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.

PNSC: Why a Huge Dividend is Probably Not Coming

 

Pakistan National Shipping Corporation’s (PNSC) share price has seen a monumental rise over the past year. It was hovering around Rs 50/share in July 2022 and spiked to reach a high of Rs 143.99/share in May 2023. The share price has since cooled off to around Rs 130/share. What has given way to such lucrative returns? Well, pricing. 

PNSC is in the business of shipping commodities mainly oil. There are two segments in oil shipping – liquid and dirty cargo. Liquid cargo refers to refined fuels (petrol, diesel etc.) and dirty cargo refers to unrefined fuels (crude oil etc.). Now, PNSC’s pricing is indexed to international shipping rates as mentioned in their annual reports and corporate briefing sessions.

We can take a look at the most widely quoted shipping futures found at the Baltic Exchange to understand PNSC’s pricing. You can see the Baltic Dry Index as well as the Baltic Clean and Dirty Tanker Index below (zoom in for clarity).

You’ll notice that the Baltic Dry Index boomed in mid to late 2021 due to coronavirus-related supply chain issues. But this did not significantly impact PNSC’s top or bottom line as PNSC’s business is concentrated in the oil shipping segment.

On the other hand, both Baltic Clean and Dirty Index boomed in mid-2022 right after the onset of the Ukraine War. The Ukraine War has caused severe disruptions in the oil market which has very much spilled over into the shipping business. As a result, PNSC’s top and bottom line skyrocketed over the past four to five quarters.

To get a true sense of this, you can return to PNSC’s financial reports. FY22’s half yearly report shows that PNSC had an earnings per share (EPS) of Rs 10.77 which was only slightly higher than the previous year’s Rs 9.12. In Q3 alone, its EPS was Rs 7.75, and it ended the financial year at an EPS of Rs 42.78 – a 149% increase YoY.

Oil shipping rates continued increasing and so did PNSC’s earnings. PNSC’s EPS marched on to hit Rs 40.8, Rs 49.94 and Rs 90.66 in the subsequent three quarters. Although the EPS in FY23Q3 is distorted since there was an unexpected rise in other income – exchange gain from the sale of one of its tankers.

PNSC has made huge windfall gains on the back of the Ukraine War. The market is expecting those gains to translate into distributed cash via dividends. But the key question is, will minority shareholders get a share of the spoils? History and PNSC’s reinvestment needs tell us: probably not.

One can go back to the last time there was such a massive oil shipping boom. That occurred in the mid-to-late 2000s. At the time, earnings skyrocketed just as they have over the past four quarters. The share price followed suit, but shareholders were left disappointed and probably a bit empty-handed.

From 2006 to 2009, PNSC’s payout ratio averaged at 14% while their dividend yield averaged out at a meagre 4.1%. Payout ratio did go up from the previous range of around 10% but it was not a colossal change. The payout ratio over the past few years has hovered around 12%. If PNSC maintains that payout ratio, it would likely offer a dividend between Rs 15 and 20 per share in the next earnings season.

Note that the market was also expecting a large dividend in Q2 of FY23. The share price had rallied 9% a few days before the announcement of financial results in February. But it came tumbling down a few days later. The company had announced a dividend of Rs 5 per share in a quarter with an EPS of Rs 49.94. The share fell 11% over five trading days after the announcement of the dividend.

Its poor dividend-paying record is not merely a result of stingy views which investors often associate with seth companies. It is a consequence of the way the management views the company. In particular, Captain Anwar Shah’s views – a longtime member of PNSC’s board of directors. In August 2022, he published an article in the Pakistan & Gulf Economist.

What really strikes an investor in that article is that PNSC is a vessel for the government to protect national interests. Or so Captain Anwar believes. He also opposes profit maximization because hiring a cheaper crew would reduce employment. This is very much consistent with the view of other PNSC managers who publish in newspapers. Their general mantra is to expand operations (and create jobs) rather than return cash to shareholders.

