KSE100 vs Pakistan Forex Reserves

After much uncertainty, the government of Pakistan has signed a stand-by arrangement (SBA) with the IMF. Under the SBA agreement, the IMF will disburse $3 billion through three tranches. The first tranche is expected to be worth $1.2 billion and is likely to be released around mid-July. The programme will last around six to nine months and will get Pakistan through till a new government is elected.

The SBA agreement was greeted with plenty of fanfare from analysts. The consensus is that the agreement will bring short-term relief and eliminate the possibility of a sovereign default in 2023. Many commentators are also expecting large improvements in Pakistan’s foreign exchange reserves. This is likely to be the case as an IMF agreement will unlock multilateral and bilateral financing.

The markets have reacted jubilantly so far. MSCI’s Pakistan ETF was up 5.5% on 1st July while Pakistan’s dollar bonds have rallied up to 30%; the same dollar bonds are up more than 100% since March 2023. Meanwhile, the dollar was trading at PKR 280 on 1st July, albeit at limited currency exchangers found at airports. For reference, the dollar was trading at PKR 286 on 28th June. The rupee is expected to further rally to 270 against the dollar, although how long it remains at that level is anyone’s guess.

But what about the Pakistani stock market? Well, the stock market will have its first trading day after the agreement on 3rd July. However, a large rally is expected as the market will price in the alleviation of default risk. 

Possible beneficiaries would be sectors which would see improved pricing and cash flows due to the SBA agreement. This would include the power and exploration & production sectors as IMF is likely to push the government to increase gas and electricity tariffs. The banking sector is another one which will likely see a strong rally. Bank stocks had been sliding down over the past few months on the back of heightened default risk and as a consequence, a debt restructuring possibility. Thus, the banking sector will see upward revaluation.

The key question is: will the rally be sustained over a longer period? Many commentators have said it might as Pakistan’s forex position will improve leading to a permanent revaluation of the ‘cheapest stock market in the world’ (as per Bloomberg). But what’s the relationship between Pakistan’s forex reserves and KSE100?

The above graphs show the relationship between the KSE100 index and Pakistan’s forex reserves. In the first graph, KSE100 index is compared to Pakistan’s total reserves (includes forex with SBP+banks and gold reserves) while the second graph compares the index to just the SBP reserves.

Both graphs are seemingly identical and show that the stock market is largely detached from Pakistan’s forex conditions. From the 2000s to mid-2010s, the index rallied all while Pakistan forex reserves were highly volatile. 

This observation is confirmed by the fact that the correlation of the index with Pakistan’s total forex reserves is -0.05. Meanwhile, the correlation of the index with SBP forex reserves is -0.06. Resultantly, there is no relationship between the index and Pakistan’s foreign exchange reserves. 

So, if the stock market does see a sustained rally in the long run, it’s unlikely to be a result of increased foreign exchange reserves.

The Curious Relationship between Interest Rates and Currency Markets

 

Over the past year and a half, the Fed’s aggressive interest rate hikes have significantly strengthened the dollar (US Fed rate now stands at 5.25%). A quick peek at the US Dollar Index would reveal just this. But in lands far away from the USA, aggressive interest rate hiking by central banks has not translated into an appreciating or steady domestic currency.

Take Pakistan as an example. A rather extreme example. The State Bank started monetary tightening a lot earlier with more hawkish momentum than other central banks. The State Bank began raising interest rates in September 2021, taking interest rates from 7% to the present 22% within a period of less than two years. This implies a monetary tightening spread of 9.75% between State Bank and Fed rates.

Despite this, the Pakistani rupee has depreciated from Rs 168 to Rs 287 relative to the dollar – since the start of State Bank’s monetary tightening cycle. What gives? To answer this, one has to understand why free-floating exchange rates move.

The long run

In the long run, the exchange rate of a currency is determined by the country’s purchasing power parity. That is what every macroeconomics course across the world teaches students. Economist Atif Mian simplifies this by saying, “Exchange rate in the long run reflects a country’s productivity relative to rest of world”. Other factors that influence exchange rates in the long run include relative price levels, trade barriers and net export demand.

But this understanding of exchange rates in the long run is based on a few assumptions – as always is the case in economics. And who knows when the long run would arrive? This is where our buddy short run steps in.

The short run

In the short run, there are two key economic theories about interest rates affecting exchange rates. One is called International Fisher Effect (IFE). IFE assumes that changes in inflation don’t impact real interest rates. Hence, the theory states that lower interest rates give way to lower inflation rates which translate into an appreciating currency (through purchasing power parity aka price level differences). This implies that in the goods market, there is no opportunity for arbitrage.

