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Pakistan Likely To Enter MSCI Emerging Markets Index

MSCI is considering reclassifying the Pakistani equity market from frontier to emerging market status on June 14th, 2016. MSCI – a leading provider of research-based indexes and analytics – announced that it will release on June 14, 2016, shortly after 11:00 p.m. Central European Summer Time (CEST), the results of the 2016 Annual Market Classification Review. As a reminder, three MSCI Country Indexes are currently included on the review list of the 2016 Annual Market Classification Review: MSCI China A and MSCI Pakistan Indexes for a potential reclassification to Emerging Markets and MSCI Peru Index for a potential reclassification to Frontier Markets. It is important to note that MSCI is not the only index provider that classifies markets but is considered the reference benchmark for many markets. MSCI and other index providers base their market classification on a number of quantitative measurable and comparative criteria while aiming to avoid qualitative and/or subjective criteria. PAKISTAN: ECONOMY IN FOCUS Pakistan is a country with a population of 190 million people. Pakistan’s GDP stands at USD 250 billion (Year 2015). Pakistan’s economy continued to pick up in the fiscal year 2015 as economic reform progressed and security improved. Inflation markedly declined, and the current deficit narrowed with favorable prices for oil and other commodities. Despite global headwinds, the outlook is for continued moderate growth as structural and macroeconomic reforms deepen. Selected economic indicators (%) – Pakistan 2015 2016 Forecast 2017 Forecast GDP Growth 4.2 4.5 4.8 Inflation 4.5 3.2 4.5 Current Account Balance (share of GDP) -1.0 -1.0 -1.2 Source : Asian Development Bank CPEC : THE GAME CHANGER FOR PAKISTAN China Pakistan Economic Corridor (CPEC) is a mega project of USD 46+ billion, taking the bilateral relationship between Pakistan and China to new heights. The project is the beginning of a journey of prosperity for Pakistan and China’s Xinjiang. The economic corridor is about 3,000 kilometers long consisting of highways, railways and pipelines that will connect China’s Xinjiang province to the rest of the world through Pakistan’s Gwador port. The investment on the corridor will transform Pakistan into a regional economic hub. The corridor will be a confidence booster for investors and attract investment not only from China but other parts of the world as well. Other than transportation infrastructure, the economic corridor will provide Pakistan with the telecommunications and energy infrastructure. MSCI INDICES AND PAKISTAN – A QUICK RECAP It is important to mention that between 1994-2008, Pakistan was part of the MSCI Emerging Markets Index. After the Balance of Payment crisis in 2008, KSE was shut down for 4 months after which the country was kicked out of the Emerging Markets Index. In May 2009, Pakistan was added back in the MSCI Index, but this time it was added in the Frontier Markets Index. In June last year, MSCI put Pakistan up for official review regarding inclusion into the Emerging Markets Index. Now, as per today’s press release, MSCI will make its decision whether to upgrade or not on 14th of June. RECAP: THE MSCI PAKISTAN INDEX Click to enlarge Click to enlarge Click to enlarge Click Here for MSCI Fact Sheet INDEX METHODOLOGY The index is based on the MSCI Global Investable Indexes (GIMI) Methodology – a comprehensive and consistent approach to index construction that allows for meaningful global views and cross regional comparisons across all market capitalization size, sector and style segments and combinations. This methodology aims to provide exhaustive coverage of the relevant investment opportunity set with a strong emphasis on index liquidity, investability and replicability. The index is reviewed quarterly – in February, May, August and November – with the objective of reflecting change in the underlying equity markets in a timely manner while limiting undue index turnover. During the May and November semi-annual index reviews, the index is rebalanced and the large and mid capitalization cutoff points are recalculated. SOME IMPORTANT NUMBERS/STATS Click to enlarge WHAT TO LOOK FOR IF PAKISTAN ENTERS MSCI EMERGING MARKETS INDEX? If the decision is positive, emerging markets funds with 40-50 times the capital of frontier funds will be forced to have a look at Pakistan. In our view, this is an opportunity with a risk-reward skewed heavily towards the positive side. PSX – Pakistan Stock Exchange – currently trades at 9.0x earnings; companies have grown faster than their regional peers in USD over the last ten years. Should Pakistan enter MSCI Emerging Markets, it does so at more than 40% P/E discounts to its Asian EM peers. We don’t believe this is sustainable, hence calls for a positive re-rating of the valuations. ETFs IN FOCUS: Several ETFs and mutual funds invest in emerging markets; on the other hand, a small number of ETFs focus on frontier markets. For comparison purpose, we are taking BlackRock Capital ETFs. BlackRock Capital offers the iShares MSCI Emerging Markets ETF (NYSEARCA: EEM ), asset base of which is approx USD 25 billion when compared to BlackRock Capital’s iShares MSCI Frontier 100 Index ETF (NYSEARCA: FM ), asset base of which is merely USD 420 million. It is important to note that the fund size of most of the frontier markets ETFs are very small when compared with emerging