On top of this, there is also the issue of PNSC’s large reinvestment needs. In general, the shipping business requires plenty of reinvestment as tankers and ships cost a lot to produce/purchase and depreciate rapidly. Tankers are usually retired or sold after 15-20 years of usage and decommissioned after a maximum of 25 years of usage. Maintenance costs become too high after 15-20-years of usage. Bulk carriers follow the same story.

PNSC usually sells off its tankers or bulk carriers around the 15–20-year mark too. It offloaded a 19-year-old Aframax tanker at the end of last year. Now, the worrying part is that the average age of PNSC’s fleet is a mammoth 17 years. Roughly speaking, half of its fleet would need replacing in the short run.

What’s more concerning is that PNSC acquired two Aframax tankers which were 14.5 years old just last year. A Senate Committee had made an inquiry into this purchase since the tankers would have a usage life of 5.5 years. They were deeply displeased. Not only are PNSC’s reinvestment needs high, but their reinvestment decisions have been poor.

Based on all the above, it seems likely that PNSC minority shareholders will be disappointed. One should expect a higher-than-past but lower-than-expected dividend.

And on the earnings side, shipping rates are well down, so the picture isn’t rosy there either. After all, PNSC is trading at a record low trailing PE ratio of 0.64. A low PE ratio is usually an indicator that the commodities cycle has peaked and so have earnings. Maybe share price has peaked too. Who knows?

PSX: What Has Been Left Out of the Rally?

Since the announcement of SLA by the IMF, the KSE100 index has gained 8.7% in rupee terms. Unsurprisingly, high beta and momentum stocks have led the rally. But besides an index-wide boost in valuations, the market has seemingly overlooked some key developments.

For one, electricity and gas prices are about to go up which is beneficial for both oil & gas SOEs as well as power sector. Why? Because although these companies are wildly profitable, they have been dogged with cash flow issues due to circular debt. With upward revision of energy tariffs, beneficiary companies should see improved cash flows and pay out better dividends.

Among this, let’s take the example of Pakistan Petroleum (PPL). Its share price has gone up 15.5% since the IMF SLA occurred. It has a 5-year beta of 1.32 which means that about 74% of its gains are a result of an index-wide rally and the remaining 26% is the market pricing in potential of higher gas prices. Obviously, due to the nature of regressions, this is not a certainty but if you carry out similar exercises for other stocks, a similar story would be seen. So – on average – the market is pricing in lower systemic risk since SBP reserves are improving and default risk is receding (at least for the next nine months).

But the market is not fully pricing in additional developments. One of these developments happens to be improved forex reserves and dollar liquidity, which should benefit importers or companies with import-based supply chains.

Currently, the State Bank of Pakistan (SBP) is instructing banks to maintain a square forex position. This was covered by Profit Pakistan in an article last week. It means that banks have to balance their forex inflows and outflows. They can only open LCs with an import value which is equal to the banks’ export remittance/repatriation value for that period. Consequently, banks are still rationing dollars and so importers who have good relationships with banks are having their LCs opened quickly.

So, although import restrictions have been lifted, trading is not taking place freely yet. Despite this, there has been an improvement in forex reserves, so importers are still seeing much better results when importing especially those who are publicly listed. And as more forex is expected to flow in over the next two weeks, the supply crunch which importers were facing should begin to ease and production should normalize.

Companies with import-based supply chains should see increased earnings but valuations haven’t fully caught onto this information yet. Perhaps, investors are waiting for earnings season to arrive so they can evaluate whether this would truly improve earnings or how the management views the recent forex/import developments.  

As a result, many import-based companies are still trading very cheaply even though they have recovered from bargain-level/distressed prices. How could an investor capitalize on this? One should look for import-based companies which have strong demand dynamics and whose demand is less influenced by interest rates. Because once production normalizes, these are the companies who would benefit most with demand available to buy up products & services.

So, how can an investor judge which companies will benefit most from improving macroeconomic conditions? For one, you can use an industry-wide sale-production model. For instance, if you want to judge whether the auto sector is poised for a rebound, you can take sale and production data from PAMA. Arrange the data in a constant growth model to assess whether the industry is due for a demand bounce back. If your model shows that production is lagging behind expected sales, there would be ample demand for companies to benefit from.

