Pakistan has undergone a major crisis over the last two years. The equity market is down 60% since the peak, the currency has depreciated more than 35% and an IMF deal has now been signed. Headlines are bad but based on history this is normally the perfect setting to get involved for a good 5 year trade. What we see on the ground make us much more positive than that however. The reforms currently undertaken by Imran Khan and PTI have the potential to make Pakistan Asia's next break out nation. This occurring at a time when the equity market trades at an all time low on P/B creates a long term assymetric risk-reward which in our view is unprecedented in an Emerging Markets context.

When we launched our Pakistan Fund 8 years ago, Pakistan was a case of perception arbitrage. Behind the common perception of the country as a hotbed for terrorism there was a surprisingly well functioning equity market that used to turn over USD 500-1000m a day, hosting a range of well run family owned businesses some being listed as far back as a century. There was a proud entrepreneurial background that fascinated us. We showed data on how Pakistani corporates outgrew their Indian peers over time (see graphs below) but still traded at half the valuations. Our argument back then was that despite all problems this was a country where you should have some long term exposure, just like in India or Indonesia. Pakistan was a boom and bust market where five strong years was followed by two bust years, but the average returns throughout a full cycle was on par with India and it provided diversification in a global portfolio. 2012-2017 was a great period for Pakistani equities and our Pakistan fund was one of the best performing equity funds in the world during that time, returning close to 300% in Swedish Krona, only to be followed by a painful bust which has brought it down not too far from where we launched it.

From boom to bust

From 2012 Pakistan underwent a traditional boom cycle. Foreigners returned as risk appetite for frontier markets improved, the first democratic election cycle was realized in 2013 as PML-N rose to power, the signing of CPEC in 2015 would resolve Pakistan's electricity deficit and provide fiscal stimulus through infrastructure investments which would provide trickle down effects in the economy. The currency was a bit too stable but inflation was on its way down and foreign direct investment was around the corner. MSCI upgradation was looming and local investors were optimistic. Pakistan was still trading at a significant discount to average Asian EM valuations. Panama leaks and the ensuing political uncertainty flared up and the negative cycle caught traction. Pakistan's historical vulnerabilities, i e a domestic consumption led economy, a narrow export base and too few local goods to feed the appetite in good times, created concerns on the increasing current account deficit as reserves started depleting. Elections in July 2018 was supposed to set a fresh start with an imminent IMF-deal but instead of the expected continued PML-N ruling, history was written when Imran Khan's PTI came to power. Expectations of an imminent IMF-deal was still there but slowly and gradually investors realized this time was different. And investors don't like surprises. From the peak in late May 2017 the KSE100 has lost approximately 60% in USD and the MSCI Pakistan IMI Net (USD) has lost slightly more than that. We now have our IMF-deal signed and delivered, local investors are comfortably pessimistic, foreign selling seems done. The classic trade vs India looks tasty again (see graph below). So a 5 year boom ahead of us? We believe there is reason to be more optimistic than that.

Why we believe Imran Khan and PTI can put Pakistan on a lasting economic recovery

We understand the picture of Imran Khan gets blurry in international press given foreigners' traditional skepticism towards politicians in what they perceive as "third world countries". These are times of populism and this person seems to have come from nowhere. Is he a Pakistani version of Donald Trump? Is he a dictator targeting to leverage Pakistan's position as a nuclear armed country? Adding to that - The opposition has claimed, and continue to claim, foul as to how he won the election. And his accountability drive seems limitless. Pakistan has jailed former Prime Minister Nawaz Sharif and former President Zardari, both former leaders of the historically dominating two parties. Family members of them are under investigation and headlines of other former government members being targeted for misconducts seem to come on a daily basis. We are not going to vouch for all of Imran Khan's actions. We are not gonna claim that the targeting of wealthy politicans have been justified in every single case. Simply because we don't know exactly what has happened in the past. We are netither going to defend what seems to be "a bit shorter leashes" on local media. But if we are blunt enough to put aside our western version of how we believe implementation of accountability in a democracy should work, the symbolic value of starting an accountability drive with the country's past leaders should not be underestimated. 90% of the population would probably say that the targeted politicans had a baggage worthy of the public's attention. And there is most likely a background as to why one of them used to go by the nickname "Mr 10%". Ask any Pakistani about their past leaders and they would say that anyone after the 60's was corrupt. Seeing "justice" being done (again from the populations' perspective) makes the very hard austerity measures that now follows more bearable. Here is our crude interpretation of Imran Khan and why his party PTI might actually change Pakistan's boom and bust cycles and set the country on a lasting recovery:

