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.