Common perception is that large foreign investors drive our stock market. Market history also tells us that foreign investors have been the driving force at the stock market throughout the 90's. However, the ground realities have changed.
The retail investors, is the biggest force at the stock market these days. Though radical, this change has come gradually with time.
How did this change take place? It's not a very old story. Things started changing in 1998 while the retailers actually grabbed the driving seat soon after September 2001, when the country started observing reverse capital flight. Before jumping to the conclusion of our subject, I would like you to take through the whole evolution of retail investors in Pakistan.
HIGH RATE OF TAX FREE RETURN: Small, or retail, investors have traditionally focused on fixed income securities especially government Savings Schemes to satisfy their investment needs. There are four key reasons for this trend:
(1) Safe nature of such investments;
(2) Attractive rate of profit on such saving instruments;
(3) Tax exemption of profit of national saving schemes and.
(4) Lack of expertise required for investing in alternative avenues, such as the stock market.
However, there has been continuous decline in the rate of return on bank deposits from 7-8% to as low as 1.34% in January 2004, as evident by numbers released by SBP and the government national savings schemes from 15% to 8% per annum.
Tax exemption on saving certificates have been withdrawn by the government. and made fully taxable.
Further, profit on bank deposits are now fully taxable at the applicable rate to an individual depositor.
Previously it used to be taxed at a presumptive tax rate of 10%. Thus, decline in profit rates and taxability of their returns have forced retail investors to look towards the stock market where capital gain of sale of shares is still exempt from tax and dividend income is taxed at 10%.
FOREIGN INVESTORS: The first encounter of the retail investors with the stock market took place in 1991 when Nawaz Sharif opened the Pakistani stock markets for foreign investors.
An immediate entry of the foreign portfolio investors led to a short bull run in the market.
This euphoria also attracted the general public. However, lack of expertise of stock investing and politically volatile economic environments led to significant erosion in investors' wealth.
The 1993-94 bull run was the second occasion when small investors increased their participation in the market.
However, this foray into the market also did not prove very fruitful for the investors as the market suffered from bad crops and political mismanagement.
Moreover, the government came up with larger issues which absorbed the available liquidity in the market and left the market dry in terms of cash liquidity.
DOLLARISATION: The continuation of political mismanagement and uncertain economic environment pushed the stock market back into a depressing bear spell.
Retail investors primarily shifted their focus towards the American dollar, which led to a phenomenon popularly dubbed as the "dollarisation" of the economy.
Pak rupee witnessed a constant deprecation against the dollar in the 1990s and the Pak rupee went down from Rs 34.23 to a dollar, at the beginning of January 1996 to Rs 64.11 to one dollar at the end of September 2001.
That is annualised depreciation of about 15% approximately. Depreciation of rupee, together with total tax exemption of investments in foreign currency accounts, led to hordes of retail investors to dollar investment.
Total return on a dollar account ie rate of interest on dollar account and depreciation of Pakistani Rupee was more than other fixed income securities and stock market.
NUCLEAR EXPLOSION: The uncertain economic situation reached its bottom with the nuclear explosions in April 1998 and the subsequent imposition of economic sanctions.
This event completely destroyed the confidence in the market and led to a rapid exit by foreign investors. The market touched an all-time low of the KSE Index 765.
The situation was worsened by the fact that the sell-off by foreign investors was also absorbed primarily by retail investors.
FREEZING OF FOREIGN CURRENCY ACCOUNTS: Freezing of foreign currency accounts had a profound impact on Pakistan's economy.
Foreign investors lost confidence in the future of the country, let alone the local economy.
Among other adverse outcomes, this loss of confidence led to a considerable decrease in net portfolio investment held by foreigners in Pakistan and it resulted in net outflow of Rs 12.17 billion in the years 1991 to 2001, by the foreign investors.
Freezing of foreign currency accounts also led many Pakistani retail investors to transfer their liquid assets abroad, as there was no other attractive investment available in Pakistan and they had lost faith in government policy.
This outflow led to a sharp fall in the value of the Pak Rupee (nears 40%) Above all, due to low foreign currency reserves, the SBP also started purchasing dollars from the open market, which further accelerated the depreciation of the Pak Rupee.
