bond markets that when economic performance of the country improves, the spread between the risk-free bonds and riskier bonds tends to decrease.

This is caused by a decrease in the yields of the risk-free bonds, which then compels investors to take bets on riskier securities offering higher returns.

This phenomenon is usually referred to as the ‘confidence index’. If one applies this same confidence theory to the local equity market, one can attribute a theoretical reason to the recent surge in the second and third tier stocks.