One of the greatest indicators for demand dynamics can be inventory direction as shown on the balance sheet. Below is a snip from the FY23Q3 report of a company which manufactures mobile phones. You’ll notice that stock in trade fell by 40%.

In the breakdown of stock in trade, the company’s finished goods (mobile phones) fell by 49%. This indicates that the company is quickly drawing down its products which are ready for sale. A clear sign that demand is running high, but supply isn't keeping up to maintain inventory levels. Moreover, goods in transit, which previously made up 39% of inventory, have fallen to 0% highlighting a clear slowdown in supply due to import restrictions. In previous years, goods in transit had always remained above the Rs 1 billion level.

Lastly, to assess the exposure of demand to interest rates, you can access data released by SBP. SBP discloses sector-wise data of loans/financing which can give a good picture of how demand is affected by interest rates in each sector.

You can also determine the extent to which sales are financed by loans in a sector. For instance, a quick look at SBP’s data and sales of auto industry would show that 40% of auto sales are financed by car loans making the sector highly exposed to interest rate fluctuations. Now when interest rates do fall, they would be a beneficiary but for now, Pakistan remains a high interest-rate environment.

Meezan Bank: What Would Happen if a Floor Rate is Imposed on Islamic Bank Savings?

Meezan Bank has rallied from a one-year low of Rs 82.96 to Rs 98.43 (as of 9th July). That implies a gain of 19%. In that same period of three weeks, the KSE100 has gained 10% from its low. This comes as no surprise given that Meezan Bank has become a favorite momentum stock (in the banking sector) for both retail and institutional investors – replacing the once-mighty HBL.

But with this rise of Meezan, many have questioned: what if a floor rate were to be imposed on deposit accounts in Islamic banks? Before answering this, a bit of context is needed.

The banking sector is a heavily regulated sector in Pakistan. The State Bank of Pakistan (SBP) decides who gets to own banks, how many banks can exist and how those banks can operate to a large extent. SBP controls how many banks can set up shop in Pakistan by issuing limited banking licenses.

By issuing few banking licenses, the banking license for a bank becomes a crucial and valuable asset similar to the old taxi medallions in NYC. This is why seemingly insolvent banks like Summit Bank continue to receive buyer interest. But this barrier to entry comes with the cost of low competition in the banking sector.

Now to solve this complication initially caused by over-regulation, SBP sets a floor interest rate on non-current account deposits of conventional banks. Currently, the floor rate is a minimum of 1.5% below the SBP target rate, leaving banks with a minimum spread of 1.5%.

Interestingly, this floor rate does not apply to Islamic banks as the government and SBP both want to promote Islamic banking in the country. You can consider it to be a part of their plan to boost Islamic banking in the country.

Now, if the government were to impose a similar floor rate for Islamic banking, that would certainly result in reduced profitability. For instance, a leader among conventional banks, Alfalah Bank has a cost of deposits of 9.2% compared to Meezan Bank’s cost of deposits of 6.7%. If Meezan’s cost of deposits were to go up, that would certainly chew off their spread and eat into their profitability.

But how much would Meezan Bank’s shareholders suffer? To calculate this, we can do a comparative analysis of cost of deposits. If a floor rate was imposed on Islamic bank savings, then we can expect Meezan’s cost of deposits to converge to that of conventional banks (provided SBP puts the same floor rate for both Islamic and conventional bank savings).

Now, Meezan’s cost of deposits stands at 6.7% while the cost of deposits for the major conventional-heavy banks is 8.6%. If Meezan’s cost of deposits were to rise to 8.6%, its interest expensed would increase by Rs 30 billion. Profit before tax be trimmed to Rs 58.9 bn.

Applying an effective tax rate of 45% on bank income would give us an after-tax profit of 32.4 bn. That would put Meezan Bank just ahead of UBL in profit-after tax rankings (UBL is currently the fourth most profitable bank). However, Meezan would still be the most profitable bank with respect to deposits. Note that HBL made a profit of Rs 34 bn last year and has over Rs 3.4 trillion in deposits (largest bank) compared to Meezan’s 1.7 trillion in deposits.

