1

BASICS OF CAPITAL MARKET

INVESTING


By:

Arif Habib Investments Limited
(formerly: Arif Habib Investment Management Limited)






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This booklet was originally written in the form of a series of articles for a newspaper in the
year 2001 by Nasim Beg, Chief Executive, Arif Habib Investments. It was subsequently
converted into this Booklet in 2002 and has now been updated by the Arif Habib team in May
2009.

IT IS REQUESTED THAT, FOR ANY QUOTATION FROM OR RE-PRODUCTION OF THIS
BOOKLET, WHETHER IN WHOLE OR IN PART, DUE CREDIT IS GIVEN TO ARIF HABIB
INVESTMENTS LIMITED.





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Table of Contents

What are Capital Markets?............................................................................... 3
Understanding Debt Investments..................................................................... 4
Factors affecting Exchange Rates.................................................................... 8
Equity Investments........................................................................................... 9
Economics and Capital Market Investing......................................................... 21
Mutual Funds Investments............................................................................... 25



BASICS OF CAPITAL MARKET INVESTING

This booklet is intended for those who are not familiar with the intricacies of investing in capital
markets. We hope that after reading this, some of the hi-finance terminology will become
somewhat demystified. Our emphasis will be in pointing out the varying levels of risks that are
involved and how an investor should weigh his or her options to achieve a realistic rate of return.
The markets can move both ways, up and down, but an average investor is more sensitive to the
risk of loss of capital and we, therefore, give more attention to this fact.

WHAT ARE CAPITAL MARKETS?

In order to understand this term, it is necessary to define the broad categories of investments:

Forms of investment

Investments can be in various forms, some of these are: real estate, business enterprises, precious
metals and stones, valuable works of art, financial investments etc. Some forms of investment may
have a non-financial reward too, such as aesthetic or emotional pleasure from works of art,
jewellery, house property etc., but in most cases, we strive to at least retain the purchasing power of
our savings (i.e. beat inflation) and preferably come out ahead.

Financial Investments

As opposed to physical assets, financial investments are generally a right or an entitlement to
receive money (or streams of money). The financial investments themselves are in two broad
categories direct investments, that we hand over to an obligor (the party that uses our money) and
get back our entitlement (dividends, interest, principal etc.) from the obligor (examples are bank
deposits and investments in the National Savings Schemes) and market-based investments that we,
normally (but not always), take-over from some other investor; and when we want to encash our
investment, we find someone in the market to take-over our investment from us. (Examples are
shares of companies, bonds issued by companies that are known as TFCs in our market or tradable
bonds issued by the government, etc.). Financial investments are normally represented by
certificates, generally referred to as securities. However, there is a trend to convert securities into
a paperless (electronic) form, which is kept track of by a custodian such as the Central Depository
Company (CDC). The essential attribute of a market-based tradable investment is that one can sell
the investment and get cash for it.



4

Capital Markets

This is the market place where financial investments (normally of a long-term nature) can be
acquired or disposed off. The term is used in the plural to signify separate market segments for
various types of financial investments. The Stock Exchange (also referred to as the Stock Market)
is where shares and bonds issued by business entities (companies) are traded. There is a sub-
category called the Money Market, which is normally the market for acquiring or disposing off
very short-term financial investments but will include inter-bank placement of very short-term
deposits and dealings in currencies too.

Equity vs. Debt

When we invest money with a business entity, it can either be in the capacity of becoming a partner
in the business or we can lend money to the business entity for a defined time period.

Equity

In the first capacity, we participate in the ownership of the business and have an equitable right
(legally enforceable right) in the business, to the extent of our share in it. Thus, we become an
equity or share holder both terms are synonymous in the investment parlance. As an equity
investor, we are entitled to distribution of profits and in the event the business is liquidated at some
stage, we are entitled to our share of the net assets left over.

Debt

In this case we have a debt that we have to recover from the business in accordance with an agreed
repayment schedule and we are entitled to compensation for the use of our money (interest). The
money we invest with government and banks is also in the category of debt. From the point of view
of the borrowing entity, we are a creditor and we rank senior to equity in the event of liquidation
i.e. creditors will be paid off first and whatever is left over after that will go to the equity holders
(owners).

UNDERSTANDING DEBT INVESTMENTS

As has been explained earlier, we pay out certain monies now and expect to get back some interest
and the principal later. There are two types of risk that affect this type of investment; these are:

Risk to Principal

First and foremost, the risk to the principal is affected by the reliability of the borrower. The
Government is considered a safe borrower, i.e., we do not expect it to default. We normally also
place a fair amount of reliance on banks and expect that they have a low likelihood of default. In
the case of other businesses, we place reliance on the specific business entity, depending on who is
running the business and what type of business it is. This is also referred to as credit risk.





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Inflation Risk

The second type of risk is the underlying inflation rate we clearly want an interest rate that will
not fall short of the inflation rate during the period of the investment. Otherwise we will not retain
the purchasing power of our principal. For example, if we invest Rs. 100,000 for a year at an
interest rate of 8% and during this period the inflation rate turns out at 9%, we will need Rs.
109,000 to purchase something that cost Rs. 100,000 a year ago but we will only have Rs. 108,000
from our investment, i.e., we would have suffered a loss in our purchasing power by the end of the
year. This is also referred to as interest rate risk.

Valuing Debt Securities

In relation to the capital markets, our concern is with understanding the risk and reward of a debt
security and as to how the market puts a value to it. This becomes important for us when we want
to buy a security from the market or when we wish to sell it. We must remember that the market
functions on the basis of demand and supply. There will be demand for debt securities, in general,
based on the investable surplus available with investors and for a debt security, in particular, based
on its riskiness and the rate of return in relation to the expected inflation rate. The supply of debt
securities comes from borrowers needing the funds. The impact of riskiness and inflation are
discussed in the following paragraphs.

Interest Rate Vs Inflation Rate

The interest rate that a borrower has to pay will normally have to be in excess of the expected
inflation rate. Please note that, whereas the interest rate has to be agreed at the time of borrowing,
the inflation rate for the borrowing period can only be guessed at. This, in itself, generates a new
risk: the longer the period of borrowing, the riskier it is to guess the inflation rate.

The Benchmark Rate

As was stated earlier, the Government is considered a safe borrower and it is the interest rate the
Government has to pay that is used as the benchmark for other borrowers. The government is
considered to have zero risk (of default) and should be able to attract debt at an interest rate
slightly over the expected inflation rate. As has also been stated earlier, the reliability of the
inflation estimate diminishes with the length of life of the debt (normally referred to as tenure or
tenor of the security), i.e., it is more difficult and more risky to predict the direction of economic
forces over longer time-frames. We, therefore, find that Treasury Bills (normally up to one-year
Government bonds) carry the lowest effective interest rate and longer tenor Government bonds
have to offer a higher rate of return. All the commercial borrowers (normally termed as corporate
sector) have to offer rates higher than the benchmark (Governments borrowing rate) for that tenor.

Rating of Debt Securities

The rate (of interest) at which a corporate entity will have to issue its debt securities (bonds) or
Term Finance Certificates as we call them in our effort to be Shariah compliant, depends on the
riskiness (degree of reliability) of the corporate entity and the likelihood of the entity meeting its
obligations over the period of the debt. It would be extremely difficult for us to try and evaluate the



6
riskiness of each corporate entity in relation to the tenor of the debt security being issued by it. To
make our lives easier, there are two licensed Rating Agencies operating in Pakistan, which use a
standardised method for measuring the riskiness of companies as well as the debt securities they
issue. Letters of the alphabet usually denote the ratings. The market then places a premium that an
A-grade borrower has to pay over a zero risk Government security of similar life. Similarly,
the premium, say, a B-grade borrower has to pay as against an A-grade borrower. However, as
is in the case of estimating inflation, over a period of time the reliability of a borrower (rating) may
change due to changes in business conditions or other factors. Therefore, the longer the life of the
debt security, the higher is the premium that the borrower has to pay.

