For years, Pakistan has traded at a chunky discount to its neighbour India and other emerging peers, hampered by a reputation for economic chaos and security issues. But Karachi, currently designated a “frontier” market, is now less than a year off re-joining MSCI’s emerging market index.
Pakistan was ejected from the index in 2008 after the local exchange imposed a price floor to halt a downward spiral and trading was practically suspended for five months. When it rejoins, passive or index-tracking funds could pump in a net $125 million, according to calculations by Renaissance Capital.
Another $550 million may come from active managers, assuming their Pakistan allocations are on a par with its expected 0.2 per cent weight in the index.
In anticipation of these flows, Pakistani stocks have already rallied 14 per cent in dollar terms this year, outperforming most other frontier markets and beating the 13 per cent emerging market average.
Asha Mehta, manager of Acadian’s Frontier Markets Equity Fund, said the UAE and Qatar had returned 98 per cent and 54 per cent respectively from the time that MSCI announced their upgrades in June 2013 until implementation in May 2014.
“Pakistan has strong earnings growth so when investors become more familiar with the fundamentals, it is reasonable to think there will be significant appreciation,” Mehta said.
But the tailwind from index entry is only part of the story.
Michael Levy, manager of the Baring Frontier Markets Fund, linked Pakistan’s promotion to the big league to efforts to create an environment for companies to deliver strong earnings growth, which should outlast any short-term fillip.
Newfound political stability, the completion of a three-year IMF programme, privatisations and a $46 billion agreement with China for an economic corridor mean economic growth is expected to reach around 5 per cent in the fiscal year to June 2017.
Earnings per share (EPS), a key profitability indicator, are expected to grow by 14.7 per cent over the next 12 months, according to consensus estimates, Levy said. But the bourse trades around 10 times forward earnings, versus an emerging markets’ average of 14 and around 17 for India.
“There are a lot of companies with good earnings growth prospects that are cheaply valued,” he said, citing positive earnings surprises this year from Lucky Cement and United Bank, both of which have been tapped by MSCI for inclusion in the emerging index.
Pakistan offers similar opportunities to most emerging or frontier economies, with cement demand growing by 15-20 per cent per annum. Less than a tenth of the population has a bank account, meaning financial stocks also have potential.
This has already lured managers such as Will Ballard, head of emerging markets and Asia-Pacific equities at Aviva Investors, who highlighted dividend yields of around 5 per cent – well above India’s 1.7 percent, according to Thomson Reuters StarMine data.
A third of Karachi’s free float market capitalisation is now held by foreign investors, but stumbling blocks remain. Many companies are not well analysed and security concerns still deter some managers from visiting Pakistan.
Liquidity is also an issue for bigger funds, with average daily trading volumes at around $106 million, according to RenCap, compared with some $2.6 billion in India.
While these volumes are good for a frontier market, larger emerging market fund managers said they would find it difficult to build positions.
Also, Pakistan’s weighting in the emerging markets index will be small enough for some funds to ignore it, while the country already features in the biggest EM index tracker – Vanguard’s $57.5 billion Emerging Markets Stock Index Fund and exchange-traded fund (ETF).
However, active frontier market funds, which according to RenCap hold around $570 million worth of Pakistani shares, could stay invested even after the move to the emerging markets category. Baring’s Levy, for instance, does not intend to sell solely on the basis of the upgrade.
Also, Pakistan, in contrast to many frontier markets, is an oil importer so frontier funds will be reluctant to sell, says Hasnain Malik, head of frontier markets strategy at Exotix Partners.
Ross Teverson, who runs an emerging equity fund at Jupiter, said Pakistan would see more measured inflows than the UAE and Qatar, where cash flooded in before their index upgrades.
“We will see a more gradual waking up to the opportunity in Pakistan,” he said. “But it has been neglected for a long time, and therein lies the opportunity.”