So even if a floor rate is imposed, Meezan’s profitability will remain intact even though it would create a temporary shock. How is this possible? Well, Meezan Bank is a leader in consumer finance which allows it to lend out cash at higher rates than conventional banks which park most of their money in T-bills and bonds. This is a result of necessity as the Government of Pakistan doesn’t issue many Islamic securities. Consequently, Islamic capital markets aren’t as deep as conventional capital markets.

This translates into Meezan having a superior return on assets (second highest ROA among banks). In addition to this, among the analysis of cost of deposits, it is essential to note that Meezan also has an above-average CASA ratio. This means that it has a higher percentage of zero- or low-interest deposits which pay little interest and minimize its cost of deposits. Both of these are a massive competitive advantage for Meezan Bank.

So now that we’ve established the impact on Meezan’s profitability, where would Meezan’s share price go and what dividend would it offer? Meezan is currently trading at a trailing PE of 3.96, a trailing dividend yield of 9.8% and a payout ratio of 39%.

Assuming that PE ratio remains the same, its share price would fall to Rs 71 (currently Rs 99) meaning it would hit the lower lock in four consecutive trading days. Meezan Bank would still trade at a premium to its book value. Meanwhile, assuming that its payout ratio remains the same, it would offer a dividend of Rs 12.6 per share which would impute a dividend yield of 17.7%.

However, we are assuming a trailing PE ratio of 3.96 when in fact, banks have historically traded at PE of 7-8. Moreover, the key assumption in this analysis is that Meezan’s cost of deposits would converge to the 8.6% cost of deposits for conventional-heavy banks. It could very well be the case that cost of deposits remain lower than this.

Despite having done this analysis, one has to take a step back and ask: what are the chances the government would impose such a floor rate on Islamic savings? That’s the real question. And my very real hunch is: very low. But of course, things can change quickly. Even more so in a nation as volatile as Pakistan.

*Note: all figures are from CY2022 Financial Results*

The P/B-ROE Valuation Model

The price-to-book (PBV) v return on equity (ROE) model became famous after Jarrod Wilcox published a research paper on it in 1984. The paper gave a theoretical basis for PBV through some formula manipulation. When you take the dividend discount formula (Price=Dividend per share/expected return – growth rate) and make a few substitutions or manipulations, you arrive at a formula for PBV: PBV=(ROE-g)/(r-g).

The formula shows that PBV has three factors influencing it: ROE, growth rate g and expected return r. Unlike many theoretical theories, this one happened to have an empirical basis for it as well. Jarrod Wilcox showed that when a regression involving PBV and ROE was performed, a neat line of best fit could be drawn.

This has stood the test of time as well. Recent empirical evidence also confirms this relation with a few additions. Aswath Damodaran has done research on this too and shown a similar relationship. However, he makes a few additions. Because ROE can be amplified through leverage, a proxy for risk has to be utilized in regression as well. Along with a regression of PBV, ROE and Standard Deviation (SD, as a proxy for risk), he simultaneously performs regression of the same variables with an addition of expected growth in EPS – which can be a bit arbitrary.

Enough of the theoretical mumbo jumbo, let’s look at some graphs for a relief.

The above graph is one of the regressions Jarrod Wilcox ran in his study. Unbelievable, right? And below is a regression Aswath Damodaran ran in 2012 for US banks. It shows a similar trend with a bit more variation.

Now, when Wall Street found out about these cool ideas, they ran with it. How? Well, if a share has a high ROE and PBV, it’s likely to be fairly priced. So is a share with a low ROE and PBV. However, if there’s a share with a low ROE but high PBV, then according to the above ideas, the market is paying too much for the share, so it is overvalued. SHORT IT!

On the contrary, if there’s a share with a high ROE but low PBV, then the market is underpricing it. GO LONG! Many traders made strategies from this analysis. Go short on all the low ROE high PBV shares or go long on all high ROE low PBV shares.

