Solving Inflation: Funding the Fiscal Deficit

Many commentators have recently suggested that monetarism is dead in Pakistan. That the monetary base or money supply going up is not one-to-one linked with inflation in Pakistan.

The thing is money supply doesn’t have to perfectly correlate with inflation all the time. In the basic equation of monetarism MV=PY, there are three variables which affect the price level P. Money supply (M), velocity of money (V) and output (Y). A basic understanding of math would reveal that inflation is linked positively with money supply and velocity of money, but negatively with output.

So, if money supply is going up by 10% and inflation by 20%, it might very well be the case that the other 10% of inflation is being caused by an increase in velocity of money and/or a decrease in output (negative supply shock). Pakistan’s recurring balance-of-payment crises have created negative supply shocks (aka import restrictions) time after time, hence a key reason why money supply has not one-to-one correlated with inflation in Pakistan.

Beyond this, many commentators have also suggested that expansionary fiscal policy or large fiscal deficit is the major cause of inflation. The government’s spending binge might very well be a crucial cause of inflation, but the way it funds its deficit is even more important.

Let’s look at two ways the government funds its debt: printing money or raising it from the public via bond financing/sale. In the former case, the government introduces newly minted money in the system which raises aggregate demand – more money chasing same number of goods.

Usually, we say that when the public sector (government) runs a deficit, the private sector must run a surplus. In this scenario, the private sector does run a surplus, but that surplus is dissipated without repayment as the value of money held by the private sector reduces due to money printing. So, the revenue earned from seignorage via money printing is, in fact, a transfer of resources from the private to the public sector. We can also analyze this via a basic IS-LM model.

When government spending expands, the IS curve shifts right. When the government funds that deficit by printing new money, the LM curve shifts right. Thus, the effect of fiscal expansion on inflation is amplified.

Now, let’s say the government decides to fund its deficit through sale of bonds to the public. In this case, the private sector directly funds the government’s deficit. Because, when the government sells bonds to fund its consumption, the public buys them. In the process, the private sector consumption translates to government consumption.

This is possible since the sale of bonds raises the interest rate (reward for saving), hence nudging people to save (reduce consumption). Consequently, increase in government spending through bond financing is somewhat cancelled out by decrease in private consumption. So, the amplified inflation seen in the previous scenario doesn’t occur.

In the IS-LM model, when the government finances its spending through bond sales, money demand increases (due to rise in wealth) so real money supply falls and the LM curve shifts left (the IS curve would shift rightwards again but we’ll ignore that since it gets too complicated). Hence, the economy doesn’t overheat, and inflation remains in range.

This model, of course, assumes government bonds are net wealth which isn’t always true. When government bonds are not net wealth, the LM curve remains static. In non-economics terminology, this means that the public buys bonds by selling other assets (stocks). So still, inflation doesn’t run as high as we saw in the first scenario.

Takeaway: government should always finance a deficit via bonds and not money printing.

How does this all relate to Pakistan? Well in Pakistan, the government does fund its deficit through bond sales – at least on paper. Before SBP Act 2021, the government could borrow money directly from the State Bank (SBP). Since the SBP is owned solely by the government, profits made by the State Bank from lending went back to the government. Hence, borrowing from SBP was essentially the government printing new money.

To put an end to this, IMF demanded that there be a complete restriction on government borrowing from SBP. The government adhered to this. But then the government found a loophole. It could make SBP lend cash to commercial banks, via open market operations, and the banks could lend cash back to the government. Hence, a new formula for money printing.

Once you realize this catch, the extraordinary inflation of the past two years becomes quite clear. What’s the way out of this then? Well, the government must fund its deficit truly through bond sales – in spirit, not just on paper.

Currently, the government sells bonds mostly to commercial banks – its main buyer. The liquidity from this avenue has been stretched to the max. However, there is potential to extract additional liquidity from the system by selling bonds directly to the public. Making it easier for the public to buy/sell bonds would do just that. The current procedure to do so is overly cumbersome in Pakistan.

Alternatively, SBP could promote and support the development of financial institutions such as microfinance banks, pension funds and insurance sector. All these savings institutions would extract existing liquidity from the system which can be utilized to fund the government deficit. For instance, microfinance banks attract deposits which the banks cannot or do not want to.

Making it more accessible for the public to buy/sell bonds and promoting new financial institutions would not only reduce inflation but also produce spillover benefits. It would reduce the government’s reliance on commercial banks for borrowing. Moreover, government’s borrowing costs would fall since the spread charged by banks would be squeezed with more competition from the public and other financial institutions.

Left out of PSX rally: Insurance Companies

 

Since the announcement of the IMF staff-level agreement, the Pakistani stock market has witnessed a spectacular rally. However, during this rally, certain sectors have received more attention than others. One of the sectors which has been largely left out of the rally – despite being a direct beneficiary of the rally – is the insurance sector.

The insurance business model consists of collecting premiums from clients and investing those premiums in fixed income and equities. The difference between net premiums received plus income from investing those premiums and claims paid out plus expenses is the earnings of an insurance company.

Usually, net premiums received, and expenses are not volatile figures. But claims paid out and investment income can be volatile. This is because claims paid out can vary heavily depending on the amount and frequency of claims. For instance, a large, insured factory might have a fire incident leading to an unexpectedly high claim amount paid in a particular quarter.

The smaller the insurance company, the more volatile the earnings tend to be due to variation in claims paid out – a result of the law of large numbers. This is why large insurance companies, particularly in the life segment, tend to have stable and rising earnings as their liabilities take longer to mature and their size allows them to take advantage of the law of large numbers.

Investment income – too – can be volatile depending on the capital allocated between fixed income and equities. Fixed income investment tends to be of low risk and thus less volatile, while equities are far riskier and hence, their investment value is more volatile.

