Sunday 30 December 2012

Equity Market of Pakistan - Portfolio Management


Free and well-developed Equity Market

Equity market is well developed and totally free & restriction-less for all investor local as well as foreigners. Having fully automated trading system with separated Central Depository and clearing company. KSE is FIX Compliant. (Financial Information Exchange Protocol) State-of-the-art computerized trading system known as Karachi Automated Trading System (KATS). Internet based routed trading facility. Each and every order/ trade is duly logged & recorded, with pre-trade client-wise margins verification system effective at order level.
The equity market plays an important role in the economic development of a country. It helps in the mobilisation of financial resources, both domestic and foreign. for investment in various sectors of the economy. Moreover, it serves as an effective medium for exchanging business information among shareholders, business community, and prospective investors. It is often considered a barometer that reflects the general investment climate of a country.
In Pakistan, like other developing economies, the equity market has not played its clue role because of interventionist economic policies and overreliance on debt financing. It was not until the mid of 1980s when the importance of an effective equity market was recognized and steps were taken to activate the market. However. the market actually became active in the beginning of 1991 when it was opened to international investors. Since then the market has made considerable progress and improved in size and depth.

PERFORMANCE OF KSE AFTER 2000 AT A GLANCE:

2001 has been quite a dull year in terms of actual stock market activity in Pakistan. The downward trend showed the reduction of KSE-100 index. The listed companies were 737 including only three new companies and the market capitalization was Rs. 296.144 billion. During financial year 2002, the KSE had implemented several structural developments. The KSE-100 index shot up by 2278.54points and market capitalization also increased up to Rs. 550.55287billion. Only four companies were listed in Karachi stock market and listed companies reached to 719.The bullish trend of stock market continued during 2003 and KSE-100index touched the highest point i.e. 4604.02. The listed companies were 705 in which only 6 companies are new and market capitalization reached up to Rs. 951.55 billion. The performance of KSE showed improvement in 2004. Seventeen new companies were listed in stock market and listed companies reached up to 705 and market capitalization reached up to Rs.1723.454 billion. The continuation of bullish trend in KSE during 2005 is also observed and KSE-100 index first time cross 10000 points. The KSE-100 index shoots up by 10303.15 points and market capitalization also accelerated up to Rs. 2467.9 billion. The year 2006 maintained bullish trend momentum and made records in Karachi Stock Market. KSE-100 index crossed the barrier of 12000 marks and reached 12273.77 points. During 2007 the bullish sentiments in stock market continued. There are several factors which are speedy privatization process; attracting foreign investors in prestigious organizations; resolution of IPP(Independent Power Producer) issue; allowing foreign investors to repatriate their funds without any restrictions; reduction in the interest rate by commercial banks; recovery of outstanding/overdue loans; rescheduling of foreign debts and prepayments of expensive foreign loans. The market capitalization increased up to Rs. 4019 billion and listed companies were 656 including 18 new companies.


Market Indices

KSE 100 INDEX

Karachi Stock Exchange 100 Index (KSE-100 Index) is a stock index acting as a benchmark to compare prices on the Karachi Stock Exchange (KSE) over a period. In determining representative compaines to compute the index on, companies with the highest market capitalization are selected. However, to ensure full market representation, the company with the highest market capitalization from each sector is also included.
The index was launched in November 1991 with a base of 1,000 points. By 2001, it had grown to 1,770 points. By 2005, it had skyrocketed to 9,989 points. It then reached a peak of 12,285 in February 2007.[1] KSE-100 index touched the highest ever benchmark of 14,814 points on December 26, 2007, a day before the assassination of former Prime Minister Benazir Bhutto, when the index nosedived.[2] The index recovered quickly in 2008, reaching new highs near 15,500[citation needed] in April. However, by November 22, 2008 during the global financial crisis of 2008 it had fallen to 9,187

KSE 30 INDEX

The Karachi Stock Exchange has launched the KSE-30 Index with base value of 10,000 points, formally implemented from Friday, September 1, 2006. The main feature of this index that makes it different from other indices are:
KSE-30 index is based only on the free-float of shares, rather than on the basis of paid-up capital.
The other indices in Karachi Stock Exchange represents total return of the market. That is, when a company announces a dividend, the other indices at KSE are not reduced/adjusted for that amount of dividend (whether cash or bonus).Whereas, KSE-30 Index is adjusted for dividends and right shares.
At the end of 13 July, 2007, KSE-30 Index reached its highest ever level of 17,162.45.