Despite government efforts to attract foreign portfolio investments, the foreign investors stayed away from Pakistan.
Limited participation by local institutions and the speculative nature of retail investment kept the index exceptionally volatile and, in return, also confined the market within the risky zone.
9/11 EVENT: The events of September 11, however, led to the creation of a completely different scenario and money that was being channelled out of Pakistan started flowing back in.
Increased scrutiny by western countries of both the source and transference of funds residing abroad created numerous inconveniences for local citizens.
These funds thus started flowing back into the country leading to a considerable increase in domestic liquidity.
The excessive inflow of funds forced the State Bank to significantly reduce interest rates.
The SBP discount which used to be 14% in June 2001 came down to 7.5% in November 2002. The effective rate has further come down to the present 6.5% as evident by the yield on Ten years PIB.
Since a large portion of foreign assets owned by Pakistanis were denominated in dollars , the conversion of these assets into local currency led to a substantial appreciation of the rupee against the dollar.
The State Bank, in fact, had to actively participate in the market to ensure that the dollar did not fall to such an extent that it ended up hurting local exporters.
Reverse capital flows and increased remittances from Pakistanis abroad has led to a rise in foreign currency reserves to an unprecedented level of dollar 12 billion.
LIQUIDITY:
THE EASY LIQUIDITY ENVIRONMENTS LED TO A CHAIN OF EVENTS:
1) Firstly, the government reduced the profit rate on federal government securities which forced commercial banks (which have invested heavily in government papers) to decrease the rate of returns on banks deposits.
2) Secondly, the reduction of rate on federal government securities forced the government, on the pressure of the IMF, to reduce returns on government saving schemes.
Due to a decrease in returns on fixed income securities, and the lack of other money deployment opportunities, forced the retail investor to the stock market and created a new class of investors in Pakistan not witnessed before.
Unlike the typical old Pakistani individual investor, this class is fairly sophisticated in terms of investment decision-making. Instead of chasing rumours or inside information, this category of investor usually indulges itself in simple valuation methods like dividend yields and PER analysis.
The recent adaptation of simple methodologies by brokers' research houses has also helped this phenomenon to grow.
Moreover, relatively better fundamental coverage by local media channels in the local language has also helped small investors in developing a fundamental understanding of the market.
Lastly, the government's recent divestments, which were tilted towards favouring smaller investors, has created a fair amount of attraction for smaller investors to channel their savings into the stock market.
IPO: The stock market, however, allows small investors to benefit from the growth in the country's economy.
Participation in Initial Public Offerings (lPOs) is a good example in this regard.
lPOs are generally priced at a discount to their fair values and offer an opportunity for capital gains.
In the case of IPOs of private companies, such offerings serve a dual purpose: investors are offered a good opportunity to make a profit while the issuer gets access to a good source of funding.
Divestments by the government through public offerings similarly allows investors to enjoy handsome gains while allowing the government to fulfil its aim of privatising corporate entities.
An added benefit for retail investors in the case of government divestments, is, that small shareholders are given a preference in these offerings in order to broaden the ownership base.
One of the most successful offerings - for both the government and investors - has been the recent offering of shares of OGDCL.
Offered at PkR32 per share, the issue was 4.4 times oversubscribed, demonstrating the interest of the market, and quickly shot up to PkR52.
This phenomenon can also be proved in numerical terms. Over the last one year, the number of applicants for smaller shares in lPOs has grown tremendously.
The better performance by these IPOs in the secondary market has also boosted the investors' confidence in share investing.
SECP AND THE STOCK EXCHANGE: Another significant step which has made retail investors more comfortable with investing in the market has been the adoption of a more active role by the SECP.
The presence of a regulatory body looking after their interest instils a great deal of comfort among ordinary investors.
The SECP, in fact, considers the protection of small shareholders its foremost objective.
THE FOLLOWING ARE SEVERAL ACTION, BEHIND THIS ASSERTION:
1) Issuance of Code of Corporate governance by the SECP and being made part of listing regulations has led to superior corporate governance;
2) Compliance with IAS for listed companies, made mandatory by SECP, has improved financial reporting and
3) Quarterly reports have raised the confidence of investors in the operations of local companies, as they have timely information about their profitability, financial conditions and growth than they had before.
