Forget India, Pakistan is the Next Big Thing

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By Daniel Shane

Forget India. Investors looking for the next big thing should look to its South Asia neighbors instead – Pakistan, Bangladesh and Sri Lanka.

With a combined 390 million people, the three countries represent what Morgan Stanley chief global strategist Ruchir Sharma calls “the quiet rise of South Asia” as opposed to India which has been “flattered by spasms of hype for years”. While overshadowed by their larger neighbor, the trio is enjoying fast-paced growth, embracing much needed reforms, and look set to enjoy a demographic dividend over the long term. “A substantially higher economic growth rate than in many other economies globally, coupled with fantastic demographics that will continue supporting growth for many years ahead”, East Capital fund manager Adrian Pop tells Barron’s Asia. The Stockholm-based firm manages nearly EUR3 billion in frontier markets.

Pakistan is the flag bearer of the positive changes taking place in the South Asian nations. Since coming to power five years ago, Prime Minister Nawaz Sharif has got inflation under control, cut the budget deficit and reined in the current account deficit. But more importantly, terrorism finally appears to be on the back-foot given more assertive action by the army. Chinese investment has also poured in: $50 billion will be spent on new roads, transport links and energy projects. “More power capacity is key for Pakistan to move to an even higher economic growth rate,” says Pop. That will benefit stocks in materials and energy. In December, the Pakistan Stock Exchange sold 40% of itself to consortium of Chinese investors.

The Karachi stock index is up by about 50% since the start of last year, propelled by index compiler MSCI’s decision to bump up the country to emerging markets status. That will bring in hundreds of millions of dollars from passive funds into the Pakistani benchmark. The rally in stocks has arguably left the market looking a little pricey as the KSE 100 index trades at over 12 times earnings, its heftiest valuation since late 2009. That’s still about a 15% discount to the MSCI emerging markets index, however, plus Pakistani stocks yield an attractive 4%-plus dividend.

Bangladesh’s rise has so far been more tempered. The country, which split from Pakistan in the early 1970s, benefits from a growing working age population and rising labor costs elsewhere in Asia. Garment manufacturing for Western clothing companies has increasingly moved from China to places like Bangladesh, where wages are lower. The government’s also investing billions in upgrading the country’s patchy power supply, which will address energy shortages and boost manufacturing.

Still, foreign participation in Bangladesh’s stock market is small. HSBC estimates foreigners make up only 2% of the Dhaka stock index’s market cap. The market does however look quite cheap on a historical basis, trading at 15 times trailing earnings. Return on equity, or profit generated as percentage of shareholder equity, is high at almost 20%.

Sri Lanka’s more understated still. The economy could slow in the short-term after an International Monetary Fund bailout in 2016 prompted by a huge budget deficit. Some of the reforms to balance the budget, like higher value-added taxes, will probably hit consumption. The government’s also been prodded to reform and privatize state-owned enterprises. “We view these measures as necessary for a healthier and more sustainable macro environment,” even if growth suffers in the meantime, says Pop. Tourism remains a bright spot, as arrivals continue to grow.

Could the election of Donald Trump halt the quiet rise of South Asia? Trump wants to bring blue collar jobs back to the States and penalize American companies that manufacture overseas. Some are sanguine, though. “We do not believe that these companies will move production back to their home countries,” says East Capital’s Pop, reasoning that the spread between wages in the West and in markets like Bangladesh is too big to realistically think about moving these jobs back.

Another threat is the rising price of oil. Crude prices have risen by about 50% from their 2016 lows, which isn’t great news for all three countries, as they’re all net importers of the black stuff. Higher oil prices can cause higher inflation, a hot button issue in lots of developing countries, and bigger trade deficits. Pop argues that higher oil prices can also be a positive given the huge number of South Asians work employed in the oil-rich Gulf nations. A rosier economic outlook in these countries boosts the flow of remittances back to workers’ home countries.

