In these early signs of economic stability, current policymakers often cite the increase in KSE 100 levels as a sign of investor confidence. While this is correct, many blue-chip companies are trading at a fraction of their peak dollar valuations reached during the MSCI Emerging Market-induced euphoria in 2017, as well as the post-COVID interest rate cut-led rally in the summer of 2021. Can increasing investments from retail small-ticket investors further develop the Pakistan Stock Exchange (PSX)?

Probably yes. In Pakistan, different estimates suggest that there are merely 200-250K active UIN accounts operating in the PSX. Out of those, only 5-10% would be trading every week (regulators or researchers can provide further details).

Invariably, the market remains concentrated within the hands of institutional investors such as mutual funds, insurance companies, banks, and some high-net-worth individuals/family houses. Foreigners do visit occasionally to hunt for value stocks. Adding retail investments can easily strengthen trust, performance, and valuation within the PSX.

Firstly, a greater number of investors can help reduce volatility. Consider a scenario where a large seller in the market aggressively sells until their order is completed. In such cases, the stock could experience a decline of 5-10% within a few days. If there were more smaller-sized investors, the decline would likely be less severe to fulfil the sell order.

Secondly, during times of distress or when stocks are at their cheapest valuations, it is typically the long-term, smart, and fundamentally driven big investors who accumulate shares and capitalise on optimism during economic cycle reversals. Just observe how drastically perceptions changed when Pakistan entered into an SBA with the IMF in July 2023. However, the benefits are often concentrated in the hands of a few, rather than being distributed more fairly and evenly, as retail investors rarely participate. The wealthy get wealthier, but it’s not entirely their fault.

Thirdly, returns on bank deposits, currency speculation, and money market mutual funds have in the long-term trailed returns from the stock market. However, plunges after years of stability (such as the peak in 2017, the COVID-19 crisis in 2020, and the default risk and political instability in 2022) often discourage investors, as they frequently witness significant negative returns. Therefore, high interest rates discourage equity investments, and the government must reduce them for its own benefit as well as for investors.

Fourthly, having more retail investors participate in upcoming IPOs would provide higher, long-term investments and an additional source of trust for companies deciding to go public and raise capital from the “public” in the truest sense. These investors may be content to buy into the company’s story and settle for returns above bank deposit rates, unlike wealthy investors who may seek lower selling prices and higher returns.

Fifthly, by diverting funds towards public equities, a culture of savings, investments, and capital formation can flourish, as many entrepreneurs seek public funds from the PSX, creating innovative business opportunities and additional jobs while enhancing intellectual skill sets within the economy. In contrast, merely parking funds in risk-free debt securities does not actively contribute to the economic well-being of the country.

Sixth, stock market investors contribute to a well-documented tax-compliant structure for savers, contrasting with cash-based savings products, cryptocurrency investments, property under-invoicing, and informal agriculture trading businesses. Potentially, millions of retailers can be added to the list of tax filers, a goal urgently pursued by policymakers under IMF conditions.

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Although the regulatory framework has significantly improved over the past decade, thanks to the commendable efforts of the SECP, such as digital onboarding, simplified KYC requirements, reduced paperwork, tier-based brokerage licenses, mandatory training for sales staff, penalties for insider trading and front-running, increased transparency through simultaneous dissemination of material notices on the PSX website, frequent analyst briefings, and disclosure requirements, more improvements are still needed.

First, capital gains tax should be progressive. Investors earning Rs100K per month should not be taxed at the same 15% rate as investors earning Rs10 million per month. The tax rate should vary, mirroring the effective tax rates on the salaried class, with a maximum cap of 20% for the highest earners.

Second, the dividend tax rate should also be progressive, promoting a more equitable distribution of wealth and fair tax rates for lower to middle-class citizens. Dividend taxes should be lower for retail investors compared to corporate investors, encouraging greater participation from the middle class.

Third, since brokerage houses benefit from minimum brokerage rates, a portion of their revenues should be allocated to investor education, sales training, and improving digital infrastructure at mandatory levels. Proper measures must be taken against any mishandling of clients to restore confidence in the system.

Fourth, PSX is already investing considerable effort in raising awareness in various institutions, universities, schools, and companies. However, there should be more emphasis on promoting discussions about equity capital markets in local languages, particularly in second and third-tier cities. Effective partnerships with telcos, microfinance institutes, and other government platforms can facilitate this. Integrating discussions on capital markets into secondary school or college curriculums could also be beneficial.

Fifth, tax credits are essential for retail investors, with a maximum upper cap of, for example, Rs2-3 million per year for both mutual and pension funds. To balance the tax benefit withdrawal, the maximum amount that wealthy salaried individuals can invest could be reduced. This would help narrow the tax arbitrage between companies investing via mutual funds in sovereign debt and those investing directly in T-Bills/PIBs.

Lastly, there is significant interest among the public in investing in new startups. While it’s true that a large percentage of startups may fail, potentially leading to significant losses, individuals from the middle class, who typically pursue property investments, could be allowed to take high-risk exposures to startups. However, this should be subject to stringent disclosures, disclaimers, and qualifications regarding net worth and risk tolerance.

Pakistan’s long-term equity market valuations have typically hovered around 8x Price to Earnings ratio, in contrast to the current 4.3-4.5x ratio of the KSE 100. This suggests significant potential for returns in the equity markets, and the PSX could serve as a valuable avenue for savings, fundraising, and income distribution if the government offers the right incentives in a timely manner. With ongoing stability and reforms, there is substantial opportunity for investors.

However, it would be disappointing if retail investors enter the market en masse at a time when the index has already been valued at around 6.5x-7 P/E, representing approximately a 50% upside from current levels. It’s crucial to remember to diversify investments, conduct thorough research, understand your risk appetite, avoid speculation, and refrain from excessive trading.

THE WRITER IS AN INDEPENDENT ECONOMIC ANALYST

Published in The Express Tribune, May 13^th, 2024.

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