Imran Khan is trusted by the people, and especially the youth and the educated. Among the Pakistani diaspora (8m Pakistanis live outside Pakistan) he is considered the great hope. When he entered the stage of Capital One Arena in Washington recently more than 20 000 Pakistani-Americans greeted him like a rockstar:

Even the most cynical parts of opposition would not call Imran Khan corrupt. They would call him a dictator, a naive idealist, many would frown upon his sometimes rude wording towards other politicians. But they will not say he is corrupt. That matters because as Pakistan now undertakes a massive tax reform, aiming to document its economy and make its citizens and corporates pay their taxes, the essential ingredient to succeed is trust. Far from everyone believes Imran Khan will spend their money wisely, but very few believe he will steal it. That’s a big, big first step when you want a nation to gather around a common goal - the "Naya Pakistan".

He is trusted by the military. “Selected” or “elected” the military is behind Imran Khan. For the first time you have an elected political leader who undoubtedly has the support from the political force which most citizens and political spectators believe is still the ultimate decision maker. For the meeting with Donald Trump in U.S. Imran Khan, as the first Pakistani leader, brought also the Army Chief General Bajwa. The two main opposition parties (PML-N and PPP) who used to take turns running the country always were perceived to lack actual powers in foreign policy as this area was anyway assumed to be decided by the military. It gives Imran Khan’s very tough reform measures, and even more so his promises to world leaders and foreign corporates, a completely different weight.

We believe the international community will love him. Pakistan's absolutely biggest problem over the last 20 years is not corruption, terrorism, lack of infrastructure or literacy. It is perception. A generation of western fund managers and corporate leaders have learnt to fear Pakistan and frown upon even the notion of investing there. We believe Imran Khan is the leader who can actually change that perception. A few more now have seen him speak post the Trump meeting and understand what we mean. My personal interpretation of him is that he has the attribute of fully understanding his own people and their culture, at the same time as he fully understands the perception of Pakistan in the international community. His speech at the U.S. Institute of Peace in Washington is a good way to get a first hand view of the message he will give the foreign community on a range of traditionally very sensitive areas. For those who have been following Pakistani politics for some time the new level of transparency is refreshing.





Rebooting the economy. As most developing economies Pakistan has a history of subsidizing its corporates and citizens. To some extent subsidies can be crucial when bringing the poorest parts of society to a level where they can help themselves (i e, electricity for lamps when you do your homework in the evening). The problem with broader subsidies is that it can cause overconsumption without necessarily leading to increased economic output (especially if the output is not properly documented). Most subsidies, except for the ones to the poorest parts of the population are now eliminated. Corporates and the middle class are paying close to actual cost for gas and electricity and frequently abused loopholes have been closed. The currency that used to be a “managed float” meant in reality that the central bank spent billions of USD in keeping it stable, building up depreciation pressure every 5 years. Post the appointment of Ex IMF-employee Dr Reza Baqir as the SBP Governor the rupee's value is now based on demand and supply. The rupee has depreciated 35% since late December 2017, vs 27% during the financial crisis 2008. It is currently in vicinity of fair value on a REER basis and from here can be expected to move in line with Pakistan's competitiveness in global trade and its ability to attract foreign investment.