Adamjee Insurance allocates roughly half of its investment portfolio to fixed income and the other half to equities. This is why you’ll notice that its earnings are highly volatile:

From the photo above, one would quickly notice that Adamjee Insurance’s earnings peak in years where equities rally and staggers in periods where equities perform poorly. So, stock market performance has a profound impact on the earnings of insurance companies, particularly those who allocate their capital more heavily towards equities.

So, why hasn’t the market taken notice of it? Well, it has – kind of. Following the IMF SLA, Adamjee Insurance’s share price has risen 28%. However, it took three weeks for the market to notice that Adamjee Insurance would be a key beneficiary of the stock market rally.

Following this, other insurance companies saw slight reratings. For example, Jubilee Life Insurance’s share price rallied 11% in July. All of this is quite rational since insurance companies such as Adamjee and Jubilee Insurance tend to have stable payout ratios, thus if earnings go up, so will dividends.

Yet, the market is not correctly pricing in expected rise in earnings. A caveat to the stock market rally affecting insurance earnings is that the earnings will only rise from CY23Q3. Because the first trading day after the IMF SLA was 3^rd July. This means the rise in investment income from the recent stock market rally will show up in the third quarter’s financial reporting.

Despite this, there are a few insurance companies who would benefit due to massive improvements in the value of their investments. Analyzing their financials can be a good guide to finding undervalued insurance companies which would reveal bumper earnings in Q3 and onwards.

Century Insurance is a small-cap insurance company. Much like Adamjee Insurance, it allocates roughly half of its portfolio to equities and the other half to fixed income. This makes it well positioned to benefit from the stock market rally. But it will likely see supersized earnings in Q2 as well.

Century Insurance owns 0.037% of Colgate Palmolive. It owned 44646 shares of Colgate Palmolive at the start of Q2 – worth Rs 59.6 mn. Post bonus issuance, that turned into 89291 shares which at the end of Q2 were worth Rs 100.2 mn. That imputes an unrealized gain of Rs 40.6 mn.

Now, Century Insurance’s Q1 investment income was Rs 61 mn of which Rs 2.6 mn was from its investment in Colgate Palmolive. Holding all else constant, Century Insurance’s investment income for Q2 should be Rs 99 mn. That would imply an earnings per share (EPS) of Rs 2.29 – a 44% increase over Q1.

Obviously, the final EPS might be more or less depending on claims paid as well as how Century Insurance’s other equity investments performed. In other words, all else is likely to not be constant. But one thing is for certain, the gain from its investment in Colgate Palmolive creates a significant enough buffer to say that Century Insurance’s Q2 earnings should be significantly higher.

Investments by insurance companies and the value of most of these investments can be found through publicly available information. Using this information, an investor can make a good estimate of which insurance companies are primed to benefit most from the stock market rally.

 

Common Fallacy: Misuse of Relative Valuation

 

Lately, lots of brokerage and equity research firms have been comparing price-to-earnings ratio (PE) over time to show how cheap Pakistani stocks are. While Pakistani stocks may be cheap as per historical standards, the usage of PE to justify it is completely flawed.

Fundamentally speaking, PE is a relative valuation metric; that means, it only tells you how cheap a company is relative to the sector. Even that comes with a caveat: provided that the comparison is to companies with similar characteristics – a condition which we will return to later.

PE tells you nothing about how cheap one market is to another (country-to-country comparison) nor how cheap a market is over time. To comprehend this, one has to evaluate the theoretical basis of PE.

The Gordon growth model can be used to determine value of equity: P = D1/(r - g). Dividing this by earnings would give you PE: PE = Dividend payout ratio/(r - g). Now, you have a theoretical basis to understand all the factors which influence PE.

In the formula for PE, you’d see that r and g (in denominator) are the key determinants of PE. If growth rate (g) goes up, PE becomes higher and if cost of equity (r) goes up, PE becomes lower.

Cost of equity is generally calculated by adding an equity risk premium (ERP) to the risk-free rate (base interest rates). So, if the State Bank hikes interest rates, PE ratio for PSX should automatically go down. Note that interest rates are at record-high levels, hence it makes sense that PE for KSE100 remains low. Therefore, using PE to say KSE100 is cheap right now is useless. It ignores the fundamental relationship between interest rates and equities.

Similarly, PE cannot be utilized to compare markets to one another. For instance, Pakistan’s ERP is likely to be far higher than USA’s due to various issues such as poor corporate governance or high political instability. Consequently, stable period PE would be far lower for Pakistan relative to the USA.  

So, what can PE really be used for? It can be used to make relative valuation plays. PE only tells you if a company is trading cheaply relative to its peers (sector averages) which share similar characteristics. What are those similar characteristics? They could include growth rate, dividend payout/yield and risk. This is coming directly from the PE formula used above.

Since growth rate is a significant determinant of PE, investors often opt to use PEG ratio which is simply PE divided by the growth rate of the company. On the other hand, companies with higher dividend yield or payout tend to trade at higher PE multiples as larger payouts are associated with lower risk – a tenet since the dawn of the joint-stock company.

So, dividend yield/payout ratio can be used as a gauge of risk and many investors incorporate this to a make a new metric out of the PEG ratio. However, others opt to use statistical standard deviation as a proxy of risk which is fine too.

By performing such relative valuation, investors can exploit temporary mispricing of securities in the market. This blog has previously done such analysis for HBL which yielded favorable results.

But note, if the sector itself sees a selloff due to any reason, then the relatively mispriced security will trade downwards as well. So, for relative mispricing to be corrected by the market, there has to be a significant positive trigger which was higher earnings in the case of HBL.

Now that the fallacies regarding the usage of relative valuation metrics have been clarified, how can an investor determine if the market is cheap? There is an excellent metric for this: 5-year annualized return for KSE100.

Much like the economy, markets are cyclical. A boom is often followed by a slump and vice versa ad infinitum. The above graph shows that cyclically, the KSE100 index is in its slump phase. It’s anyone’s guess when the market could return to the boom phase. But this is still an excellent indicator that KSE100 is cheap given its position in the market cycle.

