Depressed valuations but unloved

THE benchmark KSE-100 index, after an impressive bull run of more than 20,000 points, or 46 per cent growth, between December 2023 and September 2023, has reverted to its rocky and volatile ways despite being severely undervalued.

The confusion regarding whether elections will be held or not, followed by uncertainty regarding the formation of the government, has eroded investor confidence. Due to such erosion of investor confidence, the KSE-100 index has lost more than 6,000 points (11pc) from its peak.

Despite compounded inflation of over 100 per cent over the last five years, equity valuations continue to trail even inflation, resulting in severe market undervaluation. It is estimated that the KSE-100 trades at a price-earnings ratio of 3.6 times, which is much lower than its long-term average and even lower than the ratio at which regional peers and other frontier or emerging markets trade. Pakistan is one of the most undervalued markets in the world, and there are very clear reasons for that.

The undervaluation largely stems from a higher risk premium associated with Pakistan. Such a high-risk premium is a function of political uncertainty, which eventually leads to policy uncertainty, the absence of a roadmap for macroeconomic stability and, ultimately, a lack of growth.

Despite compounded inflation of over 100pc over the last five years, PSX’s equity valuations continue to trail even inflation, resulting in severe market undervaluation

The results of elections have led to a stalemate where there is no clear-cut indication regarding who can form a government, and if they can even form a government, for how long the government is actually going to last.

In a scenario where even the government doesn’t know how much time it has, expecting a roadmap or a policy framework that charts out macroeconomic stabilisation measures and a gro­­wth trajectory is a fool’s errand at best.

Pakistan remains stuck in a low-growth trap. The inability to achieve economic growth weighs heavily on the competitiveness and performance of entities listed on the local bourse.

Most earnings growth exhibited by many entities listed on the local bourse is largely a function of inflation rather than real growth in volumes or market expansion. The largest two sectors of the KSE-100 index, i.e. banking and energy, are marred with heavy sovereign exposure.

More than 70pc of banking assets are directly or indirectly dependent on the sovereign. The profitability growth of banks is a direct consequence of high-interest rates that exist due to the insatiable borrowing appetite of the sovereign.

Similarly, the energy sector has been stuck in a liquidity crisis for years due to the inability of the sovereign to resolve the circular debt crisis. The caretaker government wasn’t able to make a decision, and the inability to have a government with a clear mandate in place will delay the decision further.

In a scenario where the two most important sectors of the bourse are entwined with the distressed fiscal position of the government, the risk premium associated with the market ought to be higher, eventually resulting in depressed valuations.

Markets are forward-looking, and they do not see much hope in the future, given political and economic uncertainty. Equities remain grossly undervalued, but that is due to a high-risk premium emanating from political and economic uncertainty.

A government with a clear mandate and a roadmap that can give direction to attain macroeconomic stability and a growth trajectory can provide the necessary impetus for growth.

The inability to form a government or a weak government will eventually lead to higher risk as tough economic decisions are deferred further, resulting in more uncertainty and eventually depressed equity prices.

Over the last few quarters, many companies have increased their dividend payouts — the same is celebrated by the market as a sign of a healthy balance sheet. It may be a sign of a healthy balance sheet, but it is a red flag in terms of economic activity and future growth.

Companies continue to pay excessive dividends because they are unable to reinvest the profits in profitable projects or other initiatives, given the overall state of the economy.

The cost of capital, which is a function of the cost of borrowing, and the cost of equity continue to remain elevated as the government crowds out the available supply of capital, leaving little to no room for the private sector.

The market will continue to remain in doldrums till the time there is clarity regarding macroeconomic stabilisation, and a plan that can pull the country out of a low-growth trap. The overarching influence of the sovereign continues to elevate risk across the board, and the same continues to be reflected in asset values.

It is only through reducing sovereign risk that valuations can be unlocked, not just in public markets but also in private markets. If the same musical chairs continue, the music will stop one day, or maybe it has already stopped.