Back in August, Barron’s Asia recommended readers buy three Pakistan blue-chips ahead of the country’s inclusion in the MSCI Emerging Markets index. They’ve risen by 20% on average and now trade near recent historical peaks on a price-to-earnings basis. In other words, they look expensive. We’ve found two new overlooked Pakistani stocks investors should consider, as well as picks for Bangladesh and Sri Lanka.

PAKISTAN

Oil & Gas Development Co

In August we tipped downstream firm Pakistan State Oil (PSO.PK), which has since risen 10%. It’s worth hanging onto that stock, but we’d add upstream exploration player Oil & Gas Development (OGDC.PK) to the mix too.

Shares in the Islamabad-based company have powered up 45% in the last year, and could rise by a further 30%. Oil & Gas Development will benefit from any further recovery in oil prices, which have roughly doubled since hitting their nadir last February. Earnings per share should rise by 17% in full-year 2017 and 20% in full-year 2018.

Oil & Gas Development trades at eight times forward earnings, which is toward the higher end of its historical valuation. That multiple is more compelling than exploration peer Pakistan Petroleum (PPL.PK), however, which trades at 10 times next 12 months’ earnings.

Oil & Gas Development also pays a 3% dividend.

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DG Khan Cement

Lahore’s DG Khan Cement (DGKC. PK) is one of the country’s largest cement producers, with a capacity of more than four million tons a year. The stock also makes a good foundation for a Pakistan portfolio.

The firm should benefit from billions of dollars of new infrastructure in the South Asia country, much of it coming courtesy of investment from China. At the end of December, the countries jointly announced a $14 billion dam project close to DG Khan’s HQ in northern Pakistan. The dam will need about a million tons of cement.

Shares in the company have returned a solid 50% over the last year. DG Khan’s valuations looks a bit less stretched than that of rival Lucky Cement (LUCKY.PK), which we told investors to pour into their portfolio over summer. DG Khan trades at 10 times forward earnings, compared to Lucky’s 16 times. Its dividend yield of 2.6% is also bigger than its rival. Brokers think DG Khan can rise by as much as 25%.

BANGLADESH

BRAC Bank

BRAC Bank is one of Bangladesh’s biggest lenders, specializing in credit to small-to-medium-sized businesses. More than a third of the country’s entire SME loan book goes through BRAC, according to estimates.

Some of BRAC’s strengths include its large retail and ATM network, while the bank’s also well-positioned to comply with Basel III requirements within the next couple of years. Analysts think BRAC is unlikely to have to raise more capital and dilute investors as a result.

The most exciting aspect of the stock, however, is its mobile payments platform. Bangladesh is one of the world’s fastest-growing markets in the use of mobile payments, and BRAC’s bKash platform has the vast majority of market share, with 17 million users. The platform’s been profitable since 2014.

In the last year BRAC Bank’s shares have returned over 40% and the stock also yields about 4%. BRAC is thinly covered by sell-side analysts, but recent target price estimates suggest the stock could rise by almost 15% this year.

SRI LANKA

John Keells Holdings

Colombo’s John Keells Holdings (JKH.LK) is Sri Lanka’s top conglomerate, with interests spanning transport, food, property and plantations. It’s also the biggest component of the local index, at about 8% of market capitalization. The shares could rise by 15% in the next year.

The shares haven’t performed well of late, though. John Keells has slipped almost 3% in the last year, compared to an almost 20% rise in Sri Lanka’s benchmark stock index. Catalysts for a turnaround include new consumer offerings in underpenetrated areas like ice cream and soda. John Keells is also bidding to operate a proposed new container port on the island.

The shares look quite cheap at 12 times forward earnings, compared to their five-year average of 16 times. Another option is rival conglomerate Hemas Holdings (HEMS.LK), but the stock trades at a chunkier 15 times next 12 months’ earnings. John Keells also pays a 3% dividend. Barron’s Asia/Pakdestiny

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