A Case for Not Hiking Interest Rates and Tackling Risk Premium

 

Business Recorder recently proposed that the State Bank (SBP) should hike interest rates to attract foreign portfolio investment (FPI). According to Business Recorder, it would help ease pressure on the external balance, which is usually true. However, a key link is missing between rising interest rates and inflow of FPI in this story.

On a fundamental basis, the return from FPI is exchange gain/loss plus gain/loss on investment. As we’ve all heard many times, when interest rates go up bond prices go down. So why would investors buy foreign bonds when interest rates go up? Well, because on the other side of the picture, yield goes up. The picture is sweetened by the fact that when interest rates go up in a country, the domestic currency appreciates. So, foreign investors receive heftier payments in their home currency.

This story works frictionlessly for developed economies. Investors give developed countries the benefit of doubt through their confidence in them. When the currency or assets of a developed country become cheap, investors gobble them up.  

When interest rates go up in the developed world, investors’ cash flows towards that part of the world. But that cash has to come from somewhere else – the developing world. The resulting capital flight from the developing world to the developed world causes huge pain for developing countries.

Developing countries are left with depleting foreign exchange reserves and a rapidly depreciating currency which creates uncertainty. This uncertainty heightens the concerned country’s risk premium. Thus, generating a devastating price-to-price feedback loop where foreign investors sell assets in that country which produces a higher risk premium, hence more uncertainty and more capital flight and so on.

This story has played itself out many times in Pakistan. In response, IMF mandates countries like Pakistan to hike interest rates to help retain foreign capital in the country. But it usually doesn’t work.

The key friction here is confidence. Fund managers don’t want to be seen holding a pile of shit, so they avoid it even though they know it’s cheap; only until others start buying in. We observe this with the Pakistani stock market as of recent where foreign investors performed net buying of $14.91 mn in July after IMF’s vote of confidence with the approval of the stand-by arrangement.

So, the important factor to tackle here is confidence. Without confidence, risk premium remains high and so foreign portfolio investors remain on the sidelines. This is an assertion Gita Gopinath makes in a recently co-authored working paper. Hiking interest rates can actually increase risk premium by lowering a country’s growth rate or worsening its economic conditions.

To understand the importance of risk premium, look no further than what has happened this year. The regional banking crisis in the USA and fall of Credit Suisse in Europe sparked concerns of a worldwide banking crisis. Banking stocks saw massive sell-off across the board regardless of idiosyncratic characteristics of each bank.

Investors are prone to such herd behavior as, again, they don’t want to be seen holding a stinky pile of shit. The same happens time after time with emerging markets, particularly when many of them are going through a political crisis.

This herd behavior can be used to a region’s advantage too. Following elections in Brazil, investors suddenly saw political stability in Latin American countries. Brazil’s successful and peaceful transition of power acted as a trigger for inflow of capital.

This was inflow of capital was magnified by the fact that real interest rates turned positive for several Latin American countries. But all Latin American countries were beneficiaries of this in the form of improved foreign reserves. Countries like Peru, which still run a negative real interest rate, saw an appreciating currency and improved external balance.

But why would a positive real interest rate attract foreign inflows? Because, when interest rates fall, bond prices rally so capital gains on domestic bonds are in play. So, the real trigger for foreign inflows is not positive real interest rates but expectations of the central bank cutting interest rates.

By timing the market, foreign portfolio investors avoid both a currency mismatch and duration risk. And they love to jump in when interest rates are about to fall in emerging markets. 

How can Pakistan use this knowledge to their leverage? Well, a quick look across the border to India would give a good model. Invoke confidence and enhance political stability. Unlike SBP’s failed forward guidance, the Pakistani government or establishment should issue forward guidance on the path to or timeline of elections.

By clearly committing to a line of action, the Pakistani government can calm the markets and reduce risk premium. Secondly, remaining committed to the IMF programme is of the utmost importance. It would be paramount in keeping default risk at bay. By giving the impression that the Pakistani government has things in control, it can isolate itself from other emerging markets in the eyes of foreign investors.

Lastly, further hikes in interest rates should be avoided at all costs. Hiking interest rates is completely futile at this point as it does not help bring down inflation but rather causes further deterioration in the fiscal position and economic growth.

As this blog has reiterated many times, private sector credit has been curtailed as far as it could be. In fact, hiking interest rates is counterproductive. It curbs the supply side and increases inflation through higher cost pass-through due to significant pricing power of the formal sector. By avoiding worsening of fiscal debt and economic growth, risk premium will be reduced hence attracting foreign inflows and improving Pakistan’s external balance.

Inflation can only be challenged by a reduction in money supply. That would only happen when either the SBP stops accommodating government borrowing or the government induces a fiscal contraction. Raising the cost of government borrowing does nothing but harm the economy.

 

The PSX Racket: How Volatility Gets Amplified

 

This week has seen the KSE100 index act like a seesaw both intraday and day-to-day. Over the past few days, news headlines have been plastered with how the ‘bulls’ or ‘bears’ have taken over the Pakistan Stock Exchange (PSX). But why has there been so much volatility, particularly this week?

When someone would ask JP Morgan (the man, not the bank) what the stock market would do, he would say, “I can tell you exactly what it will do for years to come. It will fluctuate”. And that very well stands true for any stock market. But this statement is even more true when uncertainty is pervasive.

Currently, Pakistan is going through a nervy phase. The National Assembly has been dissolved and the caretaker government is due to takeover. However, the Caretaker Prime Minister has not been appointed yet. Moreover, there is huge unclarity over how long the caretaker setup will last and what their mandate would be.

All this had led to a lack of confidence among investors. And when there’s a lack of confidence or an abundance of confusion, markets tend to work like a gambling racket. Just like Pakistan Men’s Cricket Team, the stock market too is ‘one minute down, next minute up’.

