Via Emerging Frontiers blog, a look at Pakistan:

When Pakistan receives international media coverage, it is usually not pretty. The world’s sixth most populous country has remained in the headlines due to its shaky security situation, including bomb attacks and an ongoing Taliban insurgency near the border with Afghanistan. This year’s upcoming elections will cast a spotlight on the tense political environment that has become synonymous with instability and corruption. On the economic front, falling foreign reserves and the downward sliding Pakistani rupee may potentially require an IMF bailout. But despite the political and economic uncertainty, the Karachi Stock Exchange (KSE) performed exceptionally well in 2012, exceeding all expectations and proving that even in a notoriously turbulent emerging market such as Pakistan, there are many attractive stocks and gains to be had for astute investors.

This article is an excerpt from Leopard Asia Frontier Fund’s upcoming December 2012 newsletter. You can subscribe to the newsletter here.

The KSE is the largest bourse in Pakistan and has been one of the best performing exchanges in Asia this year, with the benchmark KSE-100 index rising 49% in local currency and 38% in USD. Bloomberg hailed the KSE as one of the top 10 stock markets in the world in 2012 and a variety of factors have contributed to the market’s success. The State Bank of Pakistan’s (SBP) easing monetary policy has cut interest rates and decreased inflation. As interest rates have fallen, investors have turned to the stock market to achieve higher returns as companies have taken advantage of cheaper loans to gain leverage. Growth in the stock market has also been spurred by the resolution of capital gains tax issues, healthy corporate earnings, and low valuations of Pakistani equities. Finally, Pakistan’s rising income levels and large remittances (a record US $1.4 billion was sent back to Pakistan in October, up 30% from a year earlier) are creating a new middle-class that has helped drive up consumer expenditures. Given the KSE’s surge, it is surprising that 2012 saw only 3 IPOs in Pakistan, compared to the 10-year average of 11 IPOs a year.

One of the KSE’s darlings has been the cement sector – as of December 26, cement stocks had posted returns of 156% for the year. Improved margins in the cement sector have been driven by increasing cement prices (up more than 25%) and greater local demand. The country’s rising middle class has contributed to this increase in domestic demand, and growth is forecasted to continue – Pakistan’s current per capita cement consumption of 180 kg is amongst the lowest in the region. In addition, this year’s elections are expected to provide a major boost to the cement sector, as pre-election government spending will focus on construction and infrastructure projects. Cost pressures for cement producers have also been reduced due to a decrease in interest rates and lower coal prices. Coal, which accounts for 50-60% of the cost of production of cement, was down 23% in 2012.

The textile sector also performed well in 2012, moving away from previous years’ slumps and benefiting from stable cotton prices. The weakening of the Pakistani rupee drove textile exports and revenue growth, and piqued investor interest in cheap textile shares. In December, it was announced that Pakistan is likely to get Generalized System of Preferences (GSP) Plus status for textile exports to the European Union by January 2014, a move that will grant tariff-free access to the European market and will spark major growth in the textile industry, which is already Pakistan’s largest export sector.

The food and consumer goods sector is also booming due to the rising purchasing power parity of the middle-class. Pakistan’s middle class has doubled in the last decade to 70 million, and consumer spending has increased by 26% on average over the past three years. This has garnered the attention of a number of international restaurant franchises and since 2011, the country has seen a large influx of global food chains including Hardee’s, Fatburger, and Cinnabon. Franchise powerhouses like McDonald’s, Pizza Hut, and KFC have been in the country for almost two decades and are opening new outlets as demand for fast food continues to grow. Additionally, interest was roused amongst foreign investors with the announcement in November that Unilever Pakistan is planning to de-list, aiming to buy back US $335 million in shares from exchanges in Karachi, Lahore, and Islamabad. This will provide a large capital inflow for the country that can be redeployed in the fast-moving consumer goods (FMCG) sector and also suggests increased future investment by Unilever in Pakistan.

Although the KSE outperformed predictions in 2012, there are a number of concerns for Pakistan moving forward. This year will likely usher in political change for the South Asian nation, and the world will hold its breath when Pakistanis go to the polls in 2013. With Pakistan’s civilian government slated to end its 5-year term this year, it is expected that Nawaz Sharif’s Pakistan Muslim League-N (PML-N) will become the largest party after the general elections. This should bode well with investors, as PML-N has historically been business-friendly and pro-investment.
Economically, Pakistan’s GDP grew at a sluggish 3.7% in 2012, hampered by the government’s growing budget deficit and electricity outages that hurt the country’s export industries. If an IMF bailout is indeed needed in 2013, the austerity measures that will most likely be required will pose a difficult dilemma for the current administration – cutting back on government spending during an election cycle could be a risky political move. But another IMF loan may be necessary – with only 1% of the population paying income taxes and the agricultural sector paying no taxes, government revenues from taxes make up less than 1/10th of GDP.

Two other challenges for Pakistan will be power shortages and its volatile level of security. Energy rationing and the lack of oil and gas availability have been damaging for a variety of power-intensive industries. Fertilizer, one of the country’s main exports, is a prime example. The sector relies on gas for the production of urea and sales were down compared to last year as a result of nationwide gas curtailment. Electricity outages continue in Pakistan, and the All Pakistan Textile Mills Association estimates that outages could cost the country US $3 billion in textile exports this fiscal year. Progress will need to be made towards getting a handle on the country’s security situation, particularly with insurgencies near the Afghanistan border. But improved US-Pakistan relations have provided a much-needed macroeconomic boost for the country – the US has pledged US $2.5 billion as part of its Coalition Support Fund (CSF), intended for Pakistani military operations in the war against terrorism. Pakistan received US $1.12 billion of the CSF in July, and a second tranche of US $688 million on December 28.

Despite Pakistan’s negative reputation, 2012 showed that there is little correlation between the country’s lackluster political and economic outlook and the stellar returns provided by its stock market. Steps are being taken towards better regulatory reform, and Pakistan’s burgeoning middle class is generating large domestic demand for consumer goods. Even in Pakistan, where questions loom over the upcoming general elections and the future trajectory for the economy, there are many winning stocks to be found on Karachi’s soaring stock exchange.