When the same whispers make the rounds of the stock market floor for a few days running, it’s likely there’s at least some truth in what’s going around.
For the last few weeks, the word at the Karachi Stock Exchange is that foreign funds—those elusive most-wanted-yet-hated entities—are back at the buying counters. Not in any big way, of course. But that their gradual and steady re-entry into this market has begun, for the first time since the mid-nineties.
The numbers support the rumours. Data from the State Bank of Pakistan shows that in the first two months of this financial year (July and September), the net inflow of foreign portfolio investment amounted to $145 million compared to just $21 million in the same period last year.
This year, of the total, more than half or $88 million came from the U.S.-based investors while the next highest amount was $38 million from U.K. investors.
Brokers say since October, another $100 million or so in foreign portfolio money has found its way into the local share market as well. Why the sudden interest? It’s certainly not on account of a recent change in the market’s behaviour. After the rapid run-up to over 10,000 points earlier in the year, the March futures crisis brought the KSE-100 index crumbling back down. Since then, amid some pretty volatile behaviour that we saw continue into this week, the index now hovers around the 8,500 points level.
Recent changes in regulation to permit banks to increase their exposure in the spot and futures markets are expected to infuse further gains in the share index. The continual addition of new mutual funds to the ranks is also sure to fire the index in the longer term. And so once more, despite short-term worries about a widening fiscal deficit as a result of unexpected earthquake-related spending and concerns about the successful completion of the PTCL-Etisalaat transaction, ever-optimistic market watchers are predicting 10,000 points by December.
“The market is up 40 per cent and so there certainly comes the question of why foreign funds would come now,” says Nadeem Naqvi, CEO of AKD Securities. “But there are good reasons why.”
Topping the list is attractive valuations. Although the index has gained ground steadily over the last four years, it still trades at a price earnings ratio of 10.5 times compared to about 13 times for markets in the Far East and 15 times for India. That means the Pakistan market is still trading at a discount of 25 to 30 per cent to its regional counterparts.
Second, is strong corporate earnings. Following three years of solid growth in earnings across the corporate sector, equity analysts expect earnings to grow by an average 25 per cent this year as well. Among the sectors that are expected to post strong earnings growth are cement, oil and gas and banking.
Third, is continued performance on the economic front. Analysts say that as aid inflows rise in the aftermath of the earthquake to meet the government’s expected rehabilitation costs of $5 billion, foreign exchange reserves will rise and the rupee will remain strong.
Furthermore, the central bank is expected to hold off on its plan to tighten monetary policy as fears of an overheating economy recede and therefore the economy will continue to hold incentives for further investment as well.
Skeptics still around: However, those on the other side argue that five years of improving economic indicators have not attracted foreign portfolio investors back to the market yet so minor improvements are not going to bring them into the fold now either. That may be true. But three factors have kept foreign investors at bay so far. Primary among these is the problematic image issue. Headlines documenting Pakistan as a place rife with terrorism, regional instability and violence have always kept investors skittish.
Recent problems in Afghanistan, internal violence in Pakistan and only shaky progress on peace with India have all continued to weigh on the country’s image and the President’s image improvement programme is yet to show results.
“The market certainly has the potential to attract $1-$2 billion in foreign portfolio funds,” says Arif Habib, chairman of Arif Habib Securities. “But the perception of Pakistan remains an issue.”
Then, there is the absolute lack of marketing effort on the part of both the management and board of the stock exchange as well as the broker community to promote the Pakistan market to investors abroad through better equities research, awareness programmes and outreach.
Despite several overtly publicized plans, the management of the exchange never put together or executed a genuine plan to market to foreign funds. “We didn’t really market ourselves in the last six or seven years,” says Naqvi. “But then again what story would we have told back then?”
The problem is that even if the story we can now tell is compelling, the small size of the market at just $40 billion and its narrow base of shares that are highly liquid shares and have sizeable market capitalization, has always and will continue to limit the level of interest in the market. This is especially true since companies in India, China and the Middle East boast giant market capitalization and therefore offer bigger, more lucrative opportunities.
“People have really been swayed by the opportunities in these markets,” says Muddassar Malik, director research at BMA Capital Management. “If an investor goes to the Middle East he’ll see one company with a market capitalization of $60 billion.”
This means the Pakistan market is under-researched by the major global brokerage firms and makes up only a very small part of the Morgan Stanley Composition Index of emerging markets. So even coming onto the radar screens of those making the investment decisions is a tough call. “Smaller markets tend to fall under the radar,” says Rajiv Jain, a New York-based fund manager who runs Vontobel Asset Management Inc. “Pakistan’s market is too narrow.”
Some critics, of course, are quite happy that these barriers are in place. They have long argued that foreign portfolio funds are unwelcome since they can jack the market up rapidly and bring it crashing back down equally quickly if investments are withdrawn in a hurry.
However, brokers say foreign funds bring the major advantage of increasing the quantum of primary investment in the market by the large sizes of their holdings. “The whole purpose of a share market is to create a venue to raise capital,” says Habib. “So foreign investment helps do that although it does add to volatility.”
In the 1990s, for example, it was the heavy interest from foreign investors that helped raised record sums of capital for companies like Hubco, Pak Telecom and cement and fibre companies. It was also during those times that several foreign brokerages set up shop in Pakistan, introduced the concept of equity research and generally raised the bar as far as quality of institutional brokerage services was concerned.
Now, local brokers hope to rekindle some of that old interest. Some of the bigger houses have started sending their research out and establishing contact with major foreign funds in the Middle East and Europe. “The interest is there but it is very cautious, very selective,” Habib says.
The hope had been that as the economy improves and corporate governance as well as market regulation is strengthened, foreign investors will start turning to Pakistan once more. But some say that despite these improvements, malpractices such as front running by some local brokers will always cast the country in a shadowy glow.
If that changes through self-imposed regulatory and ethical standards developed by brokers and if professionally created marketing campaigns carried out by the exchange and the broker community are able to mitigate image and perception concerns abroad, that may pave the way for foreign funds to consider Pakistan among its smaller regional counterparts.
But to truly get them involved with the local market, the depth and breadth of the market will have to continue to grow substantially. While privatization transactions through the stock market have done well, the private sector is yet to follow with intriguing and sizeable IPOs. Unless that happens, it’s unlikely the glance foreign funds may make towards Pakistan will turn into anything more meaningful.