Impact of Change in Inflation and Interest Rates

As has been stated earlier, a debt security is issued with an interest rate above the expected
inflation rate. If the inflation rate should go up, for any reason, subsequent to the issue, the
attractiveness of this security will diminish. The market will, therefore, no longer be willing to
offer the full value of the security. Let us assume that a Government security is issued with a face
value of Rs. 100,000 and with one-year life, when the inflation rate is expected to be 9.00 % for the
ensuing year and we further assume that, in order for it to attract investment, the security has to
carry an interest rate of 9.25 %. Assume that, for some reason, immediately after the issue of the
security, the market perception of the expected inflation rate jumps up to 13%, the government will
then be able to issue a new security for the same one year with an interest rate of 13.25 %. The first
security will lose its attractiveness and we will only be able to sell it if we offer the security at a
discount to its face value so that the new buyer will get the same 13.25% return, as is then expected
for Government securities. This means the maturity value of the first security, which is Rs. 100,000
plus interest at 9.25%, i.e., a total of Rs. 109,250 a year from now will have to be discounted by
13.25% or it will be worth Rs. 96,468. This is to say that a security that we had bought for Rs.
100,000 is now worth Rs. 96,468. Although the Government bond remains a Government bond and
there still is zero risk as to a default by the Government, we have lost nearly 4% of the value
because of the change in the expected inflation rate.

We could, of course, hold the bond till the end of the year and get the Rs. 100,000 plus Rs. 9,250 in
interest but both these amounts together (Rs. 109,250) will be beaten by inflation. Our target
purchasing power needs to be Rs. 100,000 plus 13% inflation or a total of Rs. 113,000. The point
here is that even investing in a government bond is not risk-free. However, in the event the
inflation and the interest rates drop after we have purchased the security, the converse will be true
and we will get a higher market value for the security.

Default Risk

The degree of reliability or the riskiness of the issuer of the bond defaulting is measured by the
rating given to the issuer and the bond itself. In the case of the Government, we take the default
risk to be Zero. This is so because the Government can print currency and meet its obligations. The
fact that the currency may lose its worth is already discussed in the previous paragraph. The zero
risk does not hold true if the Government issues a foreign currency bond. For example, Pakistan
has the unfortunate record of having defaulted on its Dollar-denominated bonds; these bonds were
subject to a default risk as our Government cannot print foreign currency. After the imposition of
sanctions on Pakistan in 1998 and in view of the then impending default, the bonds were being
traded at a sharp discount to their face value. The bonds issued by the corporate sector too are risk



7
prone. However, due to strict regulatory and listing requirements, normally bonds with good
ratings come to the market. The rating is assessed each year during the life of the bond and if
circumstances so demand, a rating agency can also come out with an unscheduled rating revision.
The point to remember is that any business can run into trouble anytime and the likelihood of
default can emerge during the life of a bond. The rating is not a guarantee but only an assessment
of reliability.

Zero Coupon Bonds

Normally, bonds are issued with coupons attached to them. These coupons are detached and used
for claiming interest payments. Certain bonds are issued without the feature of regular interest
payments (these are referred to as zero coupon bonds). The maturity value of such a bond is
higher than the value at which it is issued; the difference represents the interest that the investor
will earn over the life of the bond. Defence Savings Certificates (DSCs) are an example of such
bonds. If you bought a Rs.100,000 Certificate anytime between 23.06.2007 and 23.06.2008, you
will get Rs.263,000 ten years from the date you bought it. The extra Rs.163,000 represents interest
at an annually compounded rate of approximately 10.15%. It is not 16.30% per year as many
people mistakenly calculate, as you are not receiving Rs.16,300 every year but Rs. 163,000 after
ten years. As it may not be easy for some people to work out the interest rate, we have made two
calculations as ready-reckoners for your convenience If we assume an inflation rate of 9% per
annum for the next ten years, our Rs. 100,000 needs to grow to Rs. 236,736 in ten years to retain
our purchasing power. But if we are faced with an inflation rate of 12% per annum (which is more
than our return of 10.15% per annum), the Rs. 100,000 must grow to Rs. 310,585 in ten years to
retain the purchasing power. One will note that the DSCs will come out well ahead of 9% inflation
but not of 12.00%. Once someone has acquired a DSC, he can only hope that inflation remains
below 10.15% for the next ten years. DSCs are not traded bonds but the example has been given, as
most readers would be familiar with DSCs. Please note that we have not taken into account the
impact of income tax, which will reduce the net interest earned and must be accounted-for while
taking investment decisions.

Treasury Bills

Government Treasury Bills (Short-term bonds) are also Zero Coupon Bonds. These are redeemed
at face value on maturity and are issued at a discount so as to result in the desired rate of return. For
example, a T-Bill of Rs. 1,000,000 of six months maturity may be issued against a payment of Rs.
957,212; the Rs 42,788 that will be earned on redeeming at maturity represents a gain of 4.47% on
the investment of Rs. 957,212 for six months or an effective interest rate of approximately 9.14%
on an annualised basis. Banks and fund management institutions typically invest in Treasury Bills
because of their short tenor and, being Government obligations, they are relatively low-risk
investments.

Riskiness of Debt Securities (Bonds, TFCs etc.)

We have already explained the impact of change in inflation and interest rates on debt securities.
We have explained that if the inflation and interest rates go up, an existing debt security will lose
its attractiveness. However, the degree of loss in value will depend on two factors: (a) the length of
the remaining life of the security and (b) the coupon (interest) rate it carries. If the inflation rate,



8
and, consequently, the interest rates go up after we have acquired a debt security, we expect to
suffer a loss because we will be earning less than the new, higher interest rate; and the longer the
remaining life of our security, the longer (more) we will suffer. Similarly, the lower our interest
(coupon) rate as compared with the new rate, the higher will be our loss.

Rate of return on Debt Securities versus Equity

Any business entity that borrows money will do so if it expects to employ the borrowed funds more
profitably than the interest rate it will have to pay to the lender. It follows that the interest rate will
normally be less than what an owner of the business (equity investor) earns. It should also be noted
that the debt security holder is paid interest whether or not the business entity earns profits. But on
the other hand, if there is a bumper profit, the debt security holder will only get the interest already
agreed upon. As has been pointed out earlier, Government bonds pay less than similar life
corporate entity bonds. It, therefore, means that the rate of earning on Government bonds will
normally be much lower than earnings of a business entity (equity investors).

Money Market Investments

As was stated in the earlier part of the Booklet, Money Market transactions are primarily those
interest-based transactions that have relatively short maturities. Normally, we consider transactions
to fall in this category if their tenor is one year or less. Treasury Bills fall under this category, so do
short-term Certificates of Deposit (short-term Certificates of Investment as these are also referred
to). As has been explained earlier, the riskiness of a debt security increases with the length of its
remaining life. It would, therefore, follow that money market investments are less risky. This is
generally true, however, because of the lower risk, such investments offer a lower premium over
the inflation rate. Therefore, we would be giving up on the potential reward for reducing the
potential risk. It is also important to understand that a short-dated investment will come up for
reinvestment frequently and we cannot be sure if one will get a good investment opportunity on
each occasion.

FACTORS AFFECTING EXCHANGE RATES

Interest Rates

We generally notice that strong currencies offer lower interest rates as compared to the Rupee.
The reason is simple: the expected inflation rate (expected loss in purchasing power) is higher
for Pakistan and lower for the countries with stronger economies. Interest is set at a rate that at
least compensates for inflation. With the inflation rate compensated, we should be indifferent
to which currency we keep our money in, as the respective interest rates on the currencies
should compensate us for loss in the purchasing power caused by inflation. But as we know,
people prefer to keep their money in different currencies at different times (the US Dollar was
a preferred currency till recent times) the reason being that the market participants try to
forecast the future state of the economic conditions in various countries and try and balance out
the risk of loss in value versus the compensation from the interest rate. This phenomenon
results in varying levels of supply and demand for a currency and is explained in the following
paragraph.




