Right And Wrong In Pakistan

Summary

• The Pakistan stock market is one of the worst-performing in the world year-to-date.
• A plummeting currency, spiking inflation, and a belt-tightening IMF bailout package are among the many reasons not to like Pakistan equities right now.
• However, taking a step back and a good look at the big picture may put Pakistan and it's prospects in a different perspective.

The history of Pakistan dates back some 5,000 years, a storied past that has assimilated European, Asian, and Arab influences over millennia. Today, Pakistan has an equally interesting and promising future, but it also has a number of debilitating problems. In this article, we'll take a closer look at what's right and wrong with Pakistan.

What's wrong with Pakistan

Pakistan has been plagued by corruption for decades. A procession of government officials, including two prime ministers, have been accused or found guilty of bribery, misappropriation, and other malfeasance. The culture of corruption has led to woeful underinvestment in education, infrastructure, and even sanitation.

In August of 2018, there was a shift in government power favoring the Pakistan Tehreek-e-Insaf party (the PTI) led by prime minister Imran Khan. Though the party ran on promising social welfare, it ended up succumbing to austerity measures imposed by a $6 billion bailout package from the IMF, the 13th such package since 1980.

The package comes with terms, including allowing the Pakistan Rupee (PKR) to free-float, raising benchmark interest rates, implementing fiscal belt-tightening, and overhauling tax policy to increase tax revenue. Clearly, these changes are restrictive and likely to impede near-term economic growth.

As a result, both the IMF and the World Bank have been revising down growth forecasts, both institutions see growth slowing to a 2% handle. They also see inflation continuing to rise, it has already spiked into double digits following the devaluation of the PKR, shown below vs USD.

Pakistan Inflation Rate

USD vs PKR

In a worst-case scenario, these issues could boil over into an outright financial crisis and economic rout for Pakistan. Markets have responded accordingly, punishing Pakistani stocks. Pakistan has one of the worst-performing stock markets in the world year-to-date, down -27%. This is shown in the chart below, represented by exchange-traded fund PAK (which tracks the MSCI All Pakistan Select 25/50 Index in USD).

PAK YTD Price Return

And that's not even the half of it, literally, because PAK was down more than -70% from its 2017 high.

PAK Price Return Since 2017

That goes to show investors have been losing confidence in Pakistan for years and the most recent IMF issue is just salt in the wound. What else could possibly go wrong for Pakistan?

What could go right

Things can always get worse, but it's worth considering what few are talking about now - what could go right with Pakistan?

It helps to take a step back and start with the big picture. As a developing country, Pakistan is still early and ripe with unrealized potential. The people of Pakistan are young, 90% of its population is under 55 years old. Not only is this higher than in developed markets, but surprisingly it's even higher than in emerging markets like India and China. At the same time, Pakistan's population growth is also outpacing the rest of the world. Keep in mind, this is all happening even as Pakistan already has the sixth-largest population and the tenth-largest labor force globally.

Pakistani Population Source: CIA World Fact Book, BCM

This is a simple observation, yes, but economic growth simply boils down to more people doing more things, aided by productivity gains. In terms of productivity, Pakistan has plenty of room to improve. That combined with its young and growing population provides a good foundation to build upon in the decades ahead.

Of course, implementation has always been a problem for Pakistan, the government is repeatedly ensnared by corruption and dysfunction. But as with its youth, there is hope for the future. Newly elected prime minister Imran Khan, among other things, ran on reforming government and stamping out corruption.

True, he already back-peddled on a promise not to rely on foreign help, however, that was probably the right choice. The reality is the Pakistani government is structurally impaired by decades of neglect. Frankly, it needs outside help to rebuild before it can find a sustainable path forward.

Khan is not only quick to recognize this but is also willing to change course instead of stubbornly clinging to irrational ideology. Khan recently replaced financial figures including his finance minister and the head of Pakistan's central bank with appointees that have history and experience working with international bodies like the IMF and the World Bank. He also just met with US President Donald Trump for the first time ever, seen by many as a reconciliation of US-Pakistan relations.