KSE ALL SHARE INDEX

In 1995, the need was felt for an all share index to reconfirm the KSE-100 and also to provide the basis of index trading in future. By August 29, 1995 the KSE-All Share Index was constructed which became operative on September 18, 1995.
At present, the KSE has four market indices (KMI-30, KSE-30, KSE-100 and KSE-All Share Index).

KMI INDEX

KSE Meezan Index (KMI-30) comprises thirty companies which qualify by the KMI Shariah screening criteria. The index was introduced on the Karachi Stock Exchange in September 2008 and the base period for this Islamic index is June 30, 2008.
The index is calculated using "free float market capitalization". At any point in time, the level of the index reflects the free float market value of selected Shariah-complaint shares in comparison with the base period. KMI-30 is rebalanced semi-annually.
The guidance is taken from qualified and well reputed Shariah experts while Shariah complaint of stocks is done.

Demutualization Overview

Demutualization is the process of converting a non-profit, mutually owned organization to a for-profit entity owned by the shareholders. Securities and Exchange Commission of Pakistan has also been pursuing the process of demutualization of stock exchanges since 2002.
The process involves not only Corporatization, (which is conversion of a stock exchange limited by guarantee into an entity limited by shares) but also it segregates ownership and trading rights. Demutualization brings balance among interest of different stakeholders in the corporate and governance structure of a stock exchange.
WHY – Demutualization is a well established global trend and has been adopted by many recognized stock exchanges around the globe. To bring about an improvement in the governance structure and to make the stock exchanges more competitive.
WHEN – Several detailed sessions and meetings were held with the stakeholders (including the management, board and demutualization committees of the stock exchanges). ISLAMABAD, March 27: The Stock Exchanges (Corporatization, Demutualization and Integration) Law got approved in a joint session of the Parliament. This landmark achievement was long awaited since the passing of the bill by the National Assembly in October 2009.
The SECP has approved various documents submitted by the stock exchanges under the Stock Exchanges (Corporatization, Demutualization and Integration) Act, 2012. And on 7th May 2012 the Parliament’s Act received the assent of the President. “An Act to provide for the corporatization, demutualization integration of stock exchanges in Pakistan for the development of the Capital Markets of the Country”

Introduction

Ø  Capital market plays a vital role in channeling savings into investments leading in increased income, employment, and output. Being a developing country, Pakistan needs a securities exchange that enjoys the confidence of domestic and foreign investors and able to mobilize both domestic and foreign capital for economic growth.

Ø  Globally, stock exchanges have undergone transformation. Advancement in communication technology and globalization have made it possible for investors and issuers to move to more efficient capital markets, even if these are location outside geographical boundaries of their country.

Ø  The committee was constituted by the SECP to make a comprehensive plan for demutualization and give recommendations on integration or transformation of KSE, LSE and ISE.

Ø  In order to cover its terms of reference, the Committee conducted a consultative process in which it sought views or core stakeholders – investors, issuers and members of exchanges – through meetings and questionnaire

Problems Faced by the Stock Exchanges

Ø  Despite economic growth in the country, companies are not seeking listing at the exchanges and little capital formation is taking place through stock exchanges. Issuers do not appear to have confidence in stock exchanges and see minimal value addition in listing. There is limited free float in the market and it is coming under increasing pressure due to a disproportionately large growth in mutual funds and commodity market.

Ø  Investor base is small. Percentage of adult population that owns shares is less than 1%. Growth in mutual funds has not led to increase in the number of investors. The number of shareholders in listed companies has practically remained stagnant despite the bullish sentiment in the market. The only measure that is expanding investors base are offers for sale of state owned enterprises.

Ø  In spite of a series of reforms relating to governance, professional management has not been allowed to establish firmly in the exchanges. There is a general view that exchanges are being run by brokers in their own interest. Exchanges are unwilling or unable to supervise and discipline members and listed companies. The role of non-member nominated directors in improving governance is rather mixed. Although they have helped in improving the standard of governance but not to the desirable extent.

Ø  Due to existence of three exchanges, liquidity and price discovery are fragmented and costs escalate for all stakeholders. There is virtually no competition among exchanges and KSE is the dominant exchange in all market segments.

Ø  Investors are vulnerable to different forms of market abuse. Market remains rife with allegations of price manipulation, front running, insider trading and blank selling. Exchanges do not have the capacity to carry out surveillance and investigation in market abuse.

Ø  The management of settlement risk is weak and needs improvement.

Ø  Exchanges are financially weak. Unlike international exchanges, they derive most of their income from listed companies rather than trading charges and other fees on services. They do not have the means to finance capital expenditure that is required for development.