9
Supply and Demand

There are various theories that attempt to explain exchange rates. One is that the exchange rate
between two currencies should be determined by what is called Purchasing Power Parity.
The theory is explained through an example - if we can buy something in the United States for
$1,000 and the exchange rate with the Rupee is Rs. 80 per Dollar, then we should be able to
buy the identical item for Rs. 80,000 in Pakistan. However, we know that this is not necessarily
the case. Even if we start off with the prices being identical in two different countries, the
supply and demand of the currencies may alter the exchange rate after some time. Currency
markets work on supply and demand, e.g., we have observed historically that when large
import bills (e.g. for oil imports) have to be settled, the demand for Dollars goes up and results
in the price (rate) of Dollar going up versus the Rupee. The State Bank buys and sells Dollars
in the market to try and influence supply and demand of Dollars so as to keep the exchange
rate at a desired level. Exchange rates can also undergo sudden changes due to news-driven
shift in supply and demand - this could be as a result of the receipt of some new information in
the market, which alters the previous expectation of the inflation rate forecasts. For example, a
war threat is likely to result in an economic burden (inflation) on a country thereby driving
down the demand for its currency and thus its value.

EQUITY INVESTMENTS

Investing in Business not Speculating in the Market

We would first urge the readers to always remember that investing in the equity (shares) of a
company should be understood as becoming a partner in the business. It must not be seen as
taking a punt in the market with the expectation of making a killing. You may get lucky at
times but, on an average, you cannot expect to do better (get better returns) than the business of
the company you invest in.

Brokers

Brokers, who give you advice to buy and sell shares, make money (brokerage commission)
each time you buy or sell. A good broker will want your long-term custom and will try to
advise you on proper investing. But a broker who offers hot tips, should, if he is so sure of the
tips, use these exclusively for himself and make more money than he would by spreading the
news around to his clients and earn only commission from them.

Who runs the Business

One should become a partner in a business if, first and foremost, one is happy with the
managing partners of the business. Who are the Directors of the Company? Are they known in
the market place? What sort of reputation do they have? Do they have a track record of running
successful businesses? Are they known to be fair to the ordinary shareholders? Do they have a
good dividend paying record? Please note that although you have a vote attached to each share
you own, it is most unlikely that you have any real say in the affairs of the company you are
akin to being a silent partner but you do not have to be deaf and blind.



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Prospects of the Business

After satisfying yourself with the credentials of who manages the business, you have to look at
the future prospects of the business. You want to invest in a business only if you believe it to
have good prospects (likelihood to be profitable and have the ability to pay good dividends).
There is no easy formula for assessing this - you have to use your common sense and base your
judgment on proper verifiable information (such as how its products fare in the market) and not
on non-verifiable tips.

Share Price and Volatility

The price of a companys shares in the market should normally be such that it justifies what
one is acquiring (expectation of future dividends). In other words, the amount you invest
should make sense in the light of the expected future dividends. In practice, market prices are
determined taking into account the earnings of the company and not only the dividends that
may be paid out of such earnings, as they can be reinvested to grow the business. However,
market prices are not always justifiable. As has been stated earlier, the price is determined by
supply and demand at times there is a surge in demand and at times a loss of confidence. The
price of shares is normally quite volatile. It is no good if you have found a company with
excellent management and excellent prospects but for some reason the price of the share has
gone up beyond what is justifiable for the potential earnings (dividends) the best company
in the world would be a bad buy if bought too expensive. Apart from the market sentiment,
which impacts prices, there will always be general economic conditions and company-specific
reasons affecting prices. We shall be discussing various methods of trying to place a fair value
on shares of a company in the later part of this booklet but, at this stage, we would like to point
out that share prices are volatile and can be a cause of concern for an investor.

Risk -Taking Capacity

Given the fact that prices of shares are volatile, you should not invest in shares if you do not
have the financial capacity or if, by nature, you would be too anxious when the prices go down.
You have to assess your own nature but we can help you identify your financial risk-taking
capacity. Businesses and the economy are cyclical, i.e., there are continuous ups and downs in
the economy as well as within every business sector. Take for example the cement business:
during the decade of the 1990s, capacity was created to meet the cement demand. But due to
down-turn of the economy the cement industry was running at 50% of its capacity by the year
2000, resulting in the cement stocks not doing well. However, with the advent of 2000, the
economy took off and, by 2005, the cement plants were running at full capacity resulting in the
cement business becoming profitable. But, once again, most of the plants went for expansion to
create additional capacity. This has resulted in excess capacity and some of those cement
stocks may not be looking that profitable. If a retired person had his money invested in shares
of cement companies, he might not have lived to see the turnaround. Clearly, this would not be
a desirable position to be in. You must have the time horizon to brave out the difficult times
and you cannot have all your assets in shares of companies. The risk for investing in shares
will also depend on the type of industry. Certain companies such as utilities-supply companies
may be less risky because they are likely to have a fairly stable business and, therefore, stable




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12
usually at times of severe economic downturn, coupled with a high interest rate environment.
This shows the importance of keeping in view the three most important considerations when
investing in equities; 1) economic fundamentals, 2) a longer term view and 3) diversification.
We shall cover, subsequently, under the Section ECONOMICS & CAPITAL MARKET
INVESTING, how economic fundamentals can allow an investor to minimize risk and
enhance returns and, in what follows, we examine the other two factors. Later in this booklet,
we will look at how diversifying across asset-classes has the potential to further enhance
investment returns.

Total Returns

Long-term Horizon

Despite the return on shares being the best over a long term, the price volatility may have a
serious negative impact. We have stated earlier that the market price volatility can cause
temporary loss in market value of investments. Therefore, if one is able to sit out economic
downturns, one is likely to do better investing in equities than in interest-paying investments
and beat the underlying inflation rates. Historically, it is a proven fact that the long-term rate of
return on equity investments is better than on debt investments. However, as a word of caution,
there can be occasions when business entities will take time to pass on higher input costs to
customers and they may see periods of losses. Similarly, during periods of economic recession,
businesses are likely to suffer. Thus you must have time on your side. This is a cardinal
principal - invest in shares of companies only if you can take a long-term view. You must not
invest your emergency funds in shares, as in time of an emergency the prices might be down
and you could be forced to sell at a loss. Invest only such amounts that you have complete
control over with regard to the exit timing. Given below is a chart showing financial year-wise
(July-June) returns of investing in Pakistans equity market since 1970:




We have assumed that one has invested in all the shares in the market without picking some
over the others. The return is the total return, i.e., the dividend plus the capital gain or loss. The
assumption is that one invests on the first day of the financial year and disinvests on the last
60.0%
40.0%
20.0%
0.0%
20.0%
40.0%
60.0%
80.0%
100.0%
120.0%
1
9
7
0

7
1
1
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7
1

7
2
1
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2

7
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1
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2
0
0
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2
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2
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1
2
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0
1

2
0
0
2
2
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2

2
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3
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0
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2
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4

2
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4

2
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2
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2
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2
0
0
7
2
0
0
7

2
0
0
8
2
0
0
8

2
0
0
9
Total Returns each Financial Year



13
day of the financial year. You will see that the highest return was in 2003 at 103% and the
worst full year loss was in 2009 with loss of 42%. The chart also shows that during the 39
periods covered by the chart, there were 11 periods of investment that resulted in a loss, with
the 1990s seeing several bad years.

Return on Investment for 5 Years

As opposed to taking one year investment horizon, if we take the above indicated market
returns and assume that ones investment horizon was five years and we look at periods of five
year returns, i.e., we assume that an investment made at the beginning of the financial year
1975 would be held till the end of the financial year 1979 and that made at the beginning of
1976 would be held till the end of 1980 and so on. The compounded average total returns
(average return per year) for these five year periods are given in the following chart:




You will see from the above chart that the number of loss-making periods is 6 with the
maximum loss at 14% and the maximum gain at 40%. It may be noted that the second half of
the decade of the 1990s was particularly bad. This resulted in exceptionally poor results for
equity investors even on a five-year investment horizon.


Return on Investment for 10 years

The following graph assumes that the investment horizon is ten years, i.e., an investment made
in 1975 is held till 1984 or that made in 1994 is held till 2003. You will note that none of the
ten-year periods result in a loss and that the maximum return in a ten-year period is an annual
average of over 30%.

