PSX rally: don’t read too much into ‘tezi’

The stock market is booming. The KSE100 index posted a return of 60 percent this fiscal year to date, and the rally has surprised many.

The PSX is such a low-base asset class where the valuations were so beaten down, and it did not take much investment to bring the market to this crazy rally. The free float (shares which can be publicly traded) of the market on the last close was Rs2.5 trillion, which is less than deposits-base of a big bank. It’s a very small base.

Initially, the rally was spurred by a state-owned insurance company, and then companies joined the party (perhaps buying back the shares, as the valuations were dirt cheap). This further squeezes the effective free float and lowers the investments level to jack up prices.

In the last few weeks, foreigner interest started building up. Now the momentum has picked up, and the animal spirit is in play with everyone is in tezi (becoming bull).

This is overall good for the market that has remained suppressed for very long. With all this spike, the CAGR (cumulative annual growth rate) of last ten years is a mere 10.3 percent, which is less than the average annual return (10.7%) on so-called risk free 10-Year government paper.

The trailing P/E (price to earning ratio) of KSE100 index is at 7.15x. Within it, three sectors (banking, energy, and fertilizer) have over 60 percent weight, and these sectors are trading at a discount to the rest - as their trailing P/E is around 5. These are highly regulated businesses, as their profitability is linked with government policies, and the regulatory risk in Pakistan is very high.

Banks in a high interest rate environment make money by raising current account deposits (at zero cost) and investing these in government papers. Then the banking exposure is very high to the government debt, and any debt restructuring/reprofiling of domestic debt adversely impacts the commercial banks.

Energy sector of Pakistan is plagued with the circular debt, and the top performing companies have guaranteed returns while the others are state-owned where government sets prices and dictate the market.

Then the third biggest sector, fertilizer, is running on the model of government subsidy – receives subsidised gas to produce Urea and sell at a discount to international prices to farmers. The government is ensuring their demand and companies are making chunky profits.

All these regulated businesses have heightened risks.

The overall macro picture of the economy has not improved, though the economy is bottoming out as the global commodity super cycle is over, and prices are expected to slide which bodes well for net importing countries such as Pakistan. However, medium-term external repayments risks are very much present, and the fiscal house is not showing any improvement. There is no Pakistan breaking out or turnaround story.

The stock market had an overdue rally. The KSE 30 index (it’s a price index which is used for valuation purposes) is still 25 percent lower than its all-time high. The P/E ratios are still at discount to their peak.

Hence, the market moving up is not surprising; but there is no big money in it. It is a market of small club, and the free float is not even 10 percent of banking deposits, and 60 percent of market cap is highly exposed to regulatory risk.

The bottom line is that this robust performance may have been long overdue, considering the persistent undervaluation despite strong corporate results. It is noteworthy that the influx of net new money into the market has been relatively small compared to the magnitude of price movements. The market’s limited free float implies that even a minor injection can disproportionately influence market trends.

For every rupee of fresh investment has contributed almost 200-fold addition to the market capitalisation. However, investors should be aware that this volatility can also manifest in the opposite direction.

Last but not least, William Shakespeare had wisely said in the Merchant of Venice, ‘All that glitters is not gold;...Gilded tombs do worms enfold.’ Caution is always warranted for investors, especially newbies, in navigating the often-perilous landscape of the Pakistan stock market.

Copyright Business Recorder, 2023