The other economic theory is the uncovered interest rate parity (UIRP) which states that arbitrage is not possible if there is an interest rate differential between the money markets of two countries. Assuming like IFE that real interest rates are same, let’s say USA has an interest rate of 10% and UK has an interest rate of 5% with an exchange rate of 1 dollar for 1 pound. UIRP says that if British investors perform a carry trade (take advantage of higher interest rates in USA), there would be no arbitrage as lower interest rates in UK would mean appreciation of the pound. Hence, gains from higher interest rates in the USA are cancelled out by relative depreciation of the dollar.

Empirical evidence

Unfortunately, both these economic theories are not supported by empirical evidence. Traders have been able to make arbitrage profits on interest rate differentials and usually the exchange rate doesn’t depreciate when interest rates rise, although not always, due to future expectations.

So, what does practice tell us? Practice tells us that the exchange rate usually appreciates when the relative interest rate increases. This is exactly because UIRP fails to hold true in the short run causing traders to perform carry trades which appreciate the currency in which interest rates are higher. This flow of capital is what allows appreciation of the currency with higher nominal interest rates. Note that the key difference between IFE+UIRP and capital flows is that IFE+UIRP take assumptions in real interest rates while capital flows are thought of in terms of nominal rates.

An interesting application of the capital flows phenomenon is that raising interest rates is the dominant strategy for central banks in a rising inflation environment. For instance, if the Fed raises interest rates, the US dollar would appreciate causing imports to become cheaper and leading to lower inflation (lower prices of imported goods). This would cause inflation to increase abroad, and other central banks would follow the Fed by raising interest rates to keep inflation in line. So, the Nash equilibrium is for every central bank to raise interest rates when inflation rises (given central banks are targeting inflation).

The Pakistani Rupee

So why doesn’t the Pakistani rupee appreciate then? Because risk premium also comes into play. When investors look to invest in a country or profit from arbitrage, they also add in a risk premium. In Pakistan, this risk premium is currently very high due to a mix of political instability, balance of payment crisis and government interventions.

For this same reason, when a global recession is expected, investors flock to safe haven currencies like the euro, pound, dollar or Swiss franc and away from emerging market currencies. The markets tend to give developed economies the benefit of the doubt at the cost of developing economies which face destabilizing capital flight in such scenarios.

Another factor also comes into play: market reflexivity. When the rupee depreciates, it sets off a chain reaction whereby a weaker rupee causes more investors to sell their rupees and this feedback loop continues until the rupee depreciates to a low enough level. So, investor expectations play a huge role in currency markets as well.

Finally, Pakistan runs a criminally high current account deficit which is poorly financed. A current account deficit, by default, implies that the home currency should depreciate. Why? Because that country is running a capital account surplus – borrowing from foreigners. Eventually it would have to run a capital account deficit to repay the foreigners. This would entail Pakistan selling its rupees to purchase foreign currency to pay the foreigners back – causing depreciation of the rupee.

On the other hand, Pakistan’s capital account is heavily financed with debt inflows which tend to be highly volatile. As Pakistan has seen, international investors are unwilling to lend to Pakistan right now, except at prohibitively high interest rates, since investors can earn a high risk-free rate in the USA. Consequently, when the regular flow of capital stops, the rupee ends up depreciating.

 

PICT: Was it a good investment?

Pakistan International Container Terminal’s (PICT) stock has hit the lower lock for 10 straight sessions now. Over the course of those 10 trading sessions, PICT’s share price fell 50%. It has plummeted from Rs 134.5 on 12th June to Rs 66.68 on 23rd June. So, what caused this monumental drop? Before answering that question, one has to know PICT’s business model.

PICT had attained a 21-year concession agreement from Karachi Port Trust (KPT) starting in 2002. The agreement was a typical build-operate-transfer (BOT) contract. In a BOT contract, the concessionaire (holder of concession) has to build an asset and is allowed to operate it with certain conditions.

Upon the expiry of the agreement, the concession can be extended or renewed. If not, the asset is transferred to the host. In this case, the host was KPT (a federal government agency). PICT’s concession agreement with KPT allowed it to build and operate four berths at its terminal, mostly handling cargo containers.

Under a standard BOT agreement with the Government of Pakistan, the concessionaire is allowed to publicly list its shares within three years of beginning operations. As a result, PICT publicly listed itself on the Karachi Stock Exchange in the second half of 2003. At the time, it was the largest initial public offering on KSE with over 73,000 applicants. PICT shares opened trading at Rs 12.13 per share on 2nd December 2003.