Documentation of the economy. This is actually in our view the most important part of the rebooting of the economy but its significance means it deserves a section of its own. Pakistan has run a budget deficit of 5-8% of GDP over the last 10 years. The main problem is not overspending, but revenue. Tax/GDP has been on a run rate of 9-10% of GDP vs 35% in OECD countries. Pakistan has less than 2 million tax payers out of a population of above 200 million. Just to put in perspective - Sweden has more than 5 million tax payers out of a population of 10 million. Pakistan does not have too low taxes. The problem is that too few share the burden. Different estimates have put Pakistan’s middle class at somewhere between 70-80 million people. This is your potential tax base. In a recent interview with Chairman of the FBR he pointed out that out of 347 000 industrial electricity connections only 47 000 where registered tax payers and out of 3.1 million commercial lines less than 10% were registered tax payers. https://tribune.com.pk/story/2012248/2-wont-go-back-cnic-condition-fbr-chairman/ The ongoing tax reforms in Pakistan is about documenting the economy and make sure that everyone that can contribute, also contributes. Ambitions are good but it is the actions we currently see on the ground that make us really optimistic they will actually yield results. They are both extensive, practically oriented and credible. Example: My colleague the other day bought some baby accessories from one of the malls in Karachi and concluded the bill now had added 17% sales tax (GST). It never used to be there before. The store keeper explained that the FBR now had electronic access to all registers and collected data on all sales. Repeat 10 million times and yes it will make a difference. Bottomline - PTI and Imran Khan have showed that they are not afraid of implementing deep and painful reforms in order to set the economy on a more lasting path. During my 23 years of investing in Emerging Markets I can not recall having seen such drastic steps implemented in any economy during such short time.

What's next?

This is the background. Now we turn to how we expect this to play out.

Forget FY2020 (July 1st 2019- June 30th 2020). The next couple of months will be painful for most Pakistanis, corporates and citizens. They are not only digesting the deepest devaluation for more than 30 years. They are also asked to completely change the way they undertake business. The documentation requirements for all purchases above 50K PKR (ca USD 300) will slow down economic activity as traders, used to run under the radar, are trying to find ways around it. Higher input costs and lower demand will be painful and a range of Cement companies and companies in consumer discretionary (cars, refridgerators etc) will find themselves in losses for a couple of quarters. We have already seen it in cement dispatches and car sales. And recall my friend with his baby stuff receipt. It hurts to suddenly have to pay 17% more for your everyday consumption. The banks, energy and utilities (just below half of index) will however fare pretty well in the new environment and are likely to show profit growth, even during the next 12 months. Higher interest rates will improve Net Interest Margins, net cash on the balance sheet and USD-pricing of output will compensate the Energy companies and the Utilities for the slower economic activity short term. The higher interest rates will have only a marginal impact on the listed companies given the average low debt to equity among listed corporates. Shock therapy comes at a high cost short term and for a full generation of the local business community this is a completely new environment. This scares them. Just as local investors were late to react in the initial bear market because they did not see significant impact on local corporates, they are now selling as they see the short term pain on the ground. This is the reason why local mutual funds are dumping shares as foreigners are finally back in buying mood. YTD foreigners are net buyers of USD 70m (first net inflow since 2014), while local mutual funds are net sellers of USD 160m. Combined with the fact that liquidity has dried out to the lowest levels since 2011 you have a very unpredictable short term market environment in front of you. Your dilemma will be that the very low volumes in the market will make it close to impossible to get reasonable exposure without pushing prices through the roof when the market turns.

The foreign inflow into the equity market this year should in our view be only the start of a broader return of foreign investors. We believe the reform package initiated by PTI and Imran Khan are textbook changes needed for any country to significantly shrink the gap to developed economies. The tax reforms, primarily the documentation process ongoing, we would call unique and something foreign investors have never seen a country of Pakistan's size undertake in such short time. It might take some time for foreign investors to fully understand the extent and the willingness to follow through, but it should eventually put Pakistan on the very top of the list of countries with potential economic improvements ahead. This will be a new investment environment which will be about potential for reforms and long term participation in a reform story. We always said Pakistan is not a multiple expansion play. For the first time we now see a chance it might become one.