Unfortunately, this lack of confidence has been taken advantage of. Certain market participants (ahem, brokers, ahem) pumped and dumped certain pieces of news through their network of WhatsApp groups. For instance, there has been a lot of speculation over the resolution of gas circular debt. These rumors have been vigorously pumped as the truth on some days and a lie on other days. Resultantly, index-heavy oil and gas SOEs like PSO, OGDC, PPL and SNGP have seen heightened volatility.

On the 8^th of August, both oil & gas saw heavy selling as the same market participants pushed forth the view that the caretaker government cannot clear circular debt – which is false. After amendment of the Election Act 2017, caretaker government is empowered to take policy decisions such as clearance of circular debt.

Similarly, the new refinery policy was pumped positively on one day and seen completely negatively the next day. As a consequence, refinery stocks, too, have been a victim of aggressive news manipulation.

Although, these are specific incidences of what caused the spike in volatility, there are underlying reasons for why PSX is a relatively more volatile market. For example, the high usage of stop-loss orders amplifies volatility. Brokers regularly encourage their clients to put stop-losses at certain price or support levels.

Now, when the market witnesses even a slight bit of selling at market price, a huge number of stop-loss orders get activated and the selling intensifies. This creates a price-to-price feedback loop where lower prices encourage more selling, activating more stop-loss selling and so on.

Furthermore, some players in the market can use information about levels at which stop-loss orders are placed to generate huge selling to make a stock cheaper. This allows them to shadily buy back the shares at a lower price.

On top of all this, PSX investors appear to have a high confidence multiplier. That is, when the market goes up, confidence returns doubly but when the market goes down, confidence tanks harder. This creates an intensified price-to-price feedback where higher share prices produce more buying and vice versa.

And then there are our lovely technical analysts. These analysts come out with their charts and get spooked when their charts start showing them ghosts. And when these analysts share their charts showing wiggly but scary lines, the market gets spooked too because if others believe the index will fall, why shouldn’t they believe it? Sell before others would sell, no?

Finally, we arrive at our famous ‘profit-taking’ behavior. Brokers frequently recommend profit-taking to their clients. As a result, volumes intensify but so does selling pressure which again lands the market in a destructive feedback loop.

So, the magnified volatility is not a consequence of one factor but a multitude of them. But who is the main culprit in causing such volatility? Uneducated investors? A passive SECP? Brokers? Depends on who you are and how you look at the racket.

Imran Khan: How New Players Destabilize Pakistan

 

Lately, the news cycle has been dominated by Imran Khan’s three-year jail sentence, disqualification from elections and his subsequent arrest. Much has been said about it. Dawn recently posted an editorial stating that Nawaz Sharif and Benazir could not be kept out of politics after confronting a fate similar to Khan. And thus, Khan should fare no differently. But that completely depends on Khan.

Democracy is a political system that arose following objections against monarchy. After the renaissance, monarchy was seen in a bad light due to its autocratic nature, lack of representation but most importantly, inability to peacefully transfer power. This is ironic as Hobbes had believed that monarchy could enable peaceful transfer of power, hence prevent a life that is “solitary, poor, nasty, brutish, and short”.

But time after time, succession disputes turned violent under monarchic regimes. This provided impetus for a democratic system to come about as citizens demanded protection of life and eventually, liberty and property. Looking through this lens, one realizes that democracy in Pakistan has completely failed.

Not only have political leaders been brought to the helm illegally, but democracy has been unable to bring about a stable and peaceful transition of power.

Imran Khan was brought to power through undemocratic means as he was supposedly not corrupt and relatively easy to control for the establishment. Along with the judiciary, he was tasked with punishing the old political elite (PPP and PMLN) for their corrupt ways while correcting their economics errors and delivering growth.

Time and time again, former COAS Qamar Bajwa has emphasized the need for Pakistan to return to a path of economic growth. This is not out of goodwill but pure self-interest of the Pakistan Army. One would note that the army’s budget as a percentage of the total federal budget has fallen from high 20s percent to the current 13%.

Not only is the pie getting smaller but so is the army’s portion of it. That is what had spooked Bajwa. Meanwhile, a glance across the border would show that the Indian Army’s budget gets bigger even as its proportion of the budget remains same. Why? Because in India, the pie seems to be getting bigger.

With this mission, the judiciary, army and Khan were getting along well until they weren’t. And when the consensus broke, chaos spread. But this disorder only occurred when institutional infighting had begun.

There are five key institutions in Pakistan: the army, judiciary, political elite, maulvis and bureaucracy. Bureaucracy has been largely out of the limelight for decades now but so is the nature of the game – some powers rise, others fall.

Within this multi-polar system, disorder starts only when an institution begins fighting with another. Or when an institution fights among themselves. This has a ripple effect. Players in other institutions begin taking sides in either fight, thus causing internal disorder within every institution but one – the army.

The army is the only institution which is stable largely because it remains loyal to its own even in the most adverse scenarios. This loyalty is enhanced by their professional and ethnically diverse presence. Perhaps, this is the reason why army continues receiving favorable support and acceptance from the Pakistani people.

Just take the chaos of the past two years as an example. Constant mudslinging between PDM and PTI divided the judiciary and political elite along partisan lines. Maulvis took a partisan position as well but not with the same vigour or passion. Bureaucracy largely remained neutral as it has over the past few decades. Meanwhile, the army remained composed – it acted as the stabilizer.

The army brought about changes as per its will, much to the displeasure of many voters. However, in one way or another, it was forced to given the lack of consensus among the political elite. Therein lies the problem.

Before Khan, the political system was well-balanced due to its bipolar nature. Both PMLN and PPP would pass bills and amendments along bipartisan lines. Together they were able to pass the 18th amendment which curtailed the army’s influence by making the center smaller. Having been in the game for so long, they had an understanding.

