- Efficiency of Stock Markets in Pakistan - Introduction Market Efficiency is directly or implicitly tested any time a study is performed to identify stock price reactions to certain events such as dividend announcements (Bajaj and Vijh 1995), earnings announcements (Bamber 1987), stock splits (Copeland 1979), large block transactions, repurchase tender offers (Lakonishok and Vermaelen 1990), and other public announcements (Kim and Verrecchia 1990). Traditionally, event study methodology is used to evaluate the reaction of the market to certain corporate events. These studies, which are specific in nature, are designed to measure market efficiency at certain point in time and only in conjunction with specific events. A more encompassing or macro evaluation of market efficiency can be made by testing whether or not the returns in a market follow a random walk process over a longer period of time. Financial theory predicts that stock prices should fluctuate randomly in the short run if the stock market is efficient. The semi-strong form of the Efficient Market 1
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- Efficiency of Stock Markets in Pakistan -
Introduction
Market Efficiency is directly or implicitly tested any time a study is
performed to identify stock price reactions to certain events such as dividend
announcements (Bajaj and Vijh 1995), earnings announcements (Bamber 1987),
stock splits (Copeland 1979), large block transactions, repurchase tender offers
(Lakonishok and Vermaelen 1990), and other public announcements (Kim and
Verrecchia 1990). Traditionally, event study methodology is used to evaluate the
reaction of the market to certain corporate events.
These studies, which are specific in nature, are designed to measure
market efficiency at certain point in time and only in conjunction with specific
events. A more encompassing or macro evaluation of market efficiency can be
made by testing whether or not the returns in a market follow a random walk
process over a longer period of time.
Financial theory predicts that stock prices should fluctuate randomly in the
short run if the stock market is efficient. The semi-strong form of the Efficient
Market Hypothesis (Fama, 1970) holds that the market instantaneously absorbs
all relevant information as it becomes publicly available. Hence, daily returns
should fluctuate as random white noise. There has been phenomenal increase in
the turnover of shares on the stock market from1.0 billion in 1991-92 to 67.6
billion in 1999-2000. Aggregate market capitalization has increased from Rs
218.4 billion in 1991-92 to Rs 392 billion in 1999-2000 a rise of 79.5 percent.
Number of listed companies on KSE has increased from 628 in 1991- 92 to 762
in 1999-2000 (Table 1). Amongst global emerging markets, Pakistani stock
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market has been on the top with the highest percentage gain achieved during the
year 2000, in automated and electronic trading and settlement system. The
Securities and Exchange Commission of Pakistan (SECP) has accelerated its
drive to enhance the efficiency of the stock exchanges and ensure protection of
the interest of investors. Disclosure requirements are being made more stringent.
Another phenomenon taking shape with the general rise seen in the stock
markets is the revival of the mutual fund industry. The funds are becoming more
attractive and their portfolios attracting new investors to capitalize upon the
current trends. With the recovery of Pakistani stock market, it is the opportune
time for foreign funds to make their entry into Pakistani stock markets. The long-
term outlook is promising and the markets are giving enough movement to pick
up blue chips at attractive prices with good chances of reaping sizable capital
gains on medium to long-term basis. There is ample scope for income funds to
be launched. In short, Pakistani stock markets are on the road to better
performance and efficiency. Although their volatility - an essential part of all
emerging markets, creates higher risks, they also magnify the potential for higher
returns for any investor who has the patience and sophistication to participate in
the growth of this emerging market.
1.1 Scope of Study:
The scope of the study is limited to Karachi Stock Exchange. Being the
oldest and the most mature market existing in Pakistan.
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Literature Review
2.1 What Is Market Efficiency?
When money is put into the stock market, it is done with the aim of
generating a return on the capital invested. Many investors try not only to make a
profitable return but also to outperform, or "beat," the market.
Efficiency of a stock exchange can be gauged in a number of ways
some of them are described below (Pilbeam,1998).
1. Allocative Efficiency:
Allocative efficiency of a stock exchange refers to how good are the
markets in allocating scarce capital resources among competing users. In
terms of allocative efficiency capital will be allocated to the firms that can
achieve the best marginal returns.
2. Operational Efficiency:
Operational efficiency refers to the cost of raising capital. An ideal
market would be one, which provides lower costs of raising capital and
viability of long-term projects to raise capital as easily as short-term
projects. Furthermore investor would be faced with minimum transaction
costs and competition between brokers should ensure only normal profits
in the securities industry.