markets ETFs. Hence, we don’t see any major selling pressure from the liquidation of frontier market funds which are invested in Pakistan, as that selling will be absorbed easily by the emerging market funds. In fact, emerging markets funds will bring in more liquidity in the market, hence, providing frontier market funds an easy exit. OUR STANCE We are of the view that it is likely that Pakistan will be given a green signal for entering MSCI Emerging Markets on June 14th, 2016. We caution against the notion that reclassification is a panacea for market ills or underperformance. Typically, reclassification (both upgrades and downgrades) have followed or been accompanied by economic and financial policy reforms, including improvements in market infrastructure. It is these more fundamental and structural reforms that attract and retain international investors and boost the confidence of domestic investors. Reclassifications are best viewed as signaling a confirmation of policy reforms and changes in market conditions. Hence, an identification problem may arise whereby improved market conditions are attributed to market reclassification decisions, whereas they are due to policy actions and reforms which lead to a reclassification. Similarly, we note that reclassification may have perverse effects if there is an ‘overshooting’ effect whereby speculation leads to higher prices in advance of a reclassification, over and above what would be justified by market/ economic fundamentals. Prices then adjust on the actual reclassification event. As highlighted in the article, Average Annual Revenue and Net Profit Growth of companies listed in Pakistan have been phenomenal between 2005-2015. Moving forward with CPEC in place, Pakistan’s inclusion in the MSCI Emerging Markets Index will be beneficial for both local as well as global investors. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Matter Of Debate: A Return To Small Cap Quality?

By Robert D’Alelio, Portfolio Manager, Small Cap Value Team and Benjamin Nahum, Portfolio Manager, Small Cap Intrinsic Value Team After a period of small cap underperformance, the focus may shift to fundamentals. Small-capitalization equities have underperformed larger stocks over the past year, and experienced a particularly rough stretch of negative performance in the second half of 2015 and into early 2016. The Russell 2000 Index, a popular benchmark for smaller stocks, declined more than 25% from its peak last June through a low in February of this year. To assess risks and opportunities in small caps, we tapped into the insights of two of Neuberger Berman’s small-cap equity managers, Benjamin Nahum and Robert D’Alelio. Benjamin Nahum: Contrasting today’s market for small-cap stocks with June of 2015, we see significantly more value but with greater volatility. A year ago it was the inverse. Arguably the current environment presents more challenges, including economic deceleration and uncertainty with regard to China and central bank policy, but for long-term investors, we see a far more appealing value equation in small-cap equities today than there has been in quite some time. Robert D’Alelio: When prices get lower, stocks can become more attractive, provided your time horizon is sufficiently long. It’s worth noting, however, that lower prices don’t necessarily equate to an attractive small-cap market. Roughly one-third of the companies in the Russell 2000 are projected to lose money over the next 12 months, so selectivity is important. This is one reason we think small-cap equities are an area that stands to benefit from active management. Nahum: To put our thinking on the attractiveness of current valuations into context, our strategy’s “intrinsic value” discount metric exceeded historical averages in February. In our view, a “cheap” or truly distressed market would mean an intrinsic value discount north of 40%. This happened three times in the past 18 years, during periods of global financial panic or systemic risk. We believe our strategy’s current intrinsic valuation discount represents an attractive entry level of value. If you think there is a crisis lurking out there, then there could be more downside based on what we’ve seen in the past. Absent a crisis, the current discount to intrinsic value is appealing. D’Alelio: To us, the overall market does not look particularly cheap on an absolute basis, but we don’t buy the overall market. We buy individual securities, and we focus on high-quality companies with strong balance sheets, high levels of free cash flow and high returns, with barriers to entry. Until recently, in the post-financial crisis recovery, high-quality businesses like the kind we prefer have lagged. Low rates have helped highly leveraged companies and hurt companies with net cash balance sheets. In this sense, corporate savers are no different than individual savers that have been punished by Fed policy. Clearly cash is a “non-earning” asset today; however, it can always be converted into an earning asset via share repurchase, acquisition and so on. It follows that companies with net cash balance sheets have untapped earnings power. So while the market today does not appear to be attractive on an absolute basis, quality looks relatively cheap. Identifying Attractive Opportunities Nahum: We are taking a measured approach to adding new ideas to our portfolios and are demanding a higher-quality investment, not simply an inexpensive stock. We look for companies whose share