Khan’s entry disrupted the system and divided the political elite again. This is not a critique of Imran Khan but rather a critique of the system. More competition in the political sphere is harmful rather than helpful as competition is usually thought to be. Lately, that is the source of instability.

The key to stability can either be a full embrace of democracy with civilians ruling the country and other institutions acting as subordinates but supreme in their own rights. That would be an optimist’s dream. A realist would argue that it would be better if each institution either became inherently neutral or became unified in their belief and loyalty like the army.

How do the dots connect back to Khan and Dawn’s editorial? Well, Khan can certainly make a comeback but only if he wishes to make one. That wish is dependent on his willingness to play the establishment’s game. Or coordinate with the political elite as PMLN and PPP have done for many years. The latter would be better given its remarkably positive impact on stability in Pakistan.

PPL & OGDC: Mispricing of Circular Debt News?

 

On 4th August, Ministry of Finance (MoF) essentially confirmed the rumours that circular debt in the gas sector is being resolved (albeit after the market had closed). The rumours had started floating a week earlier on 27th July – again after the market closed.

The rumours had been slowly getting priced in over this past week. PPL share price is up 5% for the week. Meanwhile, OGDC finished the week 17% up. This is an anomaly.

Naturally, both companies should see equal gains. Why? Because although circular debt is getting resolved, the exact number of receivables being settled for both companies is unknown right now. Consequently, the expected FCF per shareholder from the circular debt settlement is unknown for each company.

As noted in the last blog, this exact scenario had played out six to seven months ago. Back then, PPL and OGDC share price peaked at the same time – 9th February 2023. Rumours of gas circular debt settlement had began circulating on 22nd December 2022, so the last trading day before the rumours made their way through the market was 21st December.

OGDC share price rose 52% from 21st December till its peak on 9th February. Similarly, PPL share price rose 62% over the same period. Note, there is a variance of 10% in returns. This is difficult to explain, since the expected rise in FCFs or dividends from that circular debt settlement plan was higher for OGDC. A possible reason can be that PPL has a higher beta than OGDC but that’s not a viable explanation, since news flow was driving the share price rather than an index-wide gain.

It's far more likely that the market was temporarily inefficient as is the case now. Usually this happens when certain stocks get pumped by certain ‘experts’ as well as technical analysts. Also, phenomena like price-to-price feedback come into play; that is, people buy a stock precisely because it is going up, so price goes up because price went up. That may partially explain why PPL had soared more earlier this year, while OGDC is outperforming PPL right now.

With MoF confirming the rumours of gas circular debt reduction, it is expected that the news will be further priced in next week. It is difficult to say whether returns on PPL will converge to that of OGDC. But on the odd chance that the market takes notice of this, PPL should see better gains than OGDC from here on. At least until the exact plan of circular debt settlement is revealed by MoF.

Gas Sector: In for a Bonanza?

On 1^st June, Pakistan Petroleum Exploration & Production Companies’ Association (PPEPCA) had requested the government to issue a Rs 500 bn budgetary grant for state-owned enterprises (SOEs) suffering from circular debt in the gas sector. Its demands were ignored.

Then on July 17^th, PPEPCA wrote a letter to the Ministry of Finance (MoF). The letter warned the MoF that the gas sector was on the verge of financial collapse due to cash flow issues originating from circular debt.

PPEPCA threatened to halt exploration activities and reduce gas supply if their demands of retiring circular debt were not met. This seems to have caught the attention of MoF, since a few days later the Economic Coordination Committee allowed exploration & production (E&P) firms to pay sales tax on an installment basis.

But now, it appears that the IMF wants more action. As per ‘ARY sources’, IMF actually wants the government to settle some part of the gas circular debt – Rs 415 bn worth. Now, it’s difficult to say how reliable these sources are; yet the news might be plausible.

IMF’s Staff Report – which was released a couple of weeks ago – placed a strong emphasis on circular debt. It might be possible that the IMF saw complaints and threats from PPEPCA and decided that some part of the circular debt had to be settled.

But market participants would remember that this same scenario played itself out back in January and February 2023. Rumors came out that the MoF was planning to settle Rs 543 bn worth of circular debt, mostly to be paid to PPL and OGDC – OGDC being the bigger beneficiary.

As a consequence, PPL and OGDC’s share prices skyrocketed more than 30-40% within a matter of weeks. But then, the IMF shut down these plans as it wanted the government to raise gas prices instead of settling circular debt.

Note, the IMF is not against settlement of circular debt via means of issuing bonds, grants, or dividends among SOEs. It has allowed this in the past with both the gas and power sector, most recently back in 2021. However, at the time, it wanted the government to stop the bleeding or rather, the increase in circular debt first.

Consequently, the government raised gas prices but didn’t settle any circular debt in February – just as the IMF asked. PPL and OGDC share prices came tumbling down on that news.

Many people would, and have, suggested that this is a classic pump-and-dump. But it’s not. E&P SOEs are continually trading at distressed values because they have serious cash flow issues resulting from circular debt. Moreover, the government treats them as a black hole for subsidizing gas to domestic consumers. But, if any part of their receivables actualizes into cash flows, that generates a massive impact for them given their distressed valuations.

To understand this, let’s assume that PPL and OGDC both receive Rs 100 bn each in cash inflows due to the gas sector circular debt settlement. PPL and OGDC have 2.7 bn and 4.3 bn shares, respectively. That imputes a free cash flow addition per share of Rs 37 and Rs 23 for PPL and OGDC, respectively. That is – essentially – cash which can be distributed to PPL and OGDC shareholders via dividends.

Now, if it’s confirmed that PPL and OGDC are in fact receiving such amounts, then their share price must go up and reflect this increase in free cash flow. Hence, it makes perfect sense for their share prices to go up on the rumors of circular debt settlement within the gas sector.