The best tactic seems to hedge it both ways. Go long on high ROE low PBV shares and short on low ROE high PBV shares. Why? Because if the market sways one way or the other, the risk is reduced.

However, among all this, the key thing to note is that the PBV-ROE model is a relative valuation method. The trader is taking advantage of relative mispricing of securities. It is not a fundamental investment option which can be kept in the long run.

Another thing to note is R-squared in the regressions. In Damodaran’s regressions, when a PBV-ROE regression was run, R-squared was 60%. When SD was added to the regression, the R-squared rose to 79%. You can add expected growth to the mix as well which could increase R-squared but the expected growth metric is arbitrary so the regression can become less reliable.

Due to these reasons and the fact that on average, the shares should converge to the PBV-ROE standard, trades have to be made on a higher sample of securities to remain profitable.

But how does this model fair in the Pakistani stock market? The graph below shows the regression for 17 of the 20 publicly listed banks (three were excluded due to negative equity or losses). A trend is there but it’s not as strong.

When you compare the regression with current PBV of the banking shares, you see that AKBL, BOP and NBP are significantly undervalued (shown below). But at the same time, you notice that neither of these three shares pay dividends.

Once you add dividend yield to the regression, R-squared goes up to 62% showing that dividend yield is a key variable. Now, Meezan Bank seems like the most undervalued share (shown below). While JS Bank and Bank of Khyber seem to be the most overvalued shares.

But do you see the issue with this exercise? The regression can be quite imprecise based on which variables you choose as part of your regression. The other issue is the viability of some of the variables. For instance, we used SD as a proxy of risk. Is that a suitable variable especially since high ROE can be achieved through leverage. And high ROE leads to high PBV, so would the model be reliable?

Despite these limitations, if you create trading strategies with a large sample, you should generate some profits. But note, this is not a long-term investing strategy. For long-term strategies, one has to look at the earnings potential of a company. In this case, PBV and ROE seem to be poor metrics due to various reasons mentioned both in this blog and previous blogs.

In addition to this, there are other models which offer better long-term strategies. But more on that in a later blog.

 

State Bank: Failure in Monetary Policy

 

The State Bank (SBP) has taken interest rates from 7% to 22% in less than two years. But counterintuitively, inflation has skyrocketed from 9% to a maximum of 38% within that same period, only falling to 29% just last month.

SBP was way ahead of the curve in raising interest rates and was far more hawkish than other central banks. Yet, its monetary policy has yielded negative returns. What gives?

To understand this, one must first realize the sources of inflation. Generally speaking, there are three sources of inflation: prices of domestic goods, prices of foreign goods and the exchange rate. In Pakistan’s case, the prices of domestic goods are heavily influenced by prices of foreign goods and exchange rates due to a heavy reliance on import of raw materials in manufacturing. Add high pricing power of businesses to this mix and prices of foreign goods and exchange rates become the dominating factor in Pakistan’s inflation story.

The prices of key foreign goods have fallen significantly since last year. For instance, the price of brent crude has slid from $105 in July 2022 to $75 in July 2023. Other commodities like wheat and natural gas (LNG) have seen similar downtrends. On the other hand, the rupee has depreciated heavily relative to the dollar – Rs 207/$ in July 2022 to the current Rs 277/$. That represents a 34% decline in the purchasing power of the rupee.

Consequently, the prices of foreign goods have fallen but so has the value of the rupee – a cancelling out effect. So why has inflation been rising? Well, it has a lot to do with administrative control of prices and a phenomenon called ‘base effect’.

The government controls domestic prices of a few key goods & services including petrol, gas, electricity, and agricultural commodities. It hiked the prices of these goods and services only in 2022 although the prices of these goods had risen internationally a year earlier. This hike occurred partly due to the IMF’s conditions under the 8^th review. Since prices were too low in 2021 and suddenly rose in 2022, base effect kicked in to show a significant increase in inflation.

The above are some of the statistical or supply factors for inflation. But what about the demand side of inflation? The side of inflation which the SBP can control.