The Stock Exchange like the SECP, has taken a proactive role. The introduction of electronic trading and the consequent ability to confirm the validity of executed trades have also helped make investing in the stock market more acceptable to ordinary citizens.
Further, the introduction of the T+3 trading system and future trading have improved the credibility of the market.
The adoption of risk management measures such as Exposure Rules and Capital Adequacy requirement has decreased the volatility of the stock market and significantly aided in avoiding a crisis-like situation.
The creation of a central depository system has eliminated the worries of the physical custody of shares and the long tedious process of receipt and delivery of shares, on their purchase and sale. Further it has eased and reduced the cost of transfer of shares in their names.
MUTUAL FUNDS: Last, but not least, the launching of various mutual funds and investment schemes now offers ordinary investors, the ability to participate in the market without directly purchasing shares.
THIS DEVELOPMENT SHOULD HELP INCREASE THE PARTICIPATION OF RETAIL INVESTORS IN TWO KEY WAYS:
(1) it allows investors to start with very small amounts, which would not be possible if they wished to enter directly into the market,
(2) it will attract investors who do not wish to invest directly, but are willing to participate through experienced fund managers.
Net Assets value of all Open End Mutual Funds, including NIT, has risen to Rs 56 billion as at December 03, as compared to Rs 30 billion as at December 02.
Similarly Net asset value of Closed End Mutual Funds as at December 03, has gone up to Rs 19 billion from Rs 9.6 billion a year ago.
RETAIL OUTLETS: Brokerage houses are formulating plans with retail shareholders as a key target market and are taking various steps to increase their reach in the retail sector.
The launching of expensive online trading systems is evidence of this strategy.
RETAIL INVESTOR'S STRATEGY: Our experience with local small investors indicate that they tend to follow the strategy of buy and hold instead of booking nominal gains on an intra-day basis.
In fact, it has addressed the structural flaw in the Pakistani market that was created after the 1998 fiasco when foreign investors took their money out of Pakistan after the SBP slapped a funds transfer ban on them.
This resulted in the creation of huge stock liquidity in the local market and it has been the key reason behind the extreme price volatilities in the market.
We are of the opinion that this strategy of buy and held from retail investors has absorbed eventually the excess stock liquidity in the market.
This phenomenon has provided stability to the market in the long run.
Retail investors are thus an essential part of the equity market and are likely to assume a more and more important role as time moves forward.
There is no denying the fact that financial institutions have also been investors in the market.
After the recent promulgation by the SBP of new Prudential Regulations, restricting portfolio investments by banks in the stock market up to 20% of equity, the commercial banks are no longer major players in the stock market, as they have restricted their activities.
This should have resulted in the stock market coming down substantially, but it has consolidated and moved up as some of the excess portfolio selling by banks, has been absorbed by retail investors, as foreign investors are still keeping away from the local market.
Evidence suggests that retail investors are here to stay this time. Although the market crash of 1994 saw the departure of a large portion of retail investors, such a situation is unlikely to rise again.
While there is no denying that crashes and booms will witness decreased and increased participation by small shareholders, overall retail investors are likely to remain a cornerstone of the equity market.
Talking about fundamental valuations, the stock market is still offering significantly higher returns vis-à-vis other money deployment opportunities.
For instance if one looks at the dividend yields, the KSE offers an about 300bps higher dividend yield, compared to a medium term government bond, even if one ignores the usual process of comparing earnings growth and PER analysis of any given stock, a simple comparison of dividend yield justifies investments in the stock.
FUTURE: The future holds promise for the Karachi Stock Exchange at hands of the retail investors. Why?
The equation is pretty simple. Any stock market in the world needs medium term investors to hold the stocks, thus assisting the corporate sponsors to carry on their operations.
This was missing in Pakistan's story as, relatively, punters were driving the market throughout the 90's.
Foreign investors were of good quality; their short-term stay made them unreliable.
Retail investors, which are playing simple portfolio strategies of buy and hold, have actually replaced the foreign investors, both in terms of quality and quantity.
And this phenomenon has caused a paradigm shift at the KSE. The current bull run is just the beginning.
Where will the index will go from here? Most of the market gurus are talking about 5000. Everyone has underestimated retail investors in the past. The retail money is out to stay there and this will dictate the future market direction.