The fund fell 7% in July, compared to the benchmark index which fell 0.1%. About half of the underperformance could be attributed to our exposure to cyclical equities (primarily steel and cement). At the end of May and the beginning of June, we reduced this portion of the portfolio substantially. However, the remaining exposure fell another average of 15%. Our previous concerns that led to an adjustment of the positions has now been changed for cautious optimism. We do not see that any of our portfolio companies will have financial difficulties even during tough circumstances for a longer period and their assets are today valued at a fraction of the replacement cost. We lost about 1% each in Industrials and Financials. In industry, it was primarily our position in Pak Elektron (subcontractor to the power industry) that fell just over 20% during the month. In Financials, it was primarily our underweight in Habib Bank (which rose 9% during in July).
Over the last two months, we have made some reallocations in the portfolio. With the recent months’ outflows from local equity funds, opportunities have also opened up in the energy sector where we have now taken a weight of 8%. We are seldom interested in the energy sector. Pakistan is however slightly different. PTI has already shown that they are willing to take tough decisions and there is a clear logic as to why Pakistan should improve the business conditions of the sector (higher prices). Excluding fuel imports, Pakistan ran a current account surplus already last year. It defies logic to import expensive oil & gas and undercompensate local producers where the money actually stays in the country. Given the geographical location of Pakistan, adjacent to some of the world’s largest oil & gas reserves, it does not seem unreasonable for the country to eventually reduce its dependency on imports, which is very costly for the trade balance. This provided that the right incentives are in place for the sector. Long term, we believe there is higher upside in other sectors but some exposure at 4-5x earnings, net cash on the balance sheet, USD earnings combined with potential regulatory upside risk a certain exposure makes sense.
The market was pretty much unchanged in July, compared to MSCI FMxGCC Net (TR), which rose 3.5% and MSCI EM Net TR (SEK), which rose 1.9%. However, only Fauji Fertilizer (+9% in local currency) and Habib Bank (+6%) rose more than 1%. We conclude that local investors are currently very pessimistic. While foreign investors, this year, are net buyers for the first time since 2014 (USD 78m so far this year), local equity funds have been major sellers (USD 161m) due to redemptions. In July, foreign investors net purchased about USD 30m, while local equity funds sold shares for USD 44m. At the beginning of the month, the IMF Board signed a loan of USD 6bn to Pakistan. This is something we have been waiting for since PTI took power almost a year ago and something that has historically been positive for the stock market. However, the major event in July was Imran Khan’s trip to the U.S. and his meeting with Donald Trump. The meeting far exceeded expectations and there now seems to be a consensus between the two old antagonists that peace talks in Afghanistan are the only solution to a war that has been going on for almost 18 years (the Vietnam War lasted for 20 years). Trump expressed himself very positively after the meeting, explaining the central role he sees in Pakistan taking in negotiations with the Taliban. In addition to the U.S. possibly reinstating its military support (the so-called Coalition Support Fund), the US president also opened up for increased trade with Pakistan. In addition, Khan made an acclaimed appearance to over 20,000 overseas Pakistanis in Capital One Arena Washington. Khan’s support among the 8 million Pakistanis living abroad is something we have mentioned before. He also made a speech at the U.S. Institute of Peace. For those who want to get to know him a little better, we recommend listening to this. He dealt with a lot of historically sensitive subjects and his openness is invigorating. https://www.youtube.com/watch?v=d7DUIo9MR4A&t=78s.
Following recent developments and progress Pakistan has made, both in the reform work and in its international relations, we are beginning to feel strongly positive about the market. The equity market is trading at ten-year lows in terms of Price to Book at the same time as we conclude that the tough reforms Pakistan is currently undergoing have the potential to accelerate development in the country and, in addition, improve the world’s perception of Pakistan. Tundra’s Chief Executive Mattias Martinsson wrote an article at the end of July on this subject: https://www.linkedin.com/pulse/pakistan-now-when-mattias-martinsson/.
As we write in the article the timing for a market turnaround is always very difficult and unexpected events might impact in the short term. In the first days of August, just a few days after we posted the article, we had exactly such an event. India surprisingly decided the Indian parts of Kashmir would lose its current autonomy. This will be perceived as a strong provocation by Pakistan and possibly it is an answer to Trump’s offer to mediate in the Kashmir conflict. We do not expect the situation to lead to a military conflict but even if it remains just a war of words it might short term cause concerns in the market.
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