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.