But obviously, right now we do not have such details. It is unclear how much of the circular debt being cleared will make its way to OGDC, PPL or other SOEs. Additionally, the probability of this circular debt being settled is hard to estimate too. The probability of this event happening depends completely on individual investors – some may be pessimistic, others optimistic.

As a basic formula for absolute gain in share price of company X, one should use this: (Probability of event happening) multiplied by (Amount of circular debt being settled for X) divided by (X’s number of shares). So, let’s say I assign a 50% chance of PPL receiving Rs 100 bn, then its share price should go up by Rs 18.5 from its closing price on the last trading day before this news came out – that would be 27th July.

The circular debt may or may not get settled. It’s a game of probabilities now.

HBL: A Case of the Market Not Pricing In Earnings

 

HBL announced its CY23Q2 financial results a couple of days ago on the 26th of July. The market responded by dumping its shares after the announcement of results. At one point, HBL shares traded 5% down for the day. It ended the day trading 0.59% down. What happened?

Well, for some irrational reason, the market was expecting a significant dividend from HBL. Perhaps the expectations had been built up after UBL’s results – announced a week earlier – beat market expectations. However, HBL’s payout ratio had been 29% for CY22. It had been 17% for CY23Q1. Its payout ratio for Q2 came in at 23%, which is normal. So, to expect a large dividend would be foolish. And boy was it foolish.

A day later on the 27th of July, HBL shares finished the day trading at Rs 90.77 – up 7.4% for the day. Now, why exactly had this happened? Well, because HBL’s financial result was still spectacular. HBL’s earnings per share (EPS) came in at Rs 8.86 – just below Q1’s Rs 9. HBL’s earnings were 52% higher than what it had earned in each quarter of CY22 on average.

Now, obviously none of this is limited to just HBL. The banking sector, on the whole, has enjoyed a period of incredible earnings. This comes on the back of SBP hiking the interest rate to an all-time high of 22% – which is expected to go up further by 100 basis points on 31st July. As a result, banking spreads are at a record high 9.73%.

Banks borrow from depositors at an average cost of 11-12% and lend it to the government at 22%. In the process, they earn an incredible risk-free return. On top of this, SBP injects cash into the banking sector through open-market operations allowing banks to borrow funds from SBP at 20-21% and lend it out to the government at 22%. Another risk-free, easy spread.

Now that the banking story is out of the way, why did HBL’s share price witness that seesaw? Well, the market suddenly realized that HBL’s earnings were too good for the price at which its share was currently trading. In other words, its price to earnings ratio (PE) was too low. Where other banks are trading at a PE of 3 and beyond, HBL was trading at a PE of 2.57 when its Q2 results were announced. The market hadn’t priced in HBL’s earnings.

Why is this important? Because earnings – whether retained or paid through dividends – are cash that has or will be returned to the shareholders. Usually, we would say that free cash flow is the metric to look at when determining how much cash would be returned to shareholders. However, in the case of banks it is impossible to know their free cash flow. This is simply because a bank’s business model relies on cash itself. So, earnings are the way to go for a bank.

HBL is currently trading at a trailing PE of 2.76. In comparison, UBL and MCB are trading at a trailing PE of 3.92 and 3.53 respectively. UBL and MCB are the most comparable banks to HBL based on risk, growth, deposit/asset base and legacy/brand.

So, the comparison of them to HBL makes the most sense. This is also crucial because the driving or defining variable in PE ratio calculation is growth and secondarily, risk and dividend yield. This is why many investors choose to use PEG ratio instead of PE for fundamental analysis. Calculations for the trailing PE can be found here.

The key thing to note is that HBL offers a lower dividend payout ratio than its peers. Secondly, HBL possesses some idiosyncratic risk with regards to some legal cases. Consequently, it makes complete sense that HBL would trade at a discount to other banks like UBL or MCB. However, its current share price implies a discount which is way too steep.

The average of UBL and MCB’s trailing PE is 3.72. And since HBL is trading at a PE of 2.76, that implies a 26% discount. This is way out of order. Especially since HBL had been trading at a PE ratio of 3 plus for most months of the current year. In fact, it was trading at a PE ratio of more than 3.1 after its CY22 and CY23Q1 financial results. At the same time, it was trading at a discount of about 15% to other banks like UBL and MCB.

So, if we assume a 15% discount to UBL and MCB’s PE and assume that HBL should trade at this PE, then HBL’s share price comes out at Rs 104.4. That imputes a 14.8% return if one were to buy HBL shares at its closing price on Thursday.

It’s clear that HBL is undervalued, but is it guaranteed that the market would realize this? Well, the market has already begun realizing it since the share traded 7.4% up on Thursday. In addition, the banking sector is witnessing an incredible rally with many banking stocks up by 30-50% since the announcement of IMF SLA. Hence, there is a high chance that the market would not leave this unnoticed.

The trigger might not be definitively strong but it is strong enough to make a quickfire 15% return likely.

 

The PICT Saga: The Market Overbuys?

 

Pakistan International Container Terminal’s (PICT) share price has plunged from Rs 134.5 on 12th June to Rs 58.5 on 27th July. That implies a steep decline of 56.5%. Most of PICT’s ride downwards is well justified, but the stock has picked up 52% from its low of Rs 38.6 on 7th July. Is there any credence to this rise?

One would consider PICT to be a sleepy stock. Its share price rarely budged after the 2017-18 market-wide selloff. It continued paying an above-average dividend yield over the years. Steady and rising dividends with low volatility. Sounds good, doesn’t it?

However, its shareholders barely took notice of the fact that PICT lost two court cases against the Government of Pakistan for renewal of its concession contract – first on 2nd of March and later on 6th of June (2023). It took till 12th June for the market to take notice of the fact that PICT may not remain an operating business for long; although insiders had been selling for days before that.

Now, PICT would be winding up as Abu Dhabi ports is set to take over PICT’s container terminal operations. This is a classic case of liquidation, so the share price should reflect PICT’s liquidation value. Or in other words, the value of its final dividend payout to shareholders.