prices have underperformed the market and where there is a compelling value argument in terms of cash flow, earnings or price-to-sales. If our analysis suggests a discount of more than 30% to intrinsic value, we’ll investigate further. The idea is to look for out-of-favor companies with strong value attributes, along with capable management teams and credible catalysts for a turnaround in the next three to five years. D’Alelio: Quality has been out of phase recently but, over a full market cycle, we believe the quality approach works. Small is thought to equate with sexy, new kinds of companies, but we buy established and perhaps even boring businesses with clear-cut barriers to entry. They tend to keep competitors out and generate substantial free cash flow. Because these are not the kinds of companies that need to access the capital markets, they often don’t get a lot of attention from Wall Street analysts. Advantages and Considerations of Small-Cap Equities Nahum: The small-cap marketplace has been inefficient and volatile, but over the long-term, small-cap value, in particular, has attractive relative returns versus large-caps, as measured by the performance of the Russell 2000 Value versus the Russell 1000 indices since 1979. One reason, in our view, is that managements of smaller companies are often owner-operators, rather than bureaucrats. They tend to be entrepreneurial and creative, and are often more innovative and faster to market than their counterparts in larger companies. We believe these are the people you want to partner with over long periods of time. D’Alelio: I agree. Also, the inefficiency in the small-cap markets is great for active managers. Why would you want to index inefficiency? Are U.S. Small Caps Insulated from Global Risks? Nahum: Small-cap companies are sometimes thought to be insulated from global risks, but we think this is a bit of a red herring. The financial sector accounts for nearly 40% of the Russell 2000 Value Index, and about one-third of those companies are real estate investment trusts, one-third are banks and one-third are non-bank finance companies. U.S.-based, small-cap financial companies tend to have little global exposure. The same cannot be said, however, of small-cap technology companies. So if you want the entrepreneurial benefits of small-cap American tech or medical companies, as we do, you’ll incur global risks. D’Alelio: I agree with Ben that, while small companies are in fact more domestically oriented than larger caps, simplistic analysis using SEC filings tends to overstate the magnitude. For example, this type of analysis would lead one to believe that small-cap energy companies are 100% domestic. While that’s technically true, where is the price of oil determined? It’s driven by global demand. While it’s true that small companies are still somewhat more focused on domestic markets than larger ones, we don’t think that should be a reason to embrace or avoid the space. Outlook for Mergers and Acquisitions Activity Nahum: We tend to see a lot of acquisitions among our portfolio companies, and we view a company buying one of our holdings as corroboration of our process. Regarding the level of ongoing M&A activity, we think confidence goes hand-in-hand with liquidity and risk premiums, so we find that there is more M&A activity when financial markets and confidence are strong, and that M&A will ebb when markets weaken. Year to date, we have seen healthy M&A activity within our portfolios, suggesting that confidence among corporate buyers and private equity firms appears reasonably solid. D’Alelio: We experience our share of takeovers within our portfolios, but we tend not to like them unless the premium is very large. That’s because we buy into unique, hard-to-duplicate business models. We’d rather own these companies and capture the benefits of earnings growth over the next 10 to 20 years than get a one-time premium and have to redeploy the cash into another company with similar attractiveness, which can be hard to find. As Warren Buffett has stated – the best time to sell a good company is never. Disclaimer: This material is provided for informational purposes only. Nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Any views or opinions expressed may not reflect those of the firm as a whole. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. Please see disclosures at the end of this publication, which are an important part of this article. © 2009-2016 Neuberger Berman LLC. | All rights reserved

Shifts In Leadership: Rules 3 And 4 For Investing

The stock market has moved towards new highs on the backs of the new leaders—the economically sensitive stocks. It’s not that the global economy has improved that much but it is that these companies have retooled to do better in a weaker environment. Expectations have been brought so far down and the stocks got so cheap that it has been easy to beat expectations with first quarter results. The market likes it when companies exceed expectations. Commodity prices, the bell weather for cyclicals, are increasing too, benefiting from a weaker dollar, which has now hit a multi-month low for reasons discussed in prior blogs and a somewhat stronger China. There has clearly been a mindset shift away from the old leaders towards the new and unless you recognize this shift, your performance will continue to lag behind the averages. Fortunately for our investors, we made these changes months ago beginning with covering our energy