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3. Informational Efficiency:
Financial literature has concentrated on another type of efficiency
besides allocative and operational efficiencies. This type relates to the
pricing of security. By definition, informational efficiency provides that the
current market price of a security instantly and fully reflects all the relevant
available information. However, market efficiency, detailed in the efficient
market hypothesis (EMH), formulated by Eugene Fama in 1970, suggests
that, at any given time, prices fully reflect all available information on a
particular stock and/or market. Thus, according to the EMH, no investor
has an advantage in predicting a return on a stock price since no one has
access to information not already available to everyone else.
4. Non-Predictability:
The nature of information does not have to be limited to financial news
and research alone; indeed information about political, economic and social
events, combined with how investors perceive such information, whether true
or rumored, will be reflected in the stock price. As prices only respond to
information available in the market, and, because all market participants are
privy to the same information, no one will have the ability to "out-profit"
anyone else. In efficient markets, prices become not predictable but random,
so no investment pattern can be discerned. A planned approach to
investment, therefore, cannot be successful.
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2.2 How Does A Market Become Efficient?
In order for a market to become efficient, investors must perceive that a
market is inefficient and possible to beat. Investment strategies intended to
manipulate inefficiencies are actually the fuel that keep a market efficient.
A market has to be large and liquid. Information has to be widely
available, in terms of accessibility and cost, and released to investors at more or
less the same time. Transaction costs have to be cheaper than the expected
profits of an investment strategy. Investors should also have enough funds to
take advantage of inefficiency until, according to the EMH, it disappears again.
Most importantly, an investor has to believe that she or he can outperform the
market.
2.3 Degrees Of Efficiency:
Accepting the EMH in its purest form may be difficult; however,
there are three classifications of market efficiency, which are aimed at reflecting
the degree to which it can be applied to markets.
EMH propagandists will state that profit-seekers will,
in practice, exploit whatever abnormality exists until it disappears, leaving
markets eventually to correct themselves. In instances such as the "January
effect" (a predictable pattern of price movements), large transactions costs,
moreover, will most likely outweigh the benefits of trying to take advantage of
such a trend.
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In the real world, markets cannot be absolutely efficient or wholly
inefficient. Markets are essentially a mixture of both, and daily decisions and
events cannot always be reflected immediately into a market; moreover, if all
participants were to believe that the market is efficient, no one would seek
extraordinary profits, the force that keeps the wheels of the market turning.
In the age of information technology (IT), however, markets all over
the world are gaining greater efficiency. IT allows for a more effective, faster
means to disseminate information widely. In the meantime, electronic trading
allows for prices to adjust more quickly to news entering the market. However,
while the pace at which we receive information and make transactions quickens,
IT also restricts the time for the verification of information used to make a trade.
Thus, IT may inadvertently result in less efficiency if the quality of the information
we use no longer allows us to make profit-generating decisions.
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Findings
3.1 Stock Exchanges in Pakistan:
The stock exchanges in Pakistan have witnessed a substantial
improvement since 1999-2000. With the spectacular performance of the KSE 100
index, which crossed 5600 points in April 2004, (doubling the January 2003 level)
and market capitalization increasing from Rs 555 billion ($ 9.5 billion) in January
2003 to Rs 1436.0 billion ($ 25.0 billion) in April 2004, (an increase of 159
percent). The KSE 100 index touched an all time high at 5620.7 points on April
19, 2004. A record turnover of over a billion shares was also seen twice in the
year, first on August 8, 2003 and then on April 15, 2004. The fiscal year 2003-04
has been a record year for the stock market in Pakistan, with un-precedent
growth in market activity. Pakistan has experienced substantial economic
changes since 2001-02, supported by strong sectoral growth. The stock
exchange has shown foresight in whole-heartedly accepting and successfully
implementing reforms as a result of which the Pakistani market was ranked as
one of the best performing markets in the world. The KSE is implementing further
measures to increase the retail investor base in the country.
The land-mark performance of the stock market during the current
fiscal year can be attributed to a number of positive factors including; a
continuation of pro-growth macro-economic policies; a stable macroeconomic
environment; strong economic growth; stable exchange rate; a positive
privatization process through the stock exchanges; a visible improvement in the
Pakistan-India relationship; appropriate reforms initiated by the Securities and
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Exchange Commission of Pakistan (SEC); the availability of adequate liquidity in
the market; good operating and financial results from the majority of blue chip
companies and the enhancement of investor confidence, etc. This exceptional
performance of the stock exchanges was also supported by the growth in rupee
liquidity and the consequent availability of cheap credit to the private sector. In
addition, the last four years have witnessed a recovery in the economy, which
has helped improve corporate profitability and investor confidence. These factors
have continued to drive the equity market in the current fiscal year as well.