How do we find PICT’s true value? There are multiple ways. You can begin with a book value approach. Take book value, add expected profit for Q2 and divide by number of shares. This approach imputes a value of Rs 39.8 per share.

Secondly, a net asset approach can be used. Under this approach liabilities can be netted off from assets and expected Q2 profit. According to my calculations, with some reasonable assumptions for assets sold at a discount, PICT’s final share price comes in at Rs 34.6. 

However, I have not incorporated non-current assets into this calculation as PICT’s financial reports make it unclear which non-current assets are to be transferred to Karachi Port Trust as per concession agreement. To balance this effect out, I did not apply a margin of safety to my calculations. Thus, a conservative estimate of PICT’s final share price would be Rs 34.6. Although, the true share price could be higher especially if there are off-book assets (and higher Q2 profit which is likely).

The last method is one which Warren Buffett would use for cigar butt shares. It is called the net current asset value (NCAV) approach. Under this approach, current liabilities and value of preferred shares are netted off from current assets. Current assets and liabilities are used as they are mostly liquid and are likely to be worth market value. While preferred shares are netted off as preference shares have seniority.  

At one point in time, PICT did have preference shares, but they were redeemable. PICT did redeem them hence one would notice that there are no listed PICT preference shares on PSX now. So, adding Q2 expected profit to the NCAV imputes a value of Rs 36.7. Calculations for all three approaches can be found here.

Note that all three approaches give relatively similar share prices due to simplicity of the scenario. The share price ranges from Rs 34.6 to 39.8 as per the three approaches. But the best approach is certainly the net asset approach simply due to its conservative nature. Consequently, investors can be certain that PICT’s share price must be about Rs 34.

Now, normally the market should react to bring the share price to around Rs 34 once it becomes aware of this information and halts the recent speculative buying. However, the market may still be irrationally optimistic. In that case, a potential investor with this information should know that PICT’s final dividend should be close to Rs 34.

As of now, PICT’s share is trading 40% above its net asset value. It may be true that the market still thinks PICT has a chance of attaining another concession agreement with Karachi Port Trust. However, with Abu Dhabi Ports’ recent expansion at Karachi Port, the chances are very slim as there is little to no land left for potential terminal expansion at Karachi Port.

There might be a possibility that investors with inside information are buying PICT shares – as often is the case in Pakistan. But this would indicate that either PICT has excessive off book assets (non-current assets not transferable under concession agreement) or that PICT is close to achieving a new concession agreement with Karachi Port Trust.

Either way, a regular investor shouldn’t take the risk of buying PICT shares. Because the chances of the above scenarios are low. Plus, publicly available information reveals that PICT will be liquidated at a value far below its current share price.

Why Running a Current Account Deficit Isn’t Bad for Pakistan

 

After more than two years, Pakistan began running current account surpluses on the back of import restrictions earlier this year. The PDM government used this fact as a testament of their policies. But is a current account surplus that desirable? Or rather is a current account deficit that bad?

First, let’s get some basics out of the way. There is a famous accounting identity which is always thrown around when discussing the current account. That is: a nation’s current account must be balanced out by its capital account.

Historically, Pakistan has ran a current account deficit and so, as a matter of sheer accounting, Pakistan has also run a capital account surplus. Why? Because a current account balance – among many things – is the savings of a nation’s net of its investments. So, if Pakistan runs a current account deficit, it means that it is borrowing savings from abroad (foreigners).

Recently, many Pakistani ‘economists’ have said that Pakistan is putting the country up for sale. These statements arose from Abu Dhabi Ports takeover of Karachi port terminals. But because Pakistan consistently runs a current account deficit and is unable to attract international debt flows or foreign direct investment (FDI), putting the country ‘for sale’ is a natural consequence.

Now, borrowing savings from foreigners isn’t bad in of itself. However, Pakistan borrows savings to fund its large and persistent fiscal deficit. This is called the ‘twin deficits phenomenon’.

So, to understand the nature of Pakistan’s current account deficit, one has to study its fiscal spending/deficit. And Pakistan’s fiscal spending is largely wasteful and excessive with little investment in productive capacity or productivity-enhancing avenues.

Borrowing from foreigners only makes sense if it’s sustainable and it enhances a nation’s future income so that they can repay the foreigners in the future. In Pakistan’s case, the borrowing from foreigners is in the highly volatile form of debt flows. This is dangerous as when confidence tanks, so do these debt inflows.

At the same time, the capital account surplus has to be channeled towards projects which enhance the nation’s future income. This way, the nation’s GDP growth should outrun debt servicing costs allowing the nation to repay the foreigners in the future. This does not take place in Pakistan. To understand why, the current account has to be thought of in another way.

Another way of thinking about current account is net exports sum net income flows and net current transfers. To simplify this, think of it as current account = exports – imports – net profit repatriation + net remittances. These are generally the main components of a current account especially in the case of Pakistan.

Among all this, net profit repatriation is not something that can be controlled as it depends on the business performance of FDI. Similarly, net remittances are not something that can be directly influenced as they rely on the willingness/need of people to repatriate their salaries which were earned abroad.

So, the only component in the current account which can be guided by policymakers is the net exports. And it also happens to be the largest component of Pakistan’s current account.

In FY22, Pakistan’s net exports were minus $48 bn. Exports stood at $31.8 bn while imports stood at $80.1 bn. Many analysts and commentators have repeatedly stated that Pakistan needs to focus on exporting more and rightfully so. However, this ignores the composition of our imports.

Economic textbooks say that it is natural for a developing economy to run a current account deficit. The process of industrializing requires not only importing machinery but also ideas and technology via FDI which creates a capital account surplus. Or put it this way: the high returns to be made from impending industrialization in developing countries attract investment from abroad.