We have seen it in the side deals Pakistan have signed during deep distress with friendly countries such as China, Saudia Arabia, UAE and Qatar. These countries have officially backed up Pakistan’s refinancing schedule for the duration of the IMF programme. That is a pretty unique feature in itself. But we expect the friendship to expand from here and also include more countries. The new agreement (we have to call it that) with U.S. regarding the Afghanistan peace process might unlock flows from the CSF (Coalition Support Fund which have been held back for several years). World leaders are likely to see in Imran Khan what we see in him. Someone they can relate to, who gets to the core of the problems and whom they trust. This means Pakistan will gradually be perceived as a normal and more predictable country. Improved international relations will likely feed through down to the corporates in these countries. Pakistan has been hovering at less than 1% of GDP in FDI (Vietnam is at 10%) in the past. FDI is the big unknown at this stage and official estimates by the IMF are very low. We simply conclude it is an area with upside risk.

The most logical way forward from here is import substitution and efforts to raise exports. Whatever can be produced in Pakistan should be produced in Pakistan. Imran Khan seems to have fully understand the power of Industrialization. If logic prevails this should start with the energy sector. Fact is that excluding petroleum imports Pakistan already in FY 2019 ran a current account surplus (page 34 in the IMF Staff report). In our view it would in theory make sense to pay local oil & gas producers prices in line with what Pakistan pays for imports in order to maximize local production. The documentation requirements should also mean a eventual decrease in illegal imports and smuggling, something that will support local producers (think leading names in Consumer discretionary). Raising exports significantly will take longer time. Expansion of Special Economic Zones (SEZs) from the current handful is one step. It will however take time to bring the broader local production base to the international arena. Relationships need to be built, products need to be adapted and factories need to be built. The variable cost component (labour) is far less important than strong international relations and favourable trade agreements. What we can conclude is that if Pakistan continues on the normalization path there is huge potential to long term raise exports to GDP. It is currently at a pathetic 7% of GDP vs 29% world average, 19% in India and close to 100% in Vietnam. Foreign Direct Investment will be an important part of that effort.

Opportunities in the equity market

Pakistan's equity market is well diversified. Depending on your risk profile there are different opportunities. Most of the larger companies have run their businesses for the last 30-40 years. The oldest still listed company is actually a brewery. The total market capitalisation (527 listed companies) is currently just below USD 50bn (17-18% of GDP). The last three months the average turnover a day has been just below USD 30m. 2 years ago that number was USD 100-200m a day. Back in the mid-2000 Pakistan was regularly trading USD 500-1000m a day. A feature we always liked is the presence of pension funds, state and corporate, who will provide liquidity in the most difficult times. Today around 80% of trading is done by locals, a figure that has been pretty stable since I started following the market back in 2005.





Valuations according to Bloomberg estimates puts the market at around 6x earnings for year end 2019 with an expected dividend yield of 7%. The average between 2005-2018 has been 10x and 5.5% respectively. Pakistan has always traded at a significant discount to other Asian equity markets. Are estimates correct? Most likely not. Materials (specifically Cements), Consumer discretionary, Healthcare and Consumer staples are likely to see additional downwards revisions of earnings in FY20 (July 1st 2019-June 30th 2020). These sectors constitute approximately 40% of the broader KSE100 index. Energy and Financials (approximately 48% of KSE100) are however likely to see upwards revisions. Energy because their pricing is in USD and the rupee has depreciated significantly more than expected. Financials because interest rates have risen above expectations which will translate into higher NIMs. Adding the plusses and minuses we conclude the overall valuations are probably decently representable of actual circumstances. If one is skeptical about the "E" in a stage of the market where everything is a moving target one can instead look at Price to Book valuations. Here Pakistan trades at a ten year low.





Risks

What can go wrong? As always when it comes to markets in distress - everything.

For equity investors the timing risk is the most obvious short term risk. Local investors, which constitute >80% of trading, are in pieces right now. As always towards the end of a bear cycle brokerages are closing down, people are laid off and mutual funds are pouring out shares in the market. Blood on the street? Oh yes, but it can run a lot longer than any fundamentally oriented investor can imagine. The very low trading volumes might exaggerate the final dip.

