Capital market outlook

LOOKING over some numbers of the Bangladesh capital market, it would be an understatement to say that the price performance in the last few years has been remarkable. According to the numbers published by the Dhaka Stock Exchange (DSE), the market has generated annual price return of 30 per cent in the last 10 years. Putting that in perspective, it is about two and half times the return generated by banks' fixed deposits. The annual return in the last three years is 52 per cent (since 2007). Year to date (YTD) return in 2010 is 94 per cent, and there is still a month and half to go. We usually become doubly sad if an elderly relative dies at 99; it appears that the Dhaka market would not leave us in any such regrets. The annual return should comfortably exceed 100 per cent.

Some people are skeptical about the performance calculations made by the DSE, and rightly so. If correctly calculated, a market-cap weighted index for the last 10 years tells of a more astounding performance. Annualised returns have been 37 per cent in the last 10 years, 60 per cent in the last three years and 92 per cent in YTD 2010. It is not a coincidence that the performance measure for 2010 matched DSE's. Only this year did they figure out how to calculate correctly a market-weighted index. However, index values in previous years were not revised. So what the DSE puts forward as an index value is a meaningless number, calculated differently at different times. It implies as if the DSE portrays a bird that has the legs of a stork, the body of a hen and the wings of a turkey.

Nevertheless, whatever measure we use, the market performance has been significant. Although market participants would like to claim genius for such great a performance, there have been a few extraneous contributing factors. First, the economy is flush with excess cash. Money supply in the last five years has grown by an average of 20 per cent, whereas the nominal GDP has grown by 14 per cent. The difference has appeared in the economy as excess cash. In order to keep the exchange rate stable to facilitate export, Bangladesh Bank made a number of large foreign exchange purchases from the open market. In the last fiscal alone, the purchase was for an amount of over $2.0 billion. Secondly, because of lack of power, gas and other infrastructure, investment in the real sector has stalled. Usually the net savings of a country equals net investment. Because of structural inefficiencies in Bangladesh, there has always been a gap between savings rate and investment rate and this year it has gone up to 5 per cent. Both banks and businesses have invested their excess cash in the capital markets. Although this has improved their short-term profitability, their core business has shown little growth or improvement. An excess supply of cash combined with lack of real investment opportunity has caused to move enormous amounts of funds into the capital markets, moving the only 260 odd stocks in the market to stratospheric levels.

The secondary effect of this has only perpetuated the trend. Hugely lucrative return in the market has given rise to the number of capital market intermediaries and has drawn in new investors and additional funds. These new investors have bought at higher prices, pushing the market even higher. A measure of the proliferation is the number of Beneficiary Ownership (BO) accounts, which has grown from about 350,000 in 2005 to 3.5 million in 2010. That is a 10 times increase in five years, or a 60 per cent growth each year. Capital market has finally arrived at far flung district towns. The word in the market is that many new investors are small businesspeople, who have committed their business capital to trading shares. We cannot imagine the scary scenario whereby a major correction impacts the market; the impact on these small investors would be horrendous.

Is such a correction imminent? Are we looking at a hard or a soft landing? Two of the three trends that contributed to the capital market growth are abating. First, with increasing inflation, the Central bank has very little incentive to increase money supply. Second, appreciation of the Taka would not be such a bad thing on the balance, if a stronger Taka buys more food grain. This is especially true when purchasing grain from neighboring India whose currency has steadily appreciated against the US dollar. Third, with a downward trend in net migration, remittance flow may weaken and further remove the need for monetising foreign currency reserve. Fourth, bank deposit rates are improving, making them a more competitive (and safer) alternative to capital markets. Fifth, real investment is picking up despite the agonizing delay in gas and power supply.

All these developments point to a correction in the capital market. This potential is further augmented by the fact that the government seems determined to offload a huge quantity of public company shares. If the government really follows through on its promises, i.e. selling of further shares of listed companies and listing other public companies, the market would experience a large supply of new shares amid a declining money supply. This further supports the potential of a correction in the market. What the government failed to do by managing demands (margin loan reduction) could well be achieved by a supply side intervention. It seems likely that the market would return to normalcy by substitution of funds from old to new shares, not by a drastic fall of confidence or by panic withdrawal of funds by investors. Even if it is preceded by a price correction, that would be a healthy development for the market.

A saving grace for the market is the improvement in earning by well-managed companies. Among all stocks in the market, a select group of large, most liquid, well managed (using some subjective criteria) companies grew their earning by an average of 20 per cent in the last five years. If this trend continues for the entire market, the current P/E ratio of 27.0x should come down to 22.0x in 2011 and 18.0x in 2012. The effect is more dramatic for our select group of stocks; for them the P/E would come down to 15.0x in 2011, provided that the current price levels do not change further. However, to take comfort in such a scenario, we have to be confident about the quality of reported earnings.

If there is a major correction despite such positive developments, what are the consequences? The fickle nature of public sentiment does not always follow logic. No one knows when fear takes over greed, and when it does, the platitudes by the powerful do not mean much. In course of a major correction, would the government intervene for the sake of public sentiments, or would it let the market decide? Would the banks, especially the state-owned banks, be forced to purchase stocks, or would they be allowed to reduce exposure to minimise losses? If banks are indeed forced to make large purchases in the stock market when prices are falling, what does it do to the soundness of the banking system? Would the margin ratio be suddenly made wide open as a means to supply liquidity? We ask what lessons have been learned since 1996 to develop a playbook for a share market crisis.

Rather than an amazing price performance, a much more important need is a fluidity of the market where entrepreneurs can easily raise funds for productive business enterprises.

As we increasingly look at the capital market for financing projects of national importance, it is important that the depth and the breadth of the market improve and confidence in the market is maintained. It is our expectation that we shall make progress toward that goal in 2011. Such a market needs policy stability, not reactive decisions every few days. Ensuring that genuine entrepreneurs look at the market as a source of capital is more important than ensuring the moral hazard of incidental investors who foolhardily buy at high prices.