While Khan's opponents criticize him for submitting to foreign influence, he actually looks to be making measured, strategic moves to ensure things go according to a master plan. That plan, according to the IMF, "aims to stabilize the economy and lay the foundation for robust and balanced growth." If successful, the program will unlock an additional $38 billion of financial support for Pakistan from international partners.

The IMF program comes alongside the Chinese Pakistan Economic Corridor program (CPEC) which is projected to inject $62 billion worth of infrastructure projects into Pakistan. These types of capital infusions are instrumental to Pakistan's development. But to keep the money flowing, Pakistan must show that it can play nicely with others and is committed to creating a safe, stable, and transparent environment suitable for investment. From that perspective, it appears PM Khan is moving the country in the right direction.

Lastly, despite its long list of troubles, Pakistan actually isn't doing that bad, relatively speaking. For example, both its current GDP growth and Debt to GDP figures are at levels that developed countries would be pleased to report, shown below.

GDP Figures

Source: TradingEconomics.com, BCM

Yes, these numbers are expected to deteriorate as Pakistan goes through an adjustment period. But so long as Pakistan doesn't implode in the process, it will likely resurface with a "foundation for robust and sustainable growth." So, if Pakistan is performing like this while broken, how will it perform when repaired?

What Mr. Market is saying

Meanwhile, the market has been loud and clear about Pakistan. Shares of PAK are down -70% since 2017. But looking beyond simple price action suggests the selling may be overdone. Pakistani stocks (as measured by PAK) are trading at 5.89x trailing earnings, which is a 57% discount to emerging market stocks (EEM) and 69% versus global stocks (ACWI). Similar relative valuations can be seen across the board.

Price Multiples

Source: Morningstar, ETF.com, BCM

Even against frontier markets (FM), one of the least expensive equity market groups in the world, Pakistan trades at a 45% discount based on earnings. The discount widens to 77% based on revenue. And with global stocks trading at 19x earnings it's just hard to say Pakistan doesn't look cheap on a relative basis.

With PAK currently trading at $5.86/share, I estimate fair-value to be ~$11 per share based on simple multiples of 10x earnings, 1.5x book value, and 1.2x sales. That's more than 88% above the current price.

Of course, the next question is when prices turn? Honestly, I don't know. Just because prices seem low doesn't mean they won't go lower. Uncertainty is high and buyers should be ready to endure at least a couple more years of volatility, possibly longer if there's an external shock like a global recession.

The bottom line

As with any investment, there are many uncertainties regarding Pakistan's stock market. There are many reasons not to like Pakistan and many more for why it is not the ideal place to invest.

Nobody knows if Pakistan will be successful with reforms. Meanwhile, a falling currency, rising inflation, slowing growth, and geopolitical turmoil have the trappings of a potential financial crisis and economic crash. The market has come to a consensus and is pricing in dismal prospects.

I don't know if the Pakistan market has found a bottom and there could certainly be more downside from here. What I do know is pessimism about Pakistan is deep and wide. Ironically, I find such circumstances to be a good opportunity. In all likelihood, Pakistan's current troubles will pass. It doesn't need perfection or even a complete turnaround. It just needs to survive and do less badly than expected. Right now cynicism is so pervasive and expectations are so low that it won't take much for Pakistan to deliver an upside surprise.

Yes, again, there could very well be more downside, but waiting for the "all-clear" signal may be as unrewarding as trying to time the bottom. Regardless of how much downside is left, prices already look low enough and valuation is already attractive enough to be interesting.

The bottom line is I expect a long, patient, position in PAK at $5.86 or better to be an excellent value over time. Keep in mind PAK is quite volatile and not very liquid. Buying and holding will require great patience, conviction, and nerves of steel. Do your own due diligence. If you take a position, build it over time on favorable price action and don't bite off more than you can stomach.

Disclosure: I am/we are long PAK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.