Skipping forward to present day, PICT was in negotiation with the government to renew or extend the concession agreement. Although the management had flagged the risk of possible non-extension of the concession agreement, it had remained optimistic that it would be able to operate the terminal after 17th June – as mentioned in recent financial reports. The management believed this since it had the right of first refusal when the terminal is tendered for a new concession.

On 12th June, the government decided that it would take over PICT’s terminal and operate it. But a few days later, it allowed PICT to continue managing the terminal till 30th June. Why did the government do this? Because under clause 21.3 of the concession agreement, if KPT took over the terminal to operate it, the right of first refusal becomes seemingly null. The clause also states that KPT has to invite competitive bids before expiry date if it intends not to operate the terminal.

This legal sleight of hand has dented any chances of PICT retaining its operations at the terminal. Although PICT is likely to challenge this in courts, it is unlikely to bring any change since Sindh High Court already set a precedent for the case and backed the government’s stance back in March 2023.

Consequently, chances are that PICT will wind up operations or continue offering terminal management services, which is not a stable nor a very profitable line of business.

Now, returning to the main purpose of this blog: how did public shareholders of PICT fare? To determine this, it was assumed that the shareholders:

• Owned ordinary shares of PICT
• Bought shares at open on first trading day
• Subscribed to right shares in 2004 to avoid dilution
• Were filers so dividend tax rate for filers applied
• Held shares till the end (share price hits zero after final dividend is paid)

Within the calculations, it is also assumed that PICT will wind up operations and give a final cash dividend of Rs 34.6 per share – returning any cash from sale of assets net of liabilities. Based on this, the net present value of PICT came in at Rs 860 per share. Although, NPV would’ve been higher by more than Rs 100 if the shareholder sold their shares on or before 12th June.

This is still a good sign as it means that it was a positive NPV investment for the initial public investors of PICT. So, PICT was a worthwhile investment for initial public shareholders. This is important for future investors in other companies with a similar BOT or concession agreement structure as PICT.

Currently, Pakistan International Bulk Terminal (PIBTL) is a publicly listed company which has a 30-year BOT contract with KPT which commenced in 2010. In fact, it was started by some former sponsors of PICT. However, PIBTL is not comparable to PICT as PICT has been profitable right from the start of its operations (although it began paying out dividends only in 2008). Meanwhile, PIBTL has had a rocky performance with many years of losses, and it continues to bleed red as of 2023.

A more realistic comparison could be made to Abu Dhabi Ports Group which is taking over PICT’s operations at the container terminal. AD Ports is about to sign a 50-year lease agreement with KPT for operation of the terminal. The draft agreement includes a clause which states that AD Ports could publicly list itself on the Pakistan Stock Exchange.

If PICT’s experience has any weight, initial investors in AD Ports could make worthwhile returns. However, PICT’s experience also reveals that investors should be cautious and conservative. Investors should carefully consider the legal risks in a lease or concession agreement.

 

Shell’s Exit from Pakistan: What Price could it get?

 

The rabbit is out of the hat: Shell Plc (who I will refer to as Shell global) is selling its stake in Shell Pakistan Limited. Shell global’s exit from Pakistan has been the talk of the town. Much has been said about it. Some have said that the exit is bad for Pakistan’s image – shows foreign investors that business confidence is low. Others have said the exit is good for Pakistan as it might prevent outflow of dollars through profit repatriation. Although that would only be the case if a local company purchases Shell global’s stake.

But what about the elephant in the room: Shell Pakistan’s valuation? And why does it matter for minority shareholders?

As per SECP law, in the event of a substantial acquisition, the acquiring company has to make a public offer as well. In other words, it must also offer to purchase shares from minority or free-float shareholders. The minimum offer price for this is the highest among:

(a) weighted average price of stock purchase agreement (SPA)

(b) highest price paid by acquirer for shares of target company in the past six months prior to public announcement of offer

(c) weighted average share price of target company in the past six months prior to announcement of public offer

(d) weighted average share price of target company in the four weeks prior to public announcement of intention

(e) book value per share

Now, the book value per share is Rs 46 while weighted average share prices (over any period) are much higher. So, option (e) can be cancelled out. Meanwhile, no potential buyer has bought shares of Shell Pakistan so option (b) can also be ticked off. This leaves three options.

Among these, option (a) is likely to be the minimum offer price since the market value of Shell Pakistan shares are still far below a potential acquiring price. So, this leads us onto the big question: what value can we put on Shell Pakistan?

