Pakistan on the Comeback Trail – AFC on the Road – Pakistan October 2024

Dear Investors and Newsletter Readers,

As part of our on-the-ground research process, Thomas Hugger, CEO of Asia Frontier Capital, visited Karachi and Lahore in Pakistan in October 2024 to meet with the fund’s portfolio companies as well as with policymakers.

Travelling from Europe for this visit, it struck me that, in today’s connected world, Turkish Airlines (alongside British Airways, which flies to Islamabad) is currently the only airline offering daily direct flights connecting Europe with Pakistani cities—Islamabad, Karachi, and Lahore. I have many friends in Europe who used to travel in the 70's and 80's from Europe to Asia or Australia via Karachi with Pakistan International Airlines (PIA) since it was at that time a cheap and convenient transit hub between Europe and Asia. Today however, Karachi and the other Pakistani airports have become "feeder airports" for the new transit hubs like Doha, Dubai, and Istanbul.

The flight to Karachi was for above reasons logically completely full, and we arrived early in the morning just before sunrise. I was once again amazed that the airport in Karachi is mostly the same as when I first travelled to Pakistan in 1993, except for the McDonald's building located outside the airport, directly opposite the main exit at the arrival level!

This observation highlights a broader trend in Pakistan's economic and infrastructure development over the past 30 years: neighbouring countries have surpassed Pakistan in terms of economic growth and infrastructure development, primarily because Pakistan has unfortunately been unable to maintain its investments in these areas.

Since it was Sunday—a non-working day in Pakistan—our host arranged a sightseeing tour of the old part of Karachi and Clifton. Despite this being my seventh visit to Karachi, I had never truly realized the city's hidden gems until this tour. Our excellent, knowledgeable, foreign-educated, young tour guide, who is an architect by profession and works part-time as a tour guide out of passion for Karachi, made it an eye-opening experience.

During the three-hour tour, she showed us the historical aspects of this metropolis, home to approximately 20 million people, making it the 12^th largest city in the world. I had always thought Karachi lacked historic buildings, but she proved me wrong. One highlight was our visit to a local market, where we purchased 1 kg of Himalayan salt (which the vendor crushed right in front of us) for just USD 0.12 per kilogram!

Mohatta Palace, Karachi

One of the Many Colourful Public Buses in Karachi

We spent the next two days in Karachi meeting with local companies, either in our hotel or at their offices. We met with various banks and companies in the food, fertilizer, pharmaceutical, and power sectors. One notable meeting was with the CEO of Systems Limited, a current portfolio holding of the AFC Asia Frontier Fund, which provides software outsourcing services. After our meeting, we toured their office in Karachi, which employs around 1,500 people (its head office is in Lahore) and offers IT consulting services globally, with a rapidly growing segment in the Middle East, particularly in Saudi Arabia and the U.A.E.

At AFC, we believe the IT sector could become a key pillar for Pakistan’s economic development, similar to how India has successfully demonstrated with companies like Infosys, Tata Consultancy Services, and Wipro. This sector has the potential to create well-paying jobs for Pakistan’s burgeoning young population and generate critical foreign currency income, which the country desperately needs to revitalize its economy—a real “win-win” situation for the companies, the country, and its citizens.

Additionally, we had a very informative lunch meeting with a deputy governor and the research director of the State Bank of Pakistan (SBP). They provided detailed insights into recent interest rate and inflation developments, as well as their perspective, and the outlook for the Pakistani Rupee. In summary, the SBP anticipates further declines in inflation rates, which should lead to significant cuts in the lending rate over the next couple of months, as the current rate’s spread over actual inflation is excessively high.

We Expect the State Bank of Pakistan to Continue with its Aggressive Monetary Policy Easing as Inflation Falls

During our discussions, we also addressed the issues surrounding the currency crisis and explored two main solutions to prevent future crises. The first solution is to increase exports. It is surprising to note that exports account for only 9% of Pakistan’s GDP, compared to 83% in Vietnam. I believe the IMF is applying significant pressure on the Pakistani government to boost exports. We heard from several CEOs during the week that there are plans to introduce incentives in the next state budget, such as reduced taxes, to encourage exports.