Ø  Exchanges are also unable to attract and retain professionals. Most of the staff is non-management. Due to insufficient economic and human capital, they are unable to grow and develop like international exchanges.

Ø  Speculative activity dominates the trading and liquidity is highly concentrated. The equity market has been distorted by Badla financing. Due to excessive speculation, concentration, and Badla financing, the market is exceptionally volatile.

Ø  While the number of issuers and investors is very small, the number of intermediaries is disproportionately large. The eligibility criteria for intermediaries are weak and intermediation is generally of low quality.

Ø  Analysis of the problems being faced by stock exchanges shows that these are fundamental in nature and exchanges are fulfilling their economic role and discharging regulatory responsibilities to a very limited extent.

Demutualization of Stock Exchanges

Ø  Demutualization can improve governance structures at the exchanges, provide access to economic and human capital, generate commercial pressures for growth and development, allow entry of new and better intermediaries, unlock value of membership cards for members, provide domestic and international recognition, give opportunity for making equity cemented international alliances, and help change the perception and image of an exchange.

Ø  International and in particular Asian experience of demutualization has demonstrated that after demutualization, the market capitalization, turnover, and products and services offered by exchanges have greatly increased to the benefit of all stakeholders. Brokers have benefited from demutualization through higher commission earned on increased trading volumes, and by capital gains on the shares, which they received on demutualization.

Ø  The core concern about demutualization is that it causes conflicts of interest between the regulatory and commercial role of a stock exchange. A number of measures can be taken to address this conflict including separation of some regulatory functions within or from the exchange and greater transparency into how a demutualized exchange is run.

Ø  The committee is of the view that Demutualization can help solve problems of the stock exchanges. However, demutualization should be seen as a means to an end and not an end itself. It would need to be carefully structured to achieve the desired results.

Integration of Stock Exchanges

Ø  There are a number of factors favoring integration, such as geographically neutral custody and settlement and the ability to provide remote trading terminals.

Ø  There could be various scenarios in which demutualization and integration take place. The scenario is which the interest of all stakeholders is best served is the one in which all three exchanges both demutualize and fully integrate.

Ø  Integration of stock exchanges can bring cost efficiency for all stakeholders, improve liquidity and price discovery, increase the pool of economic and human capital, offer synergies in risk management and surveillance, reduce complexity  in operations, lead to focused supervision by SECP, and provide domestic and international recognition.

Ø  If KSE, LSE and ISE integrate, the CDC and NCC shall become subsidiaries of the integrated exchange. This would further enhance cost efficiencies and help in having a single business strategy and coordinated developments. Due to integration, NCEL shall also become a subsidiary of the integrated exchange.

Ø  The core concern about integration is that it would eliminate possibility of inter-exchange competition. A balanced board of directors, inter-broker competition, close supervision by SECP, and encouragement of ECN, where brokers would be able to electronically match orders within the brokerage house, and possibility of licensing another stock exchange in the future, if necessary, would address concerns relating to lack of inter-exchange competition.

Ø  The Committee is of the view that integration can address solve the problems of stock exchanges. However, like demutualization, integration should be seen as a means to an end and not an end itself.

Ø  A number of key issues in demutualization and integration would have to be address for their successful implementation.

Ø  These issues include who should take decision to demutualize and integrate the stock exchanges, compensation to members, composition of the future board of directors, moratorium  period on grant of new trading rights, self listing of an integrated and demutualized exchange. The Committee has discussed each of these issues in the light of responses of different stakeholders and international precedents.

 

Model 1: Fully Integrated Demutualized Exchange (FIDE)

Ø  The Committee recommends that KSE, LSE, and ISE should form a FIDE. With the integration of the exchanges, NCC, CDC, and NCEL shall become subsidiaries of FIDE.

Ø  Demutualization and integration should be effected under special legislation and the two should take place simultaneously. The decision for both demutualization and integration should be taken by SECP, as the two processes have implications on the interest of investors.

Ø  The process of simultaneous demutualization and integration requires that as a first step, a new demutualized company be incorporated and licensed as an exchange (NewSE). Finanacial institutions should be given 60% shares in the NewSE against cast. Members of the exchanges should be given 40% shares against consideration other than cash for the transfer of assets of KSE, LSE, and ISE to the NewSE. KSE, LSE, and ISE should cease to exist and the NewSE becomes FIDE. Financial institutions and members should disinvest 20% of their holdings in favor of general public and FIDE should get self-listed.

Ø  All existing members of KSE, LSE and ISE should be given trading right in FIDE, subject to fulfilling the legal and other requirements. Those who own more than one membership card should be given a single trading right. However, their compensation should be according to the number of memberships held. Since each member shall be given a trading right in the new integrated and demutualized exchange, compensation to members is not for the trading rights but for the perceived ownership rights in the exchange.