shorts, increasing our exposure to economically sensitive (especially commodity) stocks that are financially strong. We also are over-weighted banks and financials as discussed previously as a win/win proposition regardless of the economy. The best part about this change in leadership is that future earnings comparisons get easier for them as the year progresses as their results turned down dramatically beginning with the second quarter of 2015. Secondly, a weaker than expected dollar for 2016 has caused management to lift forecasts for this year. We made the shift in investment emphasis months ago aided in good part by utilizing our Rules #3 and #4 for investing. After looking at managements and strategies, we look for companies with rising incremental rates of returns and margins. In addition we are always searching for companies nearing their inflection point for earnings. Companies increasing their returns and margins are potential long investments as it tends to boost valuation and stock prices over time and it’s the reverse for the shorts. In addition, companies nearing an inflection point in earnings from negative to positive or visa versa as additional tools for investing. Anticipating with accuracy the inflection point as well as changes in incremental rates of returns are two of my time-tested rules for investing. These stocks tend to rise on a wall of worry or decline on a wall of exuberance… all the way to the bank. Patience is needed to let them unfold. None of these rules work in a vacuum. A successful investor needs a systematic approach combining a global macro-view for the proper asset allocation and risk controls with a bottom-up selection of each investment, which requires first hand research and and in-depth testing. While I agree with Warren Buffett that hedge funds have unperformed as a group over the last few years. It would be unwise to paint all managers with the same brush. A handful, who really understand what it takes to be a global investor today and abide by their time-tested methodologies, have done quite well and are worth every penny that they earn. Paix et Prospérité is one of them. Let’s take a quick look at the data points from last week and see if there were any changes in our core beliefs, asset allocation, risk controls and stock selection: The United States reported first quarter GNP increasing at an annual rate at 0.5% as we predicted down from a gain of 1.4% in the fourth quarter. Consumer spending led the way with a gain of 1.9% in the quarter down from 2.4% in the prior quarter; service spending rose by a healthier 2.7%; the trade gap widened reducing GNP by 0.34%; housing rose at a 14.8% rate; nonresidential fixed investment fell 5.9% and the GDP price index increased by only 0.7%. It was important to note that disposable income accelerated to a 2.9% gain in the quarter from 2.3% in the fourth quarter and the savings rate rose to 5.2% from 5.0% in the prior quarter. Growth in employment and wages combined with low inflation will result in more consumer discretionary income, which will support continued growth in consumer spending and the economy in 2016. The Fed also met last week and there was no surprise that the Fed policy was left unchanged. It is obvious why the Fed remains on hold: the U.S. economy weakened in the most recent quarter; inflation remains well below the 2% Fed target; problems abound abroad and finally fear of the ramifications of Britain potentially leaving as a member of the Eurozone. Economic activity and employment accelerated in the Eurozone in the first quarter with a gain of 0.6% from the fourth quarter and up 1.6% from a year ago. It was important to note that consumer prices reported for April were 0.2% below the prior despite all the actions of the ECB. Expect no changes in monetary and fiscal policies until after the Brexit vote at the end of June. China’s official manufacturers index was reported yesterday at 50.1 down from 50.2 the prior month. A number above 50 signals that the economy continued to expand after seven months of contraction. New factory orders and the production sub-index both fell slightly but also remain over 50 indicating continued expansion too. I remain confident that China will expand by at least 6-6.5% this year bolstering world growth. Japan remains the trouble spot amongst all major industrialized countries. The BOJ met and maintained its policies; the yen strengthened as investors sold risk assets and the stock market fell dramatically. Etsuro Honda, an advisor to Prime Minister Abe, raised concerns that monetary policy alone cannot lift the economy however the country’s debt situation precludes much stimulus. I remain cautious on Japan. Let’s wrap up. Events of the last week reinforced many of our core beliefs. One of my key beliefs, “This is a market of stocks, not a stock market”, was bolstered this week by a combination of disparate earnings reports and commentary by companies across a wide spectrum of industries but also by the clear shift in mindset from old leadership to new. This doesn’t mean that an Amazon, Facebook, Alibaba or a LinkedIn cannot still stand out, but I am suggesting that you need to recognize the changes occurring and invest stock-specific rather than by groups, regions or industries. In closing, review the facts, and then pause to reflect on proper asset allocation, risk tools, mindset changes by investors and managements. Lastly, do in-depth research on each investment… and invest accordingly!