The second solution involves increasing foreign investments, particularly foreign direct investments (FDI), as well as portfolio investments. I expressed to the Deputy State Governor that investing in the Pakistani stock market is currently quite challenging for foreign institutional investors and basically impossible for foreign individuals. Recently, I received several inquiries from global investors asking if AFC has, or plans to launch, a dedicated Pakistan Fund (please contact us if you are also interested). Compared to other countries, especially developed markets, where anyone can open a brokerage account online within minutes, the process in Pakistan is overly complicated. Another issue we discovered in our discussion is that “omnibus accounts” for brokers were banned some time ago, which previously allowed local and foreign brokers to hold stocks on behalf of their clients.

After reflecting on this matter after the event, I believe Pakistan should consider adopting a model similar to the “Shanghai-Hong Kong Stock Connect.” This successful initiative enables foreign investors to purchase A-shares listed in Shanghai and Shenzhen through their brokerage accounts with Hong Kong-based stockbrokers (and vice-versa Chinese investors to invest in Hong Kong listed shares), all with minimal hassle. This could be a logical solution given that the Shanghai Stock Exchange is already a 17% shareholder of the Pakistan Stock Exchange (PSX). I believe Pakistan could explore establishing a “Stock Connect” initiative with Dubai, Hong Kong, or Singapore. However, an additional issue is the (bureaucratic and cumbersome) capital gain tax in Pakistan, which could be replaced by a fixed fee when selling shares easing the entire process.

The second part of our investment tour took place in Lahore, the second-largest city in Pakistan, with a population of 13 million. One of its nicknames is the “City of Gardens,” a title that is evident when travelling through the city, where trees line both sides of the roads and highways. Lahore is also home to many historical sites, as it was a capital city in the 16^th century.

We seized the opportunity to visit Lahore’s historic city centre one evening. After a tiring day filled with meetings, we enjoyed a delicious local dinner on the rooftop of a restaurant overlooking the beautiful historic Shahdara Bagh area, including Akbari Sarai, which we visited before our meal.

Entrance to to the Badshahi Mosque, Lahore

Badshahi Mosque, Lahore

View from the Restaurant over the Stunning Badshahi Mosque

Compared to Karachi, Lahore is a more industrialized metropolis. During our visit, we met with companies across various sectors, including cement, fertilizer, pharmaceuticals, technology, textiles, and banking. A personal highlight for me was visiting the factory of Airlink, one of the largest investments the AFC Asia Frontier Fund has in Pakistan.

The fund participated in Airlink's IPO in 2021 when the company was a distributor of mobile phones for brands like Huawei, Samsung, Xiaomi, TECNO, ITEL, and iPhone. However, Airlink faced significant challenges during Pakistan’s foreign currency shortage in 2022 and 2023, which hampered the company's ability to import goods, a challenge shared by many companies in Pakistan.

The result was reduced sales, leading to a decline in the company's share price below its IPO price. Fortunately, with strategic changes, Airlink's management secured an agreement to assemble smartphones in their Lahore factory for Xiaomi, now the third-largest smartphone producer in the world, along with TECNO smartphones assembly, popular among young consumers in Asia.

During a private tour, I was shown the assembly factory where Xiaomi phones are currently being assembled, and preparations were nearly complete for a new assembly line dedicated to Xiaomi Smart TV sets, along with another line being set up for Acer Gadget e10 notebooks.

Visiting Airlink’s Assembly Factory in Lahore

One of the Many Steps Needed to Assemble a Smartphone

It was fascinating to observe the approximately 75 small steps involved in producing a fully operational smartphone at the end of the assembly line. Most of these steps are performed by various machines in an automated process, although some tasks in the process require simple manual labour (as can be seen in the photo above), such as inserting tiny screws for example. Others are highly complex and must be conducted in a completely dust-free environment (usually done by robots).