Ø  A moratorium on grant of new trading rights should be placed for one year after demutualization and integration.

Ø  No one person should be allowed to hold, directly or indirectly, more than 5%  of holding shares without prior approval of SECP. A person holding trading rights in FIDE should not be allowed to exercise voting rights, directly or indirectly, of more than 1% of total voting rights in a general meeting.

Ø  Employment in FIDE should generally be on a strict basis of merit. However, as between applications for positions at FIDE who are assessed as equally capable of performing the role, preference could be given to existing staff at KSE, LSE, and ISE. FIDE should appropriately compensate the employees that might be made redundant.

Model 2: National Exchange (NE)

Ø  An alternative model is being recommended. If sufficient progress is not made towards demutualization and integration within one year, the NewSE, sponsored by financial institutions, should become National Exchange (NE) whether or not KSE or LSE or ISE merge into it.

Requirements

a)      Members – 200
b)      These 200 members become company(s) themselves and their shares are floated
c)       3 stock exchanges (6.4 shares each) – Depends on the operation
       Not More than 40% strategic buyer (foreign or any other) – till 2014
       Not Less than 20% float in market (20 or more)
       Remaining to be held by the Broker(s)


Critical Success Factors

Ø  The success of demutualization and integration shall depend on some critical factors. These are commitment by the SECP, commitment by the Government of Pakistan, participation and sense of ownership by financial institutions as shareholders and brokers in the new setup, fair compensation to the members of KSE, LSE, and ISE, quality of the first board of directors of FIDE or NE, and quality of the first CEO and key management personnel.

Ø  The passing of this law is a significant accomplishment which will bring the Pakistani capital market on par with other international jurisdictions like India, Malaysia, Singapore, USA, UK, Australia, Hong Kong, Turkey etc. However, it’s in its implementation stage right now. Demutualization will in turn enhance governance and transparency at the stock exchanges and will attract strategic investors which will not only provide equity and technical expertise but will also result in increased visibility of these exchanges on international capital market forums.

Recent Happening/Events
Capital Gain Tax (CGT)
In Pakistan, securities trading remained exempt from CGT for 36 years till June 30, 2010. In 2010, after the imposition of CGT, investors were required to file the income tax returns along with declaring the source/evidence of investments for which they did not have the documented details. New CGT ordinance has been adopted since April 2012. The tax rate for CGT will be 8 percent and 10 percent for investment holding up to six months and 12 months respectively till June 30, 2014. NCCPL will be depositing the tax with the FBR on an annual basis. In addition, no question relating to the source/nature of money will be asked by the tax authorities if the money remains invested in the stock market for a period of 45 days (till June 30, 2012) and 120 days (till June 30, 2014) before and after the promulgation of CGT Ordinance

Broker

A stock­bro­ker is an individual/institution who is espe­cially trained and cer­ti­fied to par­tic­i­pate in the secu­ri­ties mar­ket on behalf of clients and gets a commission/brokerage when the deal is exe­cuted.

 Why Brokers

Stock exchanges are like clubs and they have mem­bers (i.e. bro­kers– only peo­ple who honor trades are joined as members).Now bro­kers need to fulfill cer­tain cri­te­ria in order to become mem­ber of stock exchange. Bro­ker can be banks, finan­cial insti­tu­tions, inde­pen­dent bro­kers etc.

Technical Analysis

A method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume.  

Fundamental Analysis

A method of evaluating a security that entails attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors.

Traditional  Services

·         Obtaining information about  the financial circumstances  of  customers and companies.
·         Analyzing market trends.
·         Advising on and participating in negotiations .
·         Recording and transmitting buy and sell orders .

Online Services

·         Trading terminals are available for the user convenience.
·         Online decision making services without the assistance of the broker.
·         Cost saving benefit for online clients.
·         However corporate sector prefer to use traditional as compared to online brokerage.

Broker Client Relationship

Fiduciary relationship

A broker has a "fiduciary" relationship with their client. This means the broker has a legal obligation to make a full and accurate disclosure of the broker's own interest in the transaction.

Conflicts of interest

The primary responsibility of a broker is to advise clients and act on their behalf in the purchase and sale of shares, so obviously they cannot trade in competition with those interests.
Similarly, a broker must tell a client of any information that might suggest the transaction is not in their interests. They must also have a reasonable basis for recommending the stock.

Problem faced by Equity Market


Ø  There is a common view that exchanges are being run by brokers in their own interest. Exchanges are unwilling or unable to supervise and discipline members and listed companies.

