Prior to the widespread flooding, Pakistan’s economy seemed to be moving in the right direction. Inflation fell from 2009’s 25.3% to 11.7%, the trade balance shrank from USD 10.2bn to USD 8bn and the countries credit rating improved from CCC+ to B-. Unfortunately, the tragedy brought on by the floods have complicated things.The flooding has so far affected more than 2.5 million acres of cultivated land, destroying crops worth $2.35 billion. It could not have come at a worse time. The political situation is dire. President Zardari, is just holding onto power after two years of crisis. His opponents are trying to oust him using the Supreme Court to try and get the incumbent parties to ditch him. If this does not happen, regime change might occur with an Army coup. It doesn’t look like a pretty picture – but wait – could it be that all is not as it seams?
In order to access the risks but also the upside investment potential, Daniel Broby, our CIO, flew to Pakistan last week for a series of meetings with companies and government officials. He came back with some great insights and despite the issues, he is excited by the opportunities in the worlds lowest valued stock market.
Passing numerous military checkpoints from the airport, Daniel soon found out that the security situation in Pakistan is complex. The country is simultaneously facing more than one conflict. These include the Pakistan-India dispute over Kashmir, the unrest in Baluchistan, the Taliban insurgency in the Federally Administered Tribal Areas and North West Frontier Province, the Tehrik-e-Jafria Pakistan as well as the Sipah-e-Muhammad Pakistan divide between the Sunni Sipah-e-Sahaba and the Lashkar-e-Jhangvi. These have all led to an increase in the government budget for defence from 8% to 18% in the last year. Soldiers and private security guards are everywhere.
Most companies Daniel met with re-assure him that whatever happened the country was still the a great place to invest. This is nothing new to this complex country. Consider, however, that there is free movement of capital in and out of the country. In view of the current situation this is indeed remarkable. In fact, Pakistan is a land of opportunity for those with funds to invest, although admittedly not the place to be poor.
In various meetings with Silk Invest’s hosts, TSK Securities, it became apparent that international investors are too pessimistic. JSK’s power analyst was as enthusiastic as the brokers Head of Research was on the cement sector (think rebuilding 1.2m households).
As far as the textile industry is concerned, the largest industry, the floods caused 10 days of logistics disturbance, but not much else. Cotton production will actually be up 2% this year as much more was planted last year. Global cotton stocks are at an all time low, so Pakistan is gaining market share. The main issues facing the textile companies Daniel met are electricity and the aforementioned security situation. Unfortunately, on the security side the situation is scaring away buyers. They just dont want to come to Pakistan to negotiate. On the electricity side, the country suffers 20% downtime and there were five power cuts during Daniel’s visit.
The power problem is being addressed. Firstly, the floods have filled the hydroelectric dams to historic levels. Secondly, tariff reform should attract new capacity. Electricity is an inelastic commodity and faces no threat of demand slowdown. With these companies yielding 15% in dividends, there is clear value.
The exciting upside to Pakistan inc. comes from potential trade agreements, giving Pakistan more access to global markets. The most likely tariff to come down is the 11% tariff imposed by China on textiles. It turns out that Pakistan is more competitive than China (in fact a massive 25% more productive)! Textile wages in China are USD 350 a month, in Egypt USD 400 a month but in Pakistan only USD 80 a month. Indeed, and this is a real Silk Route story, Daniel met with one company that is in negotiation for a Chinese company to move its factory to Pakistan!
The Oil and Gas Development Corporation represents 20% of the market cap of the Pakistan market. Despite this, Silk Invest had access to top management during Ramadan! They told Daniel that he was one of the few Western investors they had ever met in Islamabad. The company is the upstream market leader with more share than all others put together. The USD 3 per barrel extraction cost is one of the lowest in the world. That means that the company will be profitable under any oil price regime. Who said you cant find a diamond in the rough?
Admittedly, the floods will result in some earnings downgrades, the Fertilizer industry is obviously important in a country that is still agricultural and may get hit. Detail on the impact of the floods be negligible, but referring to the previous floods we can see that the industry will suffer on the salkes side. When you get flooding you get new nitrogen rich soil and 1.5m farmers have lost their ability to pay for product. That said, Daniel met a really fascinating company in which we hope to invest when our Silk Road Frontier Fund goes live.
Like all frontier markets, telecom is an interesting sector. PTCL is the fixed line incumbent and has no competitor. It is using its cash flow to build out broadband (which has a miserable 500,000 customers so far) corporate services and data. Broadband is doubling every 3 months. Even fixed line is an exciting case for a country with 170m people with only 3% market penetration. Upside, however, will come from headcount reduction. They have 30,000 employees and in a perfect world they can get this down to 15,000.
The opportunity is evident. The risk is that there will be a military coup. Interestingly, Research by Invest Capital was shown to Daniel that illustrated that the economy actually performs better under the less corrupt and better organised army than the disparate politicians!
Pakistan is currently trading at a 40% discount to historic valuation, making it the cheapest country by pe multiple in the world.
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