20.0%
10.0%
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
1
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2
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2
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2
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2
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7

2
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8
2
0
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8

2
0
0
9
Yearly returns on Investment for 5 Years



14


As stated earlier, the second half of the decade of the 1990s was particularly bad. This resulted
in below-inflation returns for equity investors even on same ten-year periods as a result of that.
We have run such exercises for several time horizons and the results are summarised in the
table below:


This also highlights the fact that equity investment is best suited for a ten-year horizon or more.

Diversification

Another cardinal principal of investing in equities is that you must diversify. The proverb:
Dont put all your eggs in one basket perhaps holds true for investing in shares more than for
anything else. When trying to grasp the concept of diversification, the idea is to invest in a
collection of different shares (a portfolio) that includes multiple investments of varying risk.
The purpose behind this is to reduce the riskiness of certain high-yielding shares with the
lower-riskiness of others. Consider, for example, an investment that consists of only the stock
issued by a single company. If that company's stock suffers a serious downturn, your entire
portfolio will bear the impact of the decline. By splitting your investment between the stocks of
two or more different companies, you reduce the potential risk to your portfolio.

Volatility is a measure of the tendency of a market or security to rise or fall within a period of
time. Market sentiment influences share prices as an event or the news of the moment can
impact the future earnings of a company or the industry in general. Apart from this, there may
prevail certain economic conditions which may also drive the prices of shares away from their
fair value. To understand how share price volatility affects the risk undertaken by an investor
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
1
9
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2
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2
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2
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2
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2
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2
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0
8
2
0
0
8

2
0
0
9
Yearly returns on Investment for 10 Years
Investment horizon Frequency of loss Probability
of loss
Maximum
loss
01- year 9 24% (-) 34%
02- years 5 14% (-) 21%
03- years 4 11% (-) 18%
05- years 5 15% (-) 14%
07- years 2 06% (-) 7%
10- years 0 0% 0%



15
we may consider the graph below. If one were to choose between Investment A and B, most
investors would go for Investment B in view of the significant (price volatility) risk associated
with Investment A. This is largely due to the rapidly fluctuating price and the uncertainty
associated with it. An investor choosing Investment A has a great chance of buying high and
selling low:



This may also be illustrated with a real life example using the graph below, where we compare
the difference in volatility between a 20-stock portfolio and a single scrip, Oil and Gas
Development Corporation (OGDC) from actual data taken over a period of twelve months. We
notice that the volatility for the OGDC stock is much greater than that for the 20-stock
portfolio:


-
50
100
150
200
250
300
1
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1
/
2
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0
6
20-stock portfolio OGDC



16
Ideally your assets must be split into financial and non-financial (e.g. real estate) investments.
Within the portfolio of financial investments, it must further be split into different types of
investments 1.Bank deposits (to meet immediate needs), 2. Debt securities (bonds, TFCs etc)
for protection from volatility and 3. Equities for better long-term return over inflation for
protection of purchasing power. Within the equities portfolio, you must diversify between
business sectors and, within that, amongst different companies.

The idea is that, despite careful investing, some companies may run into problems but,
hopefully, not all will. Similarly, not all business sectors should do badly at the same time. The
desired level of diversification will not, normally, be feasible for small investors - they should
look at investing through mutual funds, a matter dealt with in the later part of this booklet.

Valuation of Shares of Companies

In the earlier parts of this booklet we have explained that buying a share of a company is like
becoming a partner in a business. A business will normally have two ingredients that give it
value. One ingredient is the value of its assets (the value of, say, a factory, value of stock-in-
trade and value of trade receivables etc., LESS the money it owes to banks, creditors etc.); and
the other is the value of the franchise, i.e., its products, its market strength, its management
quality, its financial resources etc., which culminate in the profits it can generate. We will
address each ingredient separately.

Book Value of a Company

When a business is set up, it acquires certain assets. These could be a factory building, and
plant and machinery. In addition, it may also invest in raw materials, etc. These items are
referred to as its assets and will include any bank balances as well as any trade debts that it has
to receive. This is an indicative list of assets but not an exhaustive one. Over the course of
time, it may add some assets and dispose off some.

Accountants record the value of these assets in the companys books at original acquisition
cost and do not normally adjust the books to market value of the assets. However, they do
recognize the fact that assets have a useful life and they record the fact that the assets diminish
in value over that life. They record this loss in value in the books and call it depreciation (and
amortization). Similarly, some book debts can become uncollectible or some stock in trade can
become unusable or lose value. In such an event, the accountants record this loss. If we add up
the book value of the assets and deduct from there the money the business owes to others, we
are left with the book value of the business. If the book value is divided by the number of
(ownership) shares that a company has issued, we will get the Book Value per Share. This is
also called the Break-up Value per Share.

Market Price Vs Book Value

It is reasonable to expect that the market price of the share of a company will normally be, at
least, equal to the book value per share. In fact, over a time period the assets may have a higher
value (due to inflation) than their book value (remember accountants maintain the books at the



17
original cost). If we were trying to take over a business, we would have to work out the book
value of the company adjusted for the market value (as against the original cost) of the
business. This value is also referred to the Net Asst Value.

However, when we become a minority shareholder, we cannot close down the business and
realize the market value of the assets; we are therefore concerned with the book value of the
running business. If a business is already set up and running, we should be willing to pay
somewhat higher than the book value as we do not have to wait for it to become operational
nor do we have to go through a period when the business may be having teething problems.
One of the measures stock market analysts use is expressing the market price of the share as a
multiple of the book value. The market price of a well-established company should normally
be higher than the book value. We can express this mathematically if we divide the market
price of the share by the book value, the answer should be greater than one. How much greater
will depend on the franchise value (future profitability) of the business. But if the market price
divided by the book value is one or below one for a well-established business, the price would
indicate value for money (an attractive purchase price), provided there are no serious threats to
the future of the business.

Franchise Value

As stated earlier, the franchise value is the strength a business entity builds, which results in its
profitability. The expected profitability of a company is the key factor that will determine the
price we should be willing to pay for the share of the company.

Earnings per Share

The earnings of a company belong to the shareholders. In order to determine the right that one
share is entitled to, over the profits of the company, we must divide the total profit earned by
the company by the number of shares the company has issued. This is the Earnings Per Share,
referred to as EPS. Stock analysts try and forecast the EPS of a company in order to determine
a fair value of the company. For this purpose they use both the past track record of the
company and also try to factor in future estimates, based on the companys management
quality, the demand and supply for the companys products (and services), the overall forecasts
for the business sector and the economy in general. Based on the forecast of the earnings, we
can try to estimate as to how much of the earnings the company may retain for expansion and
how much it may pay out in dividends.

Price Earnings Ratio

The stock analysts also express the market price of a companys shares as a multiple of the
EPS. This is called the Price Earnings Ratio (PER). For example, if the share of a company is
trading at a price of Rs. 20 per share and its EPS is Rs. 2 per share, the PER is 10 times. The
PER (or Price Earnings Multiple) is somewhat similar to the pay-back period i.e. the price of a
share times one-year earning. If a share is trading at Rs. 30 and has an EPS of Rs. 3, it is
trading at a PER of 10 times or equivalent to ten years earning. However, as earnings may
grow in the future, it would not be correct to assume a simplistic 10 year pay-back, thus it



18
could be a payback period for less than 10 years. However, the PE ratio does not give the
whole picture by itself. It is a useful tool to compare the PE ratios of companies in the same
industry, or to the market in general, or against the markets or a company's own historical PE.

This approach towards the PER is considered a simplistic notion because the Multiple ignores
several factors that must be considered. First of all, we look at the risk free rate of return. You
will recall that we consider government bonds risk free and we expect riskier shares to give
better return.

Assume a ten-year government bond, with a coupon of 10% per annum, is issued for
Rs.100,000 face value; expressing as a multiple of the earnings, its Price Earnings Ratio is 10,
or we can say the earnings we receive over 10 years will equal the initial price paid for the
investment, i.e. its payback period is 10 years. An investment in a business is subject to some
risk and we would want a better payback period. In other words, we want to earn back the
investment in less than 10 years. If we are investing in a business where we feel that the
franchise value is good and it has very low risk, we may be willing to go for say an eight-year
payback. In other words, if the expected EPS of the company is Rs. 3, we would be willing to
pay up to Rs. 24 per share. Alternatively, if the companys expected EPS is Rs.4 we would be
willing to pay up to Rs. 32 per share. On the other hand, if the expected EPS is Rs 3 and we
consider the company to be of a higher risk, we may want our money back in 6 years; in such a
case the PER would be 6 times and the maximum price we would be willing to pay will be Rs.
18 per share.