In the event of an acquisition, the acquirer can value the target company in different ways. Firstly, it can choose to pay attention to book value. Book value is simply the accounting method of valuing equity. However, it can be highly outdated since assets purchased are valued at cost minus depreciation. This is very much the case for Shell Pakistan as well since Shell’s most valuable assets (land, an appreciating asset) were purchased decades ago and have been valued at cost as opposed to market value.

Secondly, the acquirer can choose discounted cash flows (DCF) as a method of valuation. DCF is generally a good valuation tool, but it relies heavily on a good prediction of future cash flows. In the case of oil marketing companies in general, future cash flows are uncertain due to the transition to renewables (hard to estimate terminal value). In the Pakistani context, margins are fixed by the regulator making it even tougher to predict FCFs. You can take assumptions to arrive at a DCF value, but it could be wildly optimistic or pessimistic depending on the assumptions taken. Thus, it would be a poor measure of value (easily manipulated).

There are other methods as well such as multiples valuation (revenue multiples as an example) or relative valuation, but they’re generally not used to value a large, long-term investment like Shell Pakistan’s business. This leaves us with the valuation technique I’ve used: net asset value.

Net asset value is calculated by taking the market value of assets and netting off liabilities. It is simply taking book values and updating them with market values to arrive at an estimate of the company’s equity. This is the best approach to valuing Shell Pakistan because much of its valuable assets (land) are in prime locations and can be sold or converted into other ventures readily. Also, net asset value is a good valuation indicator since Shell Pakistan used to be wildly profitable in the past. One could argue that with a change of management direction, Shell Pakistan’s assets could be used more profitably (unlocking greater value).

I have calculated a conservative estimate of Shell’s value based on this method here. The major point of contention would be land valuation. The land was valued using Zameen.com’s index tool. Commercial property rates were used if they could be found. If they could not be found, general plot rates were used. If no data was available on a location, values from a neighboring location were used. For instance, no value was available for Keamari industrial/commercial land, hence plot rates from Clifton Block 1 (located next to Keamari) were used.

It must be highlighted that the land valuation could be inaccurate. For example, Shell’s Marine Drive petrol pump land was valued at PKR 1.4 billion. But when I called a real estate broker in Karachi, he gave a rough estimate of 175 crore (1.75 bn) rupees for the same property. Since my aim was to be conservative in the valuation, I applied a 20% margin of error on the land value. Although, to get a precise estimate of Shell’s land, one would have to make use of property brokers and land appraisers from across Pakistan.

Similarly, I applied a 20% margin of safety or discount on Shell’s net value. This was done to accommodate the fact that Pakistan has a tough business environment currently with huge hurdles in profit repatriation. Meanwhile, global interest rates are high and global liquidity is constrained so a potential acquirer might be willing to pay less for Shell Pakistan.

Based on this valuation, Shell’s price per share would be 177 rupees. This imputes a market capitalization of 37.9 billion rupees ($131.9 million). So, Shell global’s stake in Shell Pakistan would be worth $101.9 million.

However, Shell’s ultimate SPA price might be wildly different. This is because acquisitions are very much about supply-demand. If there are several potential acquirers vying for a piece of Shell Pakistan, then Shell might be valued much higher than this. But the converse could be true too.

For shareholders of Shell Pakistan, it’s a waiting game now. But the good thing is that the wait might not be too long.

The Banking Sector: The Red Flags 🚩🚩🚩

 

As I’ve mentioned before, banks are notoriously tough to value. But an investor must not feel daunted by this. This should be a good opportunity to make gains where others find them hard to see.

As part of this effort, one should have a good understanding of what key metrics mean and the red flags that can pop out of evaluating them.

What to look at

Many analysts place importance on absolute values of certain metrics. For instance, investors have for a long time believed that a PEG ratio of 1 equals fair value. Or a PEG ratio of greater than 1 means lower potential returns.

However, it is very difficult to objectively assess a range for a metric which would make a company cheap or expensive. This is why a metric for any company has to be compared relative to the average (mean or median) of the metric in the sector as a whole. This is the method I use.

The median should be the benchmark if there are plenty of outliers in the data. But the benchmark could be the mean if there are little to no outliers or if there are significant outliers, they are excluded from the data.

Return of Assets (ROA)

ROA is an important metric for all sectors but perhaps even more so for banks. This is simply because banks earn directly from their assets (loans).

A higher ROA indicates better profitability and more efficient use of assets. So, one must look for banks with a ROA higher than the average. Standard practice in the banking sector is to use ROE as a judge of profitability which I believe is incorrect.