To understand the demand side of inflation, one has to start at the monetary base. The monetary base is the amount of currency in circulation and bank reserves within an economy. It is important because it is the initial source for the creation of money and credit. Through the multiplier process, we arrive at money supply. Although there are many different kinds of money supply, M2 money supply is usually a good reference point for money supply in an economy.

As seen in the graph above, monetary base has risen steadily since SBP started hiking interest rates in 2021. This has undoubtedly translated into a rise in money supply as we see below with the M2 money supply graph.

Both the above graphs are puzzling, especially given the SBP’s aggressive interest rate hikes over the past couple of years. What really happened and why is SBP failing to curb the money supply?

The purpose of hiking interest rates is to rein in credit demand which would help reduce demand in the economy. The transmission channel of monetary policy usually involves higher interest rates reducing credit demand for both consumption and investment. Hence, both consumption and investment fall in an economy leading to lower aggregate demand or output (note: Y=C+I+G+NX as taught in a standard macroeconomics class).

This monetary policy transmission works effectively in Western economies where both consumption and investment are heavily fueled by lending. However, this is not the case in Pakistan. In Pakistan the biggest borrower is neither businesses nor consumers. It is in fact the government which spends and borrows as much as it likes or wants.

From July 2022 to April 2023, the private sector borrowed just Rs 220 billion, while the government borrowed Rs 3.06 trillion. Although private sector borrowing was just over Rs 1 trillion in the same period a year ago, it is still peanuts compared to the government’s borrowing binge. So, while higher interest rates have reduced credit demand in the private sector, monetary policy has been ineffective due to the weak link between interest rates and investment/consumption in Pakistan.

But hiking interest rates has another effect: it induces consumers to save for the future rather than spend now. As a consequence, hiking interest rates can still reduce demand in an economy. But for this effect to really kick in, real interest rates must turn positive. The dividends from this can currently be seen in Latin America where positive real interest rates have reduced inflation. In Pakistan, real interest rates still stand at -7%.

If SBP can turn real interest rates positive, it would also cause appreciation of the rupee which would further lower inflation. How? Well currently, Pakistanis have high investment demand for foreign currencies due to the plummeting value of the rupee. By turning real interest rates positive, higher returns on saving domestically will reduce this investment demand for foreign currencies while foreign investors would also look to invest in Pakistan to take advantage of this scenario. But yet again, this transmission channel is weak and usually the flow of hot money from foreign investors dissipates or reverses after a while.

So, the puzzle still remains unresolved; why doesn’t SBP just target and reduce money supply instead? Well, money supply targeting is incredibly tough for three crucial reasons. For one, SBP cannot control how much banks lend to borrowers. Secondly, SBP cannot control how much money consumers choose to park in deposit institutions which affects the money multiplier process. Lastly, SBP has no control over money itself as money can take various forms and expand itself ad infinitum.

Despite these limitations, SBP does have control of some part of the monetary base and money supply – currency in circulation. Pakistan has a large informal, cash-based economy so cash in circulation (CIC) has a drastic impact on demand within the economy. Since SBP chooses to issue or retire currency notes and coins, it can directly influence CIC. However, it has chosen to expand CIC by increasing it 10% YoY. This is a questionable policy given that the SBP is hiking interest rates on the one hand while increasing CIC on the other – essentially making its monetary policy efforts less effective.

To make matters worse, SBP has lost its independence by caving into the government’s demand for borrowing. Since the government’s demand for credit is not being met naturally, SBP is lending to banks via open market operations so that they can further lend it to the government via T-bill and PIB auctions. This way, the government is happy that its credit demand is satisfied while banks earn a quick and easy spread on such transactions.

Both these factors explain the inexplicable rise in money supply despite the increase in interest rates. The end result is that the private sector is squeezed to the edge while the government continues spending lavishly. In other words, resources are being allocated away from the private sector and towards the public sector – a disaster in the making.

State Bank urgently needs to restore its independence and build its credibility. It must realize that government borrowing is a source of inflation. Furthermore, SBP must not let CIC grow further or curtail it if possible. Lastly, raising interest rates is completely futile at this point. Its effect on credit demand is nearly negligible. SBP has to wake up to these realities or the suffering will continue.