Over the past few years, the Securities & Exchange Commission of
Pakistan (SEC) has taken measures to restore confidence of both foreign and
domestic investors by endeavoring to ensure that the market functions in a
smooth and transparent manner. Its regulatory mechanisms are aimed at
minimizing the elements of systemic risk on the one hand and promoting
institutional strengthening/capacity building of various segments of the stock
exchanges on the other. The SEC has actively pursued a stock market reform
program geared towards the development of a modern and efficient corporate
sector and stock market, based on sound regulatory principles that provide the
impetus for high economic growth.
During the first ten months of the current fiscal year the KSE share index
has increased by 59.6 percent (from 3402.5 points on June 30, 2003 to 5430.4
points on April 30, 2004). Similarly market capitalization has increased by 92.4
percent or from Rs 746.4 billion on June 30, 2003 to Rs 1436.0 billion on April
30, 2004. In terms of US dollars the market capitalization of the Karachi Stock
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Exchange was about $ 25.0 billion on April 30, 2004 increasing from USD 6.78
billion in the end of June 2002 and USD 12.92 billion in the end of June 2003.
Primarily some heavy weight blue chip companies in power and communication
sectors have brought the unprecedented boom in the stock market in the current
fiscal year, although other trading groups also remained buoyant in the market.
The share of the top ten scripts in total market turnover increased significantly
from 67.2 percent in October 2003 to 71.1 percent in December 2003, reflecting
a strong co-movement of trading in these scripts (the total market turnover
increased from 4934.3 million shares to 6088.0 million shares in the respective
months). Interest in the energy sector stocks was also an important factor in the
movement of the KSE-100 index. The monthly trends of the leading stock market
indicators are given in Table 1 and Fig: 1 (a) and (b).
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As documented below, (Table 2 and Fig: 2), out of the 15 leading stock
markets in the world, the KSE share index increased by 61 percent in terms of
US dollar during July-April 2003-04, surpassed only by India. The other 13
leading world stock markets recorded growth ranging from 7.0 percent (China) to
48 percent (Thailand). It is pertinent to mention here that unlike the previous
year, all the leading stock markets of the world posted positive growth in the
current fiscal year, which may be an encouraging indication of the world
economic recovery. The SEC has introduced a number of significant reforms in
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the field of risk management. It has already constituted an expert committee
comprising national and international market experts with the objective of
formulating a comprehensive plan for the de-mutualization and integration of the
stock exchanges. The recommendations of the committee on the de-
modularization of the stock exchanges will be implemented by the end of the
year as part of an ongoing stock market reform process. Carryover transactions
(COT) will also be phased out by the end of the current fiscal year. For the
development of cross border scrip listing the SEC consulted with SAARC
corporate regulators and a memorandum of understanding has already been
signed with Sri Lanka’s corporate watchdog. A number of other structural reforms
are also underway in the KSE and other stock exchanges which include: the
introduction of trading in odd-lots; the development of an I.T. infrastructure for a
backup system and the upgrading/expansion of the existing I.T. systems; the
strengthening of the market monitoring and surveillance wing; the
commencement of internet trading; the introduction of an over the counter (OTC)
market; index trading; margin trading rules; and cross border listing. A future
reforms agenda will also include a code of corporate governance for unlisted
public companies and statutory corporations, an enhancement of monitoring and
surveillance to prevent market abuse, and a corporate social responsibility (CSR)
sector. The SEC has addressed numerous distortions in the stock exchanges
and the corporate sector with a view to evolving a fair, transparent and efficient
system that engenders investor confidence. At the same time, the SEC has
ensured stringent enforcement to curb market abuses, particularly, in the
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securities market. A number of new products are also being envisaged which
include the introduction of index and option trading. To cater to the expected
increase in trading activities, especially through Internet trading, the up-gradation
and provision of backup trading and clearing systems is also in process. During
the outgoing year, the KSE has further strengthened its international relations
and continued to play an active role through the platform of the Federation of the
Euro-Asian Stock Exchanges (FEAS) and the South Asian Federation of
Exchanges (SAFE).