ROE is a poor measure of profitability because a bank can have a large ROE if it is highly leveraged. This means that a bank with a high ROE could carry huge risks with it too. Secondly, ROE is hugely influenced by book value which is a poor metric for valuing banks.

Book value is simply the accounting way of measuring equity. Banks generally invest in human capital to generate high returns on lending and brand image to attract deposits. Book value takes no aim at measuring either of these or the value they generate. It also must be noted that book value can be written down and it can easily be distorted by accounting measures like ‘goodwill’. In fact, book value is a measure of liquidation value for debt investors, so not very relevant for equity investors who are more interested in the returns a company can generate from its assets.  

Interest spread

In the previous blog I mentioned: the interest spread for a bank is the difference between its cost of deposits and lending rate. One fact to notice is that most banks would have very similar lending rates due to competition or in the Pakistani context, due to regulations on conventional banking. So, within the interest spread, the key metric of focus is actually cost of deposits.

How do banks lower the cost of deposits? By maintaining a higher number of current accounts (pay no interest) as opposed to savings account (which pay interest) for depositors. This can be a significant competitive advantage for banks, especially as they become larger. So, look for banks which have an above average interest spread (or below average cost of deposits).

A very high cost of deposit will be a red flag which needs further investigation by a look-through at how the bank is then investing those deposits. Will the bank sustainably generate high lending rates in the future?

Percentage of securities held-to-maturity

In bank accounting, securities can be marked-to-market (usually mentioned as ‘available-for-sale’ [AFS] or ‘held-for-trading’ [HFT] in financial statements) or flagged as held-to-maturity.

The difference is that under marked-to-market, securities are valued at their current market values which translates into unrealized losses on the income statement. In comparison, under held-to-maturity, securities are marked at their original value as opposed to market or fair value. This means that unrealized losses from held-to-maturity securities do not translate into unrealized losses in earnings.

This slight difference in accounting can be very consequential. Banks should have almost all securities under marked-to-market. Why? Because it gives an accurate picture of a bank’s investments.

Let’s say depositors withdraw their deposits greater than the bank expected – leading to a depletion of reserves for this purpose. Now, the bank would have to fund additional deposit withdrawals by selling their assets. They can’t sell loans so they would be forced to sell their securities. If securities are marked-to-market, the losses on them have already been realized so it’s not an issue. However, if the securities are held-to-maturity securities, they will have to be sold realizing the losses in the next financial report. So, held-to-maturity can be manipulated by banks to underreport their true losses especially in a rising interest rate environment.

Consequently, one should look for a bank with a below-average percentage of securities held-to-maturity. If the bank fails this check, it can also be indicative of poor management which is cooking the books to hide other losses – a common occurrence with banks.

Tier 1 Capital Ratio

Tier 1 capital ratio is certainly the most important metric for banks as it indicates the capitalization of a bank. But first, what comes under tier 1 capital? Or rather, how is capital defined for banks?

Capital is divided into tier 1 and tier 2 capital. Tier 1 capital includes disclosed reserves (retained earnings) and shareholder’s equity. While tier 2 capital includes non-deposit debt, hybrid capital (callable bonds), undisclosed reserves as well as other kinds of reserves (revalued reserves). Tier 1 capital is more important as it is far more liquid, can be measured more accurately and can readily absorb losses as they come.

Now, capital ratios are calculated by dividing the capital by risk weighted (adjusted) assets. Risk weighted assets are calculated by assigning a risk weight to each asset the bank has and summing up the multiples of the weight and asset. For instance, if a bank has $1,000 of loans with 50% risk and $1,000 of government bonds (risk-free), the risk adjusted assets would be $500.

Basel III regulations dictate that tier 1 capital ratio must be at least 10.5%. Besides this regulatory importance, the tier 1 capital ratio can reveal the risk appetite of the bank.

One should look for an above-average tier 1 capital ratio as it would mean the bank has lower risk. Well-capitalized banks generally have a tier 1 capital ratio of 15% or above. This cushion above the regulatory requirement is essential to absorb unexpected losses and stay clear of any future regulatory troubles or sanctions.

Basel III regulation also has minimum requirements for two other capital ratios (common equity tier 1 capital and total capital), but tier 1 capital ratio is the gold standard due to its liquidity and accuracy in measurement.

How does this all come together?

The difficulties in valuing banks means that analysts have to rely on certain metrics. Although there is a plethora of metrics out there, I decided to focus on the four most important ones.

Look for banks which after well-capitalized through tier 1 capital ratio, are transparent in their financial reporting (low % of securities in HTM), have a high interest spread and a high ROE relative to the sector averages. Besides these metrics, a high dividend yield would be a cherry on the top.