In Pakistan’s case, FDI hovers around $2 bn per year while machinery imports only make up 13% of all imports. Most of Pakistan’s imports are consumption-based such as mineral products (fuel, oil etc). This is a result of decades-long policymaking initiatives which have made Pakistan’s energy production highly dependent on imports. And that is why Pakistan’s current account deficit – as it stands – is not good.

If one looks across the border at Pakistan’s neighbors, they’d see that the neighbors too run large current account deficits. However, their current account deficits are not consumption-led but rather investment or export-led. For instance, electrical equipment and machinery makes up 17% of India’s total imports. And although mineral products make up 38% of India’s imports, much of those mineral products are imported to be refined for exports (not absorption).

Therein lies the problem for Pakistan. Pakistan’s imports are largely for fueling domestic demand. That is what needs to change. Pakistan has to throw out its consumption-based growth model and adapt both, an investment-channeling and export-based growth model. It might run a current account deficit in the process, but it won’t be a current account deficit to worry about.

Why PSX is Not Suitable for ‘Value Investors’

 

A quick scroll through the Pakistan Stock Exchange (PSX) community on Twitter would reveal the dominance of ‘value investors’. These value investors flap their wings in Twitter threads and spread their visions of value investing, hoping that the ideas catch on like wildfire. But perhaps, for good reason, the ideas haven’t caught on. The market has resisted but for wildly different reasons.

Warren Buffett used to say that every investor is a value investor. Because each investor is buying a security to gain from the difference between price and value of that very security (in contrast with the speculator). In that sense, the term ‘value investor’ is redundant. But followers of Buffett all over the world have embraced the term.

The issue with the value investing community, in general, is that it puts a select group of investors on a pedestal. Every word or sentence that has been spoken or written by investors like Peter Lynch and Buffett is taken as the gospel. Don’t get me wrong, there’s a lot to learn from esteemed investors like Li Lu, but even above-average investors are human beings. They are vulnerable to making mistakes like all investors are.

One should always learn something from investors who’ve done well in the past, particularly if they have outperformed the market consistently. However, as an investor, you are in it to make money. And whether that ability to make money comes from something you learned from George Soros, or a value investor is irrelevant. After all, sustainable returns are the true indicator of an investor’s success.

But beyond this, in the Pakistani context, there are far bigger issues with value investing as a concept.

When you look at value investors which have generated excellent returns, you’ll notice a similarity among all of them; no, it’s not their philosophy. It is, in fact, their luck. Most successful value investors have had the good luck of being investors in stable countries with stable economies.

The rise of Mohnish Pabrai is not merely attributable to his value investing philosophy. It has coincided with India becoming a stable democracy with stable macroeconomic conditions in the 1990s.

If you take a peek at other value investors, you’d see most of them are based or heavily invested in the USA or Western European countries – nations which have been economically and politically stable for decades. That’s not to say that these nations have not faced financial difficulties. They have. But sparingly as compared to a nation like Pakistan which enters a BoP crisis every few years.

Stability is a pre-requisite to investing anywhere; ultimately, most investors are risk averse. But it is an even greater pre-requisite to value investing. Value investing requires that (i) an investor finds an undervalued stock and then (ii) the market takes notice of it.

Now, part (i) may come easy as it is something an investor can do. But part (ii) is not under an investor’s control unless they exercise huge influence as someone like Buffett does.

In Common Stocks and Uncommon Profits, Phil Fisher mentions that if his security did not show favourable returns within three years, he would sell it. But he mentions that occasionally, the security he had sold after the three-year deadline would go on to show good returns. This is where part (ii) comes in.

Peter Lynch picks up on this in his book Beating The Street. He rightfully acknowledges that for an undervalued security to show a return, other investors (Wall Street) would have to realize it and invest in it too.

Now, most (value) investors say that a security can remain undervalued for a few years – like Phil Fisher had thought – but the market will correct itself in the long run. But what if those few years become too long? How long can the long run be? Remember what Keynes once said: “In the long run we are all dead”.

This is where Pakistan steps in. As an inherently volatile nation – both politically and economically – Pakistan does not provide a solid foundation for value investing. Think of it like this… The economy is a flat concrete block on which all businesses lie. When the wheels of capitalism begin churning efficiently, those businesses start shooting off the concrete block at different speeds.

At the same time, the businesses are tied to the concrete block hence pulling it up over time – some more than others. Occasionally, the concrete block will plummet for reasons beyond the control of any business manager. The government would step in to support the concrete block.

In Pakistan’s case, the businesses try their best to pull up the concrete block, but the block keeps falling and pulls the businesses down with it. The end result is that the securities which are issued by businesses (stocks or bonds) get hammered time after time. Domestic investors get demotivated and turn their attention toward real estate or the dollar. While foreign investors evacuate their capital and happily invest back home.

Investors turning their attention elsewhere is the culprit here. Because in this way, the market may not realize undervalued securities until significant triggers arrive. That might be years or maybe even a decade away.

Usually a value investor would say: Well, wait out the downfall or rather accumulate when others are fearful. But that only works when the downfalls come sparingly. When the recessions are as frequent as they are in Pakistan, you’re better off actively reallocating the capital you devote to the Pakistani stock market.

This is even more true when you’re a small investor who can find bargains and exploit them more easily. In line with this conviction, a Pakistani investor would be better off equally allocating capital between short-term plays and long-term/value investing plays. In fact, short-term plays tend to have the greater payoff since the Pakistani stock market is so heavily influenced by sensitive information or momentum.

It is much easier to see predictable patterns with which the Pakistani stock market operates. And no, I’m not talking about technical analysis for which I hold significant disdain. It’s about the way the market reacts to different kinds of information. Especially relevant to state-owned enterprises which remain priced at distressed levels given their poor cash flows.

Once an investor sees a particular pattern about how the market prices in new information, one can easily get ahead of the curve and make profitable short-term plays.