Loss Making Companies

It would appear that a loss-making company should have no franchise value and we should,
therefore, not be willing to pay anything for its shares. However, it is the expected profitability
that we look at and not, simply, the losses in the past. Of course, the past performance may be
indicative of future performance. But we will also keep the book value in mind. On the other
hand, if it is a company that is likely to shut down, we would look at the net realizable value of
its assets. Such assets would include the tangible assets like land, buildings, plant and
equipment etc., and non-tangibles as well, such as any intellectual property, brand names etc if
these can be sold.

Earnings Multiple and Market Sentiment

As has been explained earlier, if we consider the future profitability of a company to be
reasonably assured (i.e., subject to low risk), we are willing to pay a higher multiple of EPS as
compared with that for a company with lower level of certainty (higher risk). Similarly, we
also have a feeling for some business sectors to be more stable than others or we may consider
certain sectors due for a turnaround (or a slowdown) in the future. The collective feeling of
participants in the market results in the P/E (price earning ratio) to be different for different
sectors and types of businesses. Generally speaking, the commodity-based businesses (like
textile spinning) are subject to higher levels of uncertainty from year to year and will therefore
be at lower P/E when compared with, say, the food business, which may have more stable
earnings. Equally, a Multinational selling basic consumer items will have a higher PER due to



19
the perceived stability in earnings. Similarly, the entire economy at times looks more
promising and at times less so. This will result in the entire P/E being re-rated by the market
participants. A sector or company may trade at a P/E of ten times at some stage. However, if
there is a downward change in the market sentiment, the same sector or company may start
trading at five times. This does not mean that the company has become half the company; it
was but simply the fact that, because of perceived threat to its earnings, investors are now
looking for a shorter payback period. The average PER for a developing country (emerging
economy) will normally be lower than that for a country with a stable and mature economy.

What is the right P/E?

What is the right P/E for a country? What is it for a particular business sector within that
country? What is it for a particular company within the sector? There is no simple answer for
these questions. But we remind you that it is the underlying inflation rate (the rate of loss in
purchasing power of the currency) that should determine the floor (the PER for a government
bond) and everything else according to the relative level of certainty of the expected
profitability. Broadly speaking, the level of desired P/E is influenced by various factors such as
earnings growth, the level of interest rates, economic growth prospects and overall political
stability. Since 1966, Pakistani stock market P/Es have ranged from a high of 22 in 1992 to 4
in 1974. The chart below reflects the P/E ratios for the 44 years from 1966 to 2009.

Historic P/E bar chart of Pakistani market (historical PEs)

The bars below reflect the P/Es for each year.

Market PE



Average PE for period 1966 31 Dec 2008: 8.76
Current PE (as of May 2009): 7.68
0
5
10
15
20
25
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9
Market PE
market P/E Ratio Historical Average P/E Ratio



20

Earnings Growth

We have so far considered the price of the shares of a company in terms of the EPS and P/E.
However, the growth in earnings of a company will impact the price of its shares. If two
companies (in a similar business) start with the same earnings but the earnings of one remain
constant and the other has 10% growth, we will observe the difference in the valuation of the
two companies. We take the following example and assume that the P/E is and remains ten
times:


Although we are assuming the same price of Rs. 20 for both the companies in Year-1, it is
obvious that Company-B should have a higher market price than Company-A in year-1, as the
market will take into account the higher expected growth rates of Company-B. However, the
market will also differentiate between a one-off increase in profits and sustainable growth
rates, thus it will price the share taking all factors into account.

Present Value of Future Cash Flows

In the previous example (see table) it is clear that the two companies should have different
prices although their year-1 earnings are the same. The difference will arise because of the
different future earnings.

However, the problem in putting a value to this is that by the time the future earnings are
received, the Rupee may have lost some portion of it purchasing power. The way to deal with
this is to work out the present value of the future cash flows by discounting these with the risk
free rate of interest (earnings from a government bond of a similar life). This may be a
complicated exercise for a reader who is not initiated to the concept of discounted cash flows
but it will be clear that Rs. 100,000 received today is better than Rs.100,000 received, say, one
year in the future. We explain this through the following example: If you receive Rs. 100,000
today and you invest it in a (safe) government bond with an interest rate of 9%, you will get
Rs.109,000 a year from now. This is better than getting Rs. 100,000 a year from now.
Alternatively if you have Rs. 91,743 today and invested it at 9% interest, you will have Rs.
100,000 a year from now. This Rs. 91,743 is the Present Value of Rs. 100,000 being received
one year hence discounted at 9%. The main purpose of putting across this concept is to assist
the reader in understanding the fact that money received in the future has a lower value than
money received today. Analysts use variants of this concept in calculating the value of
companies and the individual shares thereof.
Details Year 1
(Rs.)
Year 2
(Rs.)
Year 3
(Rs.)
Year 4
(Rs.)
Company A EPS 2.00 2.00 2.00 2.00
Company A Price (10 times) 20.00 20.00 20.00 20.00
Company B EPS 2.00 2.20 2.42 2.66
Company B Price (10 times) 20.00 22.00 24.20 26.60



21
ECONOMICS AND CAPITAL MARKET INVESTING

Business Cycles

Business cycles are the ups and downs in economic activity that typically occur around a long
run growth trend of the economy. Business cycle fluctuations can be observed by noting the
trend in Gross Domestic Product (GDP), the broadest measure of economic activity. GDP
refers to the total goods and services that an economy produces in a given time frame.
Economists have separated Business cycles into four distinct stages:

Recovery: - Stimulatory economic policies, confidence picks up, inflation still falling. Capital
Markets:- short rates low or falling, bond yields bottoming, stocks rising, commodities rising,
Property prices bottoming.
Early upswing: - Increasing confidence, healthy economic growth, inflation remains low,
Capital Markets: - Short term rates at neutral, bonds stable, stocks and commodities strong,
Property picking up.
Late upswing: - Boom mentality, inflation gradually picks up, policy becomes restrictive,
Capital Markets: - Short term interest rates and bonds yield rise, stocks top out, property and
commodities prices rise strongly.
Economy slow or enters recession:- Short term interest rates peak, confidence drops suddenly,
inventory correction begins, inflation continues to accelerate, Capital Markets:- Short term
interest rates peak, Bond yields top out and start to fall, stocks and commodity prices fall,
Property prices peak.
Recession: - production falls, inflation peaks, confidence weak, Capital Markets: - short term
interest rates and bond yields drop, stocks bottom out, Property and commodities weak.
















However, the length and timing of business cycles can be subject to uncertainty. This means
that it may not be easy to predict how long a particular phase of the cycle lasts. For example, a
recession may last longer, if consumer and investor confidence remains depressed, despite low
price levels. In spite of this, economic indicators are highly useful in reflecting business cycle
trends. As discussed in the business cycle phases, economic indicators such as GDP growth,
Business Cycles

Late Upswing Economy Slows

Early Upswing

Recovery Recession



22
Inflation and interest rates levels generally correspond to a certain position on the business
cycle. For example, GDP growth peaks or is higher than historical average in a boom and
inflation and interest rates are generally low in a recovery.

Economic Indicators and the Stock Market

Stock Markets generally are reflective of the economic activity in an economy. This is because
when, for example, an economy is expanding, it increases demand for a companys products
and thus increases its earning potential. As a result, the companys stock becomes more
valuable as it will have an increased likelihood of delivering positive returns. In this way,
business cycles have a considerable bearing on how the Stock Market, as a whole, moves.

GDP Growth:
As is indicative from the previous discussion, there is a positive relationship between stock
prices and expected GDP growth. At the onset of a recession, GDP growth falls below its
potential as businesses start producing output below capacity. In Pakistan, potential GDP
growth corresponds to a rate of 5.1 percent and growth below this level implies a recession. At
this point, equity markets will have started to deliver negative returns as earning prospects look
dim. Once a recovery starts to look highly likely, earnings prospects will start to improve and
GDP will start to increase. The graph below shows this point which was around the middle of
FY2002 and the corresponding stock market behaviour. During FY2003, or the period
seemingly consistent with an early upswing, the Pakistani equity market delivered a total return
of 103 percent.


