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.