Despite the automation, some tasks still rely on manual labour, with workers receiving a monthly salary of about USD 132, along with additional compensation for overtime, as each shift lasts 12 hours instead of the usual 8 hours. What stood out to me was that each phone undergoes rigorous testing and validating after every single step. Only after passing a 100% evaluation based on precedence methodology does a phone move on to the next assembly phase. Interestingly, each testing machine, equipped with AI, is connected to the Xiaomi factory in China for live monitoring of production.

Even after the smartphones are fully assembled and ready for delivery, a random selection of phones undergoes further testing. For instance, I was shown a room where tests are conducted, including dropping a phone from about two meters height onto a stone floor multiple times without any breakage or scratches.

Airlink's strategy for the future involves expanding its capacity to assemble smartphones and exporting them, similar to what Samsung is currently doing in Vietnam, where labour costs are (like in Pakistan) significantly lower than in China. According to the CEO of Airlink, labour is abundant in Lahore, and many of the young female workers "were previously sitting at home not earning a rupee".

Additionally, Airlink plans to begin assembling laptops for Acer for the local market and has announced a strategic collaboration with Itel to produce smart and lifestyle products in Pakistan. The company is also considering a partnership with Xiaomi to produce electric vehicles (EVs) in Pakistan, based on market studies.

I believe Airlink exemplifies the direction in which Pakistani companies could head in the future:

• Assembling or, even better, producing goods locally instead of relying on imports of finished products
• Increasing the export of partially locally produced or assembled items, such as consumer goods, low-technology products (smartphones, laptops, gadgets), commodities (like cement, clinker, coal, iron ore, copper), and pharmaceutical and chemical products, as well as agricultural products

Another significant topic discussed during meetings with CEOs and CFOs of Pakistan’s top listed companies is the potentially lucrative copper-gold mine, “Reko Diq,” located in the province of Balochistan in the west of the country. The Canadian gold mining company Barrick Gold holds a 50% stake, while the remainder is owned by the Government of Pakistan and other government-related companies. There is also widespread anticipation that the Kingdom of Saudi Arabia will become a strategic shareholder and investor in this mega project. If executed successfully, this mining venture could help Pakistan increase its foreign exchange reserves in the future.

Pakistan is currently engaged in ongoing discussions with the IMF (International Monetary Fund) to restructure its economy and state budget following the approval of a USD 7 billion IMF loan program. We expect further announcements soon regarding plans to incentivize exports and integrate the "undocumented" economy, which is estimated to be about twice (!) the size of the formal economy.

The AFC Asia Frontier Fund has managed to capitalize on the strong rally of the Pakistani stock market by increasing the fund's exposure to the country when the economy was at its lowest point in the first half of 2023. This decision has paid off, as Pakistan is currently the second best-performing stock market globally in 2024, with a USD return of 60%. Over the past 12 months, it has been the best-performing stock market worldwide, with a USD return of +72%. Despite this impressive performance the stock market trades at a P/E ratio of only 5.7x and a dividend yield of 7.1%.

As a result, Pakistan is now the AFC Asia Frontier Fund’s largest country weight at 14.3%, thanks to both price appreciation and increased allocation.

I left Pakistan with an optimistic outlook and believe that with the assistance of the IMF and key allies, this current government can finally turn the country around, making it a more prosperous and stable place for its friendly and welcoming people.

If you would like to know more about our AFC Asia Frontier Fund, please find below the links to the latest factsheets and presentation as of 31^st October 2024: 

I hope you have enjoyed reading our AFC on the Road report. If you would like further information about our AFC Asia Frontier Fund, please get in touch with me or my colleagues.

With kind regards,

Thomas Hugger
CEO

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