Rhs Refers to scale on Right Hand Side of the graph

Inflation:
Inflation is defined as the persistent general increase in prices. This should not be confused
with the price level, as inflation is the incremental change in the price level. Therefore, it is
0
1
2
3
4
5
6
7
8
9
FY2000 FY2001 FY2002 FY2003 FY2004 FY2005 FY2006 FY2007 FY2008
20%
0%
20%
40%
60%
80%
100%
120%
GDP Growth and Stock Market Returns
Stock Market Returns (Rhs) GDP Growth



23
possible to have a high general price level in an economy, but a low inflation rate. On the same
note, a decrease in inflation does not imply prices are decreasing but that the rate of increase in
prices is decreasing a phenomenon known as disinflation. A falling price level is defined as
deflation or negative inflation. Deflation in general is a rare phenomenon and usually occurs in
times of extreme economic slowdown or a depression. Inflation results in the loss of
purchasing power as the same amount of money is no longer able to buy the same amount of
goods and services. Thus, when investors evaluate potential returns, they subtract the expected
inflation that they expect over the same time horizon as the prospective investment. This
adjusted return is known as the real rate of return. As a result, when inflation rises, the real
rate of return on an investment diminishes, making it less attractive. Typically, in a recovery
phase inflation rates are falling or low which means that there is a favourable environment for
investing in the Stock Market. This has also been observed in the Pakistani equity market
during the recovery phase in FY02 and FY03 when inflation was low and highly bullish
activity was seen in the Stock Market.



Interest Rates:
Interest rates refer to the equilibrium price of money that is set between its suppliers and
demanders. In this respect, interest rates are also known as the cost of doing business. Thus,
when the cost of doing business rises, profitability shrinks and new capital is available at a
higher price. Increasing interest rates, thus, imply that a slowdown in the economic activity is
about to take place and Stock Markets start adjusting to this lower level. In the local economy,
interest rates began to increase around FY05, when the economy seemed to be in a boom and
continued to increase and peaked when the economy fell into a recession in FY09. This was
also reflected in the equity market; consistent with economic theory, the market surged when
interest rates were low and slowly began to consolidate with respect to annual returns as the
interest rates started increasing gradually.

20%
0%
20%
40%
60%
80%
100%
120%
0
2
4
6
8
10
12
14
FY2000 FY2001 FY2002 FY2003 FY2004 FY2005 FY2006 FY2007 FY2008
Inflation and Stock Market Returns
Inflation



24


Economic Indicators and Debt Markets

Interest rates and prices of simple debt instruments follow an inverse relationship; when
interest rates are increasing, yields rise and prices fall whereas when interest rates are falling
yields fall and price increases. Thus, debt markets are most attractive in the late upswing and
recessionary phases of the business cycle. Another indicator that promotes activity in debt
markets at this point is expected inflation. Since inflation is expected to be lower going
forward in a recession, the real rate of return on these securities increases. Longer tenure debt
instruments are more sensitive to changes in yield. Thus, they become of particular interest
around the time when interest rates start to peak. The graph below shows the price yield
relationship of a 10 year PIB with an issue date of 22 Aug 2007 using actual data. Yields were
highest when interest rates peaked around January 2009 and price was lowest. Lower interest
rate expectations however, lowered yields and increased its price.



20%
0%
20%
40%
60%
80%
100%
120%
5
6
7
8
9
10
11
12
13
14
FY2000 FY2001 FY2002 FY2003 FY2004 FY2005 FY2006 FY2007 FY2008
Interest Rates and Stock Market Returns
Interest rates
60
65
70
75
80
85
90
95
100
10.00 11.00 12.00 13.00 14.00 15.00 16.00
P
r
i
c
e
Yield
10 year PIB PriceYield Relationship



25
MUTUAL FUNDS INVESTMENTS

A good option for most people is to invest through mutual funds. Investors, who do not have
large sums of money or those who feel that they do not have the luxury of allocating time to
managing investments in the capital markets or feel that they would not be able to understand
enough to make the correct decisions, should invest through mutual funds.

What is a Mutual Fund?

A mutual fund is a pool of money belonging to a group of investors entrusted to a Fund
Manager (investment specialist) hired by the group. The Fund Manager invests the money on
behalf of the investors and is paid a management fee normally in the range of 1% to 3% per
year of the amount of funds under management. If there is a profit or gain on the investments,
it belongs to the mutual fund owners (investors) because they mutually own the pool. On the
other hand if there is a loss, it is a loss suffered by the owners of the pool.

How is it Different to a Bank?

A bank too manages a pool of money, but the money it receives from investors (depositors) is
treated as a loan from the depositors on which the bank pays a fixed rate of return. The bank in
turn lends the money to various businesses and earns a higher rate of return. The bank makes
money by earning the difference between the rate at which it borrows (from the depositors) -
currently around 7% and the rate at which it lends to the businesses currently around 14%.
The gross earning of the bank in this example will be 14% minus 7%, i.e., 7% versus 1% to 3%
charged by the mutual fund manager. In the event there is a loss in the lending business, the
bank will still pay the depositor the agreed rate. However, in the event the bank runs into major
losses (such as major defaults by its borrowers) and has to close down, the depositors are not
likely to get their full principal but will get whatever can be recovered by the liquidators.

Types of Mutual Funds

Closed-end Funds

Open-end Funds

What is the difference between Closed-end and Open-end mutual funds?

A Closed-end fund is a mutual fund that has a fixed pool of money, which is collected when
the fund is set up. The fund is set up as an investment company (or trust) with a certain amount
of capital (pool of money). The fund manager invests the pool in the capital markets (normally
shares of other companies). An investor, wishing to participate in the mutual fund, buys shares
of the investment company at the time of its initial public offer or, as in the case of any other
company, the investor may buy shares of the investment company subsequently from the Stock
Market at the prevailing market price. When the investor wishes to disinvest, he has to sell his
shares of the investment company through the Stock Exchange at the prevailing price. As in
the case of any other company, the price of the shares of the investment company (closed-end



26
mutual fund) in the Stock Market will be determined by the supply and demand for such
shares, which may be higher or lower (normally lower) than the net asset value (true value of
the investment portfolio) of the investment company.

An Open-end fund does not have a fixed pool of money. The Fund Manager continuously
allows investors to join or leave the fund. The fund is set up as a trust, with an independent
trustee, who has custody over the assets of the trust. Each share of the trust is called a Unit and
the fund itself is called a Unit Trust. The portfolio (pool) of investments of the Unit Trust is,
normally, evaluated daily by the Fund Manager on the basis of prevailing market prices of the
securities in the portfolio. This market value of the portfolio is divided by the number of Units
issued to determine the Net Asset Value (NAV) per Unit. An investor can join or leave the
fund on the basis of the NAV per Unit. However, the Fund Manager may have a small charge
called load added to the selling price or deducted from the redemption price of the Units so
as to cover distribution costs. Under Pakistan law, open-end and closed-end funds are set up
under the NBFC Rules, and are regulated by Securities & Exchange Commission of Pakistan
under the Non-Banking Finance Companies & Notified Entities Regulations, 2007.

What are the benefits of investing through mutual funds?

Mutual funds allow investors to benefit from the collective strength of the group (pool). The
benefits include:

Services of Investment Professionals

An average investor may not be as well-versed in the capital markets or may not have access to
adequate information to invest successfully or simply may not have the time to acquire
information and analyze it. By investing through a mutual fund, the investor is able to acquire
the services of a team of professionals dedicated to the investment business, whose cost is
spread over the entire pool and thus is a very low cost for the investor.

Ability to Diversify

An average investor will normally invest small amounts of money and cannot achieve an
adequate level of diversification. An investor of even a small amount in a mutual fund will
achieve immediate diversification by becoming a part owner of the entire portfolio of the
mutual fund. This has been dealt with previously in the Diversification section.

