Attract retail investors to expand PSX

Attract retail investors to expand PSX

In these early signs of economic stability, current policymakers often cite rising levels of the KSE 100 as a sign of investor confidence. While this is true, many high-end companies are trading at a fraction of their peak dollar valuations achieved during the euphoria caused by the MSCI Emerging Markets in 2017, as well as the post-COVID interest rate cut rally in the summer of 2021 Could boost investment from retail investors further develop the Pakistan Stock Exchange (PSX)?

Likely Yes. In Pakistan, different estimates show that there are only 200-250K active UIN accounts operating on PSX. Of that, only 5-10% will be traded each week (regulators or researchers can provide more details).

Often, the market remains concentrated in the hands of institutional investors such as mutual funds, insurance companies, banks, and a few high-net-worth individuals/family homes. Foreigners visit occasionally to hunt for valuable stocks. Adding retail investment can easily strengthen trust, performance and valuation in PSX.

First, more investors can help reduce volatility. Consider a scenario where large sellers in the market sell aggressively until their orders are filled. In such a case, the stock can experience a drop of 5-10% within a few days. If there are more smaller investors, the decline may be less severe to fill sell orders.

Second, during times of distress or when stocks are at their cheapest valuations, it is usually large, long-term, smart and fundamentally driven investors who accumulate stocks and capitalize on optimism during economic cycle reversals. Just notice how the perception changes drastically when Pakistan signs an SBA with the IMF in July 2023. However, the benefits are often concentrated in the hands of a few, rather than distributed more fairly and equally, as retail investors rarely participate. The rich get richer, but it’s not entirely their fault.

Third, returns on bank deposits, currency speculation and money market mutual funds have long-term lagged returns from the stock market. However, falls after years of stability (such as the peak in 2017, the COVID-19 crisis in 2020 and the risk of default and political instability in 2022) often discourage investors, as they often see significant negative returns. Therefore, high interest rates discourage equity investment, and governments must reduce them for their own benefit as well as for investors.

Fourth, having more retail investors participate in future IPOs will provide higher long-term investment and an additional source of trust for companies that decide to go public and raise capital from the “public” in the true sense of the word. These investors may be content to follow the company’s story and be content with returns above bank deposit rates, unlike wealthy investors who may seek lower sales prices and higher returns.

Fifth, by diverting funds towards public equity, the culture of saving, investment, and capital formation can develop, as many entrepreneurs seek public funds from the PSX, creating innovative business opportunities and additional jobs while improving intellectual skill sets in the economy. On the other hand, only parking funds in risk-free debt securities do not actively contribute to the economic well-being of the country.

Sixth, stock market investors contribute to a well-documented tax compliance structure for savers, in contrast to cash-based savings products, cryptocurrency investments, undervalued property invoices and informal agricultural trading businesses. Potentially, millions of retailers could be added to the list of tax filers, a goal urgently pursued by policymakers under IMF conditions.

Although the regulatory framework has improved significantly over the past decade, thanks to efforts that the SECP is proud of, 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, improving transparency through the 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. An investor who earns Rs100K per month cannot be taxed at the same 15% rate as an investor who earns Rs10 million per month. The tax rate should vary, reflecting the effective tax rate on the salaried class, with a maximum cap of 20% for the highest earners.

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

Third, since brokerage houses benefit from minimum brokerage rates, part of their revenue should be allocated to investor education, sales training and improving the digital infrastructure at a mandatory level. Appropriate action must be taken against any misuse by customers to restore confidence in the system.

Fourth, PSX has already invested considerable effort in raising awareness in various institutions, universities, schools and companies. However, there should be more emphasis on encouraging discussions about equity capital markets in local languages, especially in second and third tier cities. Effective partnerships with telecommunications companies, microfinance institutes and other government platforms can facilitate this. Integrating a discussion of capital markets into the high school or college curriculum can also be beneficial.

Fifth, tax credits are important for retail investors, with a maximum upper limit of, for example, Rs2-3 million per annum for both mutual funds and pensions. To offset the withdrawal of tax benefits, the maximum amount that wealthy salaried individuals can invest can be reduced. This will help reduce tax arbitrage between companies investing through mutual funds in government debt and those investing directly in T-Bills/PIBs.

Finally, there is significant public interest in investing in new companies. While it is true that a large percentage of startups may fail, potentially leading to huge losses, individuals from the middle class, who usually pursue real estate investments, can be allowed to take high-risk exposure to startups. However, this should be subject to strict disclosures, disclaimers and qualifications regarding net worth and risk tolerance.

Pakistan’s long-term equity market valuations typically hover around 8x Price-to-Earnings ratio, in contrast to the current 4.3-4.5x ratio of the KSE 100. This indicates a huge potential for returns in the equity market, and the PSX can serve as a valuable channel for savings, fundraising and income distribution if the government offers timely incentives. With stability and ongoing reforms, there are great opportunities for investors.

However, it would be disappointing if retail investors entered the market in droves at a time when the index is already valued at around 6.5x-7 P/E, representing roughly a 50% upside from current levels. It is important to remember to diversify investments, conduct thorough research, understand your risk appetite, avoid speculation and refrain from excessive trading.

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