Possibly somewhat surprising is that we are less concerned about risks to the economy. That in itself probably tells you something of our expectations in the short term. We believe these risks are already more than discounted by the market. Based on what we are currently seeing on the ground there are downside risks to GDP growth this year. On the other hand growth undershooting will positively impact the current account and inflation, both which are more important than expansion at this stage of market depression. We believe IMF's estimate of 13% average inflation for 2020 is on the higher side. With the stated objective from the SBP to look at inflation environment for the next 1-1.5 years and with the Policy rate already at 13.25% we might be closer to the end of interest rate hikes than many expect. In 2008 long term bond yields peaked at 16.5%. They are currently at around 14%. In terms of the IMF agreement we believe Pakistan's efforts, rather than the outcome, will be the most important parameter for IMF. The structure of the IMF deal leaves a lot of room for interpretation and it seems there is a far more wide ranging mutual understanding between the two parties this time. As long as Pakistan maintains its efforts on documentation and revenue raising measures we would be very surprised to see the relationship go sour. Everyone involved understands the challenge of undertaking such deep reforms during crisis.

When we discuss our core markets (Bangladesh, Vietnam, Sri Lanka, Pakistan, Nigeria, Kenya and Egypt) we normally claim that investors tend to overestimate politics' impact on the long term case (good companies find their way regardless). For Pakistan's ongoing transformation we believe however Imran Khan is crucial at this stage. He is tearing down Pakistan's traditional model of functioning and now he needs to rebuild it. Anything happening to him at this stage would create severe short term uncertainty, at least for us. Given Pakistan's history of violence this risk can unfortunately not be ignored.

We briefly touched upon Imran Khan's accountability drive. Although one can see the rationale for the actions so far, it is however rational to ask the question how far he will take it. Even among the majority who trust him and believes in what he wants to achieve there is a nagging uncertainty whether his idealism will get the better of him. Will we also see headlines of jailed businessmen of listed enterprises? There has recently been talks of one prominent businessman leaving the country due to fears of being targeted in the investigation of one of the energy deals made during previous governments. How many more businessmen/businesswomen have those fears? A broader stroke against businesses who actually acted in accordance with previous governments' policies would however be counterproductive and so far we have not seen Imran Khan acting irrationally. If he wants to rebuild Pakistan he needs corporates to work alongside him and look forward, not constantly looking over their shoulder. So far the new government has been all about "sticks" and little "carrots" however. Expectations are low, but it is soon time to give some incentives as well.

Conclusion

Yes we know how popular you will be when you pitch Pakistan as part of your global mandate. We have seen those eyerolls too many times and are used to being ridiculed. And we are in the midst of a financial markets meltdown which puts Pakistan at the very bottom of performance tables for the last two years. The "instant information society" is fantastic but one side effect is that sell side analysts have increasingly taken upon themselves to find trades, rather than long term value. There might be undisputable evidence that you should refrain from market timing but you still don't want to look like the fool that lost 20% in a quarter. In Pakistan of all places. There is a smart saying: "Tops and bottoms are for fools". But there comes a time when you just have to take the risk of taking some short term hits to get involved and looking at the very headline of this article - we are saying that the time is now.

The end game of any financial meltdown is played in low volumes (as was the case in 2011 and which is the case right now). The downside risk of that is that you might see an exaggerated final drop due to lack of depth in the market. The upside risk is that it will be next to impossible to find relevant volumes in the first stage of the market recovery. As a long time investor in emerging markets I like to think of my investments in best case and worst case scenarios. If I can accept the worst case scenario I feel much more comfortable thinking about the upside. And looking at Pakistan today I see one of the most assymetric risk-reward scenarios I have seen since Russia in Autumn of 1998. Worst case you have a market that is trading at ten year lows on most valuation metrics and that everyone still hates. But if we are somewhat right that Pakistan is actually turning the page, and is willing to undertake at least part of the reforms we currently see are being implemented, our perception arbitrage case from 2011 suddenly became a case of Asia's latest break out nation. A new India, only at 1/3 of the valuation.