Ability to invest very small amounts

An investor, who wishes to invest very small amounts, even Rs. 1,000, can do so by investing
in some mutual funds (normally open-end funds). The same amount of Rs.1,000 will not be
entertained by any broker in the capital markets, which are normally the exclusive domain of
the rich and wealthy.






27
Ability to multiply savings

If an investor wishes to build up savings of small amounts every month, he does not have to
wait to first build up large enough amounts to invest meaningfully. By investing every month
in a mutual fund, the investor can make the monthly savings earn and grow as these are
accumulated.

Ability to diversify price volatility risk

At the point in time when an investor has some funds to invest, the market may be rising
(bullish) or declining (bearish). He is never too sure if he is entering the market at the right
time. By investing small amounts in mutual funds regularly, the investor is able to average out
the fluctuations in the purchase price some investments will be made when the market is high
and some when it is low; the average investment is likely to be at the mid-point.

Ability to match investment with risk taking ability

Most investors have their own unique risk taking ability. Retired persons will normally have a
low risk taking ability. On the other hand, younger persons or persons with adequate resources
are normally able to take higher risk and should, therefore, be able to benefit from higher
potential rewards. Mutual funds normally offer different investment styles, i.e., there are funds
that invest in the stock market and carry a higher potential risk and reward. Apart from stock
market funds, there are mutual funds that invest in the debt securities, which expose one to
relatively lower risk; and then there are mutual funds that invest in money markets, which
expose one to very low risk. By allocating ones savings into several mutual funds, the investor
can balance out the investments into a combination that suits the investors risk taking ability.

Less volatile

By investing in diversified assets, mutual funds are generally less volatile than the average
equities portfolio of an individual investor.

Size does matter

With the growth in the size of funds under mutual fund management, the reach and dimension
of that fund in itself enhances its ability to exploit investment and trading opportunities in the
market.

Liquidity

Money invested in mutual funds can be redeemed either by selling the shares of a closed-end
fund in the market or by simply asking the Fund Manager for redemption (refund at current
market price) in the case of an open-end fund. There are normally no penalties for early
termination of the investment, which one may have to suffer in the case of term deposits with
banks or other savings schemes.




28
Protection of Regulation

If one invests directly in the capital markets, the rule of Caveat Emptor or buyers beware
applies in its full meaning. However, in case of investing in a mutual fund, one is protected by
the government-enforced regulation of mutual funds. In most countries Mutual Fund Managers
are regulated under fairly stringent regulatory rules and investors can rely on the enforcement
of good practices by the fund managers. In Pakistan the Securities & Exchange Commission of
Pakistan (SECP) is the regulator of mutual funds and is very stringent in issuing licenses to
fund management companies, especially in the case of unit trusts. The SECP also carries out
continuous monitoring of mutual funds through reports that the mutual funds have to file with
the SECP on a regular basis.

Protection through the Trustee

In the case of unit trust schemes, the trustee, who has to be qualified under the law to act as
such, offers additional protection by having complete custody over the assets of the mutual
fund. The trustee ensures that the Fund Manager takes the investment decisions within the
defined investment policy of the mutual fund. Under Pakistan law, banks, trust companies
which are subsidiaries of such banks and central depository companies, approved by SECP, or
NBFCs carrying out investment finance services, approved by SECP, can act as trustees.

Why invest through mutual funds

The benefits of investing through mutual funds have been elaborated above. The simple fact is
that most people do not have time outside their work and family life to scrutinize dozens of
stocks and bonds before putting their money in for investment. This job can be left to
professional managers. Anyone can pick and buy certain hot stocks and make money in the
process. However, this fact should not make us believe that we will always hit a sixer. It is an
established fact that majority of part-time speculators lose in the game of speculation. One
should not confuse speculation for investment. Investment through mutual funds is an ideal
option for those investors who do not have time to explore investment opportunities in todays
dynamic and ever changing capital market conditions.

Which Mutual funds to invest in

Following are the basic guidelines for choosing which funds to put money into:
Well-established and reputable companies managing the Funds.
Fund Management Companies that issue timely, transparent and investor friendly reports.
The Fund Management Companies that follow good corporate governance practices and
comply with proper disciplines.
The offering document (prospectus) of the particular fund has a clearly defined investment
policy and clearly states the potential risks.
Choose a Fund, the investment policy of which is suitable for the time horizon of your
investment and the level of risk that investment can be exposed to. However, it is
recommended that you should allocate the investment amount between two or more Funds that



29
suit the criteria. This will ensure that you diversify the risk on the fund managers performance
as well.
Invest early, Invest now
Taking a disciplined approach is the key to retiring rich. The most powerful tool when it comes
to retiring rich, is compounding your returns on money saved when you are young. Through
the power of compound interest, cash invested today has a massive impact on your wealth level
when you retire. Time plays an essential role in building future wealth because the
contributions already made continue to work for you. As time goes on, you make money not
only on your original investment but also on your gains from earlier years. If your investment
earns 8% a year for five years, you don't earn 40%, but 47%. This is because you make money
not only on your original investment, but also on your accumulated gains from earlier years.
Let's assume that you decided to invest just Rs. 5 a week and your investment earned 8% a
year. At the end of 10 years you would have saved Rs. 3,985; at the end of 20 years, Rs.12,847.
If you were able to invest Rs.20 a week, you would have accumulated over Rs. 51,389 at the
end of 20 years. That's the magic of compounding. You just systematically invest and let
compounding do the rest!

The fact that investing a small amount today is better than investing a larger amount later can
be very clearly demonstrated by an example. If we assume two cases, the first where you start
investing Rs. 10,000 per month now for the next twenty years and the second where you invest
Rs. 20,000 a month for ten years but starting after ten years. If we also assume that in these
cases the rate of return on your investment is 10% per annum, the following will emerge:

Case -1 Case-2
Amount invested per
month (Rs.)
10,000 20,000
Total number of
months
12 X 20= 240 12 X 10= 120
Total amount of
investment
10,000 X 240 = Rs. 2,400,000 20,000 X 120 = Rs. 2,400,000
Rate of return 10% per annum 10% per annum
Accumulated amount
at the end of twenty
years from now (Rs.)

7,656,969

4,131,040

You will see that the total amount invested is the same in both cases but in Case-1 the savings
started earnings ten years earlier thereby allowing you to accumulate a higher amount as
compared with Case-2.

Long-term investing in the Pakistan Stock Market

We have also carried out another exercise of seeing what someone would have achieved
through long-term investing in the Pakistan Stock Market. We have assumed that a business



30
executive started investing Rs.100 per month in the Pakistan Stock Market (equally in all the
listed shares) in the year 1975.

After conducting a random survey among individuals over the age of 55 years, we estimated
that their annual salary increase over the years was about 15 percent annually (taking inflation
into consideration as well). The accumulated value of such a persons investment after thirty-
three years would have grown to a huge Rs. 7.7 million by June 2007. Even after the steep drop
of the market in 2008 and 2009, the said investment would have been worth Rs 4.2 million by
May 2009. Such are the gains that may be reaped from just the stock market and the impact of
compounding.

Pensions Savings

While investing towards a long-term goal such as providing towards retirement income, it is
important that we allocate our money amongst various asset classes (types of investments), in a
manner that allows us to get the best blend from the various asset classes.

As has been stated in the earlier part of this booklet, equity returns are likely to out perform
other forms of financial investments in the long run, however, it has also been demonstrated
that the funds invested in equity should be of long-term nature so as not to suffer losses
resulting from cyclical downturns. If a young person at 30 starts investing towards retirement
at the age of 60, he has 30 years to ride out economic cycles and thus have the ability to reap
the benefits of equity investing while almost eliminating the risk associated therewith.

A well researched method is to use what is called the life cycle investing approach. Under
this method, our young person aged 30 would start making regular (say monthly) investments
in mutual funds. Of the amount being invested every month a very large portion (say 80%)
would go to an equity fund and the rest (20%) to a debt or money-market fund. Each year, as
the person advances in age, the allocation to the equity fund would gradually reduce and the
investment in the debt or money-market fund would correspondingly increase such that by the
time the person retires, only 20% is being invested in the equity fund and 80% is being
invested in the debt or money-market fund. Also, since an individuals income usually
increases as he progresses in his career the amount he can save also increases subject to
variation in these patterns, based on typical spending habits associated with his age. For
example, an individual can save the most when he is young and unmarried and when he is
more advanced in his career and his children have grown up.