Ø  Despite economic growth in the country, companies are not seeking listing at the exchanges and little capital formation is taking place through stock exchanges. Issuers do not appear to have confidence in stock exchanges and see minimal value addition in listing. There is limited free float in the market and it is coming under increasing pressure due to a disproportionately large growth in mutual funds.


Ø  Exchanges do not have the capacity to carry out surveillance and investigation in market abuse. Market remains ordinary with allegations of price manipulation, front running, insider trading and blank selling.

Ø  Exchanges are also unable to attract and retain professionals. Most of the staff is non-management. Due to insufficient economic and human capital, they are unable to grow and develop like international exchanges

Ø  Lack of the technical skills and knowledge of investors, brokers and research market analyst.


Debt vs Equity


Debt vs. equity financing is one of the most important decisions facing managers who need capital to fund their business operations. Debt and equity are the two main sources of capital available to businesses, and each offers both advantages and disadvantages.

Debt Financing

Debt financing takes the form of loans that must be repaid over time, usually with interest. Businesses can borrow money over the short term or long term. The main sources of debt financing are banks and government agencies, and Business. Debt financing offers businesses a tax advantage, because the interest paid on loans is generally deductible. Borrowing also limits the business's future obligation of repayment of the loan, because the lender does not receive an ownership share in the business.
However, debt financing also has its disadvantages. New businesses sometimes find it difficult to make regular loan payments when they have irregular cash flow. In this way, debt financing can leave businesses weak to economic downturns or interest rate hikes. Carrying too much debt is a problem because it increases the perceived risk associated with businesses, making them unattractive to investors and thus reducing their ability to raise additional capital in the future.

Equity  Financing

Equity financing takes the form of money obtained from investors in exchange for an ownership share in the business. The main advantage to equity financing is that the business is not obligated to repay the money. Instead, the investors hope to reclaim their investment out of future profits. The involvement of high-profile investors may also help increase the credibility of a new business.
The main disadvantage to equity financing is that the investors become part-owners of the business, and thus gain a say in business decisions. "Equity investors are looking for a partner as well as an investment, or else they would be lender. As ownership interests become diluted, managers face a possible loss of autonomy or control. In addition, an excessive reliance on equity financing may indicate that a business is not using its capital in the most productive manner.
Both debt and equity financing are important ways for businesses to obtain capital to fund their operations. Deciding which to use or emphasize, depends on the long-term goals of the business and the amount of control managers wish to maintain. Ideally, experts suggest that businesses use both debt and equity financing in a commercially acceptable ratio.
Some experts recommend that companies rely more heavily on equity financing during the early stages of their existence, because such businesses may find it difficult to service debt until they achieve reliable cash flow. But start-up companies may have trouble attracting venture capital until they demonstrate strong profit potential. In any case, all businesses require sufficient capital in order to succeed. The most prudent course of action is to obtain capital from a variety of sources, using both debt and equity, and hire professional accountants and attorneys to assist with financial decisions.

Recent Happening

Capital Gain Tax (CGT)

In Pakistan, securities trading remained exempt from CGT for 36 years till June 30, 2010. In 2010, after the imposition of CGT, investors were required to file the income tax returns along with declaring the source/evidence of investments for which they did not have the documented details. New CGT ordinance has been adopted since April 2012. The tax rate for CGT will be 8 percent and 10 percent for investment holding up to six months and 12 months respectively till June 30, 2014. NCCPL will be depositing the tax with the FBR on an annual basis. In addition, no question relating to the source/nature of money will be asked by the tax authorities if the money remains invested in the stock market for a period of 45 days (till June 30, 2012) and 120 days (till June 30, 2014) before and after the promulgation of CGT Ordinance


Suggestions And Steps for Attracting Investment
Some suggestions/steps are
Enhancing the technical skills of investors, brokers and research analyst
Ø  Karachi Stock Exchange had a meeting with Morgan Stanley Capital International (MSCI), a leading provider of market indices across the world, at MSCI office in London.
Ø  KSE highlighted the change in monetary policy stance, centralization of Capital Gains Tax at National Clearing Company of Pakistan and implementation of KYC and anti money laundering regulations in the stock brokerage industry

Ø  As the inflation-driven monetary policy stance of the State Bank appears to be more predictable in the months ahead, the market observers foresee a positive domino affect on the share market that, they believe, would keep attracting more investors with the benchmark KSE 100-share index poised to hit new highs.
Ø  Integration of Stock Exchanges can lead to cost efficiency for all stake holders, offer better risk management, focused supervision by SECP and provide international recognition

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