In addition to allocating the annual investments between the two asset classes in the changing
proportion, the investment pool that is built up would also be reallocated every year in a similar
manner so as to ensure that the overall investment ends up at 80% in debt and money-market
by the time the person retires.





31


The lifestyle investing regime will not only ensure that the person does not suffer price
volatility risk of the stock market at the tail end of ones working life but will also benefit from
gradually buying into equity in the earlier years and, thereafter, gradually divesting from equity
in the later years. Thus at both stages, the person will be buying and selling at the average
prices over a period rather than investing or divesting large chunks at any one stage and being
caught at the wrong end of the market. What this means is that one not only mitigates the
business (economic) cycle risk associated with equity investing but one also reduces the price
volatility risk of the market

We have worked out a sample calculation for a set of assumptions, whereby a person invests in
all asset classes discussed previously as well as a life cycle allocation investment strategy for
35 years consisting of equity and DSCs. The allocation between the two asset classes starts off
with 80 percent in equity and 20 percent in DSCs and gradually reallocates towards 80 percent
DSCs and 20 percent equity as discussed previously. The investments made every month
starting with a 100 Rupees a month also grow at a rate consistent with a typical demographic
pattern of saving (see proceeding chart) where maximum savings occur at the beginning and
near the end of ones career.



0%
20%
40%
60%
80%
100%
1
9
7
4

7
5
1
9
7
5

7
6
1
9
7
6

7
7
1
9
7
7

7
8
1
9
7
8

7
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1
9
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9

8
0
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0

8
1
1
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1

8
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2

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3

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8
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1
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6

8
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1
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7

8
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1
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9
0
1
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0

9
1
1
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1

9
2
1
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1
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2
0
0
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2
0
0
0

2
0
0
1
2
0
0
1

2
0
0
2
2
0
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2

2
0
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3
2
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3

2
0
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4

2
0
0
4

2
0
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5
2
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2
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6
2
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6

2
0
0
7
2
0
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7

2
0
0
8
2
0
0
7

2
0
0
9
EquityDSC Allocation Schedule
EquityDSC Allocation Schedule
Equity
DSC
0%
2%
4%
6%
8%
10%
12%
14%
16%
23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 56
age
Typical Demographic Savings Patern (% growth)



32


Nominal
Return (IRR)
Real Return
(IRR)
Value at the end
of 35 years
KSE 13.64% 4.80% 2,166,980
DSC 14.17% 5.33%

2,417,033
Bank Deposits 7.41% 1.43%

663,001
Life Cycle Asset Allocation Return 16.12% 7.28%

3,246,032

As can be seen from the preceding chart and table, the life cycle approach clearly outperforms
all other asset classes. What is particularly interesting to note is that the life cycle approach
fares well even in the worst of times, whether it was the depressed equity market situation in
the mid- and late nineties or the crash at the end of 2008.

In our country the standard post-retirement plans are not so well thought-out. Let us first look
at the method most people follow: assume you have just retired at sixty, have a total of Rs. 5
million in savings and expect to live to the age of 75; if we also assume that you will manage
to get an income of 9 percent per annum, it will give you about Rs.37,500 per month. Even if
you think this is enough to get by on today, it will only buy you about half the groceries ten
years from now, assuming an inflation rate of 8 percent. However, of course, with this method,
your heirs will be left with the original Rs.5 million at the end of the fifteen years but the
purchasing power of this amount would be less than one third compared to when you started
off with.
.
The better way to manage this is to recognise that what you had put away over the years for
your retirement is yours to spend during retirement and not necessarily to leave behind. You
can simply divide the Rs.5 million by your expected remaining life (we had assumed 15 years)

500,000
1,000,000
1,500,000
2,000,000
2,500,000
3,000,000
3,500,000
4,000,000
4,500,000
5,000,000
1
9
7
4

7
5
1
9
7
5

7
6
1
9
7
6

7
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1
9
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7

7
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2
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0

2
0
0
1
2
0
0
1

2
0
0
2
2
0
0
2

2
0
0
3
2
0
0
3

2
0
0
4

2
0
0
4

2
0
0
5
2
0
0
5

2
0
0
6
2
0
0
6

2
0
0
7
2
0
0
7

2
0
0
8
2
0
0
8

2
0
0
9
Asset Class Life Cycle Comparison
KSE DSC Bank Deposits Life Cycle Asset Allocation



33
and spend the resultant Rs.333,333 i.e., approximately Rs.28,000 per month. Meanwhile, you
would invest your capital preferably in a mixture of shares and bonds. Thereafter, you would
carry out a similar exercise every year. However, this would expose you to two risks, one that
you might live longer than you had estimated and secondly, that the share prices might be
down when you cash out your investments for spending during the year or in the event you
need some extra money in an emergency.

In order to manage these two risks, you can first put aside one-eighth of the Rs. 5 million, i.e.,
Rs. 0.625 million as a reserve. Divide the balance, i.e., Rs. 4.375 million by the remaining
years you expect to live, this gives you Rs. 291,667 for the first year to spend i.e.,
approximately Rs. 24,300 per month. This Rs.4.375 million will be invested in safe debt
investments that are expected to earn in line with, or a little better than inflation. This means if,
say, your debt fund increases by 9% each year, your annual and thus monthly income will also
increase by the same percentage, i.e., Rs. 24,300 per month in first year, Rs. 26,500 per month
in second year, Rs. 28,900 per month in third year and so on. By doing this every year, you
will stay in line with inflation and still have a reserve to fall back upon in emergencies. The Rs.
0.675 million you have put away as reserve may be invested in equity investments, earning,
say, 15 percent per annum. This amount at the end of your 15-year term (when last payment is
made from the debt account) will accumulate to Rs.5.1 million, if it earns 15% per annum on
equity investments, which is very much possible. So you have earned an increasing income
stream during your 15-year term (coping efficiently with inflation), and are still ending with
the amount you started with, approximately Rs. 5 million, which, therefore, covers the
longevity risk. By doing this every year, you will stay in line with inflation and still have a
reserve to fall back upon in emergencies.

The recently introduced Voluntary Pension System (VPS) offers such savings plans.

Conclusion

The market is an ever-changing place new concepts and products are being introduced
continuously. Some products are common in other markets but not yet in Pakistan. We have
attempted to address the basics of securities traded in the capital markets and have deliberately
kept away from convertible bonds (hybrids between equity and debt securities) and derivatives,
which are not common in our market as yet. Some readers of this booklet may feel that we
should have put across the concepts in simpler language. We do apologize to any such readers
and would urge them to seek professional advice.

A final piece of advice: please take time over your investment decisions. Do not be pressured
by anyone telling you that you are about to miss an exceptional opportunity to make money
quoting a sage It is better to lose an opportunity than to lose your money.

The booklet has been printed by Arif Habib Investments Limited for free-of-cost distribution in
its effort to promote investor understanding of the risks and rewards of the capital markets.
However, readers who wish to support any of the non-profit charitable organisations listed
below are requested to fill-out the accompanying Form and send a donation to the concerned
organisation:




Date: __________________________

Head of Investor Services
Arif Habib Investments Limited
2/1, R.Y. 16, Old Queens Road
Karachi-74000

Dear Sir,

I recognise that Basics of Capital Market Investing is distributed by Arif Habib Investments
free of cost. However, in an effort to support the good work being done by the charities
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Yours faithfully,

Name____________________________________________________________________

Address__________________________________________________________________

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Charities being supported by Arif Habib Group:

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The Aga Khan University Hospital
DSRA Education & Welfare Trust
Al Umeed Rehabilitation Association
LRBT
Edhi Foundation
The Cardiovascular Foundation
SOS Children Village Sindh
The Kidney Centre
Pakistan Centre for Philanthropy
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Poor Patients Aid Society, Civil Hospital
Thalassemina Care Centre
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Amina Public School
Panah Shelter Home
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