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3.2 Policy Measures and Progress
The Securities and Exchange Commission of Pakistan (SEC) has actively
pursued a stock market reform program geared towards the development of a
modern and efficient corporate sector and stock market, based on sound
regulatory principles that provide an impetus for high economic growth. Provided
below are the various reform initiatives introduced during the year under review:
a) Improvements in Governance
In order to prohibit unfair trade practices, ensure a level playing field,
inculcate good governance in business conduct and promote transparency in
the securities market, a clause 187 (i) was inserted in the Companies
Ordinance, 1984 which places a prohibition on any person from being
appointed as a director of a listed company if he is a member of a stock
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exchange, engaged in the business of brokerage or a spouse of such a
member.
In order to safeguard public interest and improve governance and
transparency in the business conduct of brokers, the Commission, issued a
directive to brokers in February 2004. Pursuant to the said directive, brokers
shall provide brokerage services to an investor only after ensuring that an
account has been opened in the investor’s name using a standardized
account opening form. In addition, a broker shall not recommend to an
investor the purchase or sale of any security that is unsuitable for the investor
with due regard to his/her age, financial situation and investment objectives.
The Commission formulated a standardized account opening form in
consultation with the stock exchanges and directed the exchanges to
adopt/implement the standardized account opening form with effect from
January 15, 2004. The standardized account opening form contains the
standard terms and conditions which shall govern the broker-investor
relationship at all the three stock exchanges. The form strikes a balance
between the rights and obligations of both investors as well as brokers.
The Commission issued a directive in August 2003 directing the exchanges to
insert appropriate clauses in their listing regulations in order to establish the
necessary framework for transfer pricing whereby transactions between
related parties are measured at an arm’s length price and adequate records
and disclosures are maintained in respect thereof.
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In terms of the amendments in the Listing regulations of the stock exchanges,
companies must now seek the approval of the Audit Committees and the
Board of Directors for the transfer pricing policy. They are also required to
prepare and maintain complete records in respect of transactions with related
parties.
After considering the amendments as proposed by the stock ex changes, the
Commission accorded approval to the regulations for the system audit of
brokers of the exchange, 2004 under section 34(1) of the Securities and
Exchange Ordinance, 1969.
b) Risk Management Measures
In order to strengthen market integrity and to reduce the incidence of
systemic risk, the Commission has introduced a number of significant reforms
in the field of risk management as provided below:
Unlike other countries, COT/Badla financing is available only in Pakistan.
While the system of Badla financing has added liquidity to the market, it has
been one of the major causes of market crises experienced over the last few
years. In order to avoid systemic risk associated with Badla financing, the
SEC has finalized the Margin Trading Rules, 2004 to replace Badla financing
in consultation with the stock exchanges as well the Margin Trading Rules,
2004 to replace Badla financing in consultation with the stock exchanges as
well the Central Depository Company (CDC). The Margin Trading Rules,
2004 have been sent to the Ministry of Finance for approval by the federal
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Government. As a measure to gradually phase-out COT facility, the SEC has
restricted the COT facility to the shares of 30 eligible companies only with
effect from December 15, 2003.
The National Clearing Company of Pakistan Limited (NCCPL), which is fully
operational as of January 19, 2004 with 474 securities inducted in the system,
will improve the efficiency of the settlement process, reduce systemic risk of
the current clearance and settlement procedures and improve the investor
confidence level in the integrity of the securities market. The integrated
national clearing system would provide for the settlement of trades executed
in respect of companies in the Central Depository System (CDS) on all three
exchanges, under one system as opposed to the past practice of separate
clearing houses of the exchange.
c) New Products/Developments
The Commission had approved the regulations governing the over the
counter market in December 2002 for establishing a quote-driven OTC
Market for smaller capitalized companies and debt securities. The OTC
market, which is expected to start operation by June 2004, would also serve
as a second tier market for green field/illiquid scrip currently listed on the
exchange.
Appropriate amendments have been made in the Securities and Exchange
Ordinance, 1969 and a new section 32D has been inserted exclusively for the
regulation of business of the national commodity exchange limited (NCEL).
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The emergence of trading in futures contracts in commodities would provide
investors and stakeholders with basic hedging instruments as well as
enabling economic players to lock in costs. The NCEL is expected to be
operational by June 2004.
The Commission on February 17, 2004 constituted an expert committee
comprising national and international market experts with the objective of
formulating a comprehensive plan for de-mutualization and integration of the
stock exchanges. The expert committee shall submit its report and
recommendations to the Commission within 120 days of its first meeting or
June 15, 2004, whichever is earlier. An interim report is to be submitted to the
Commission within 60 days of its first meeting. The Commission has
formulated a detailed terms of reference (TOR) for the expert committee to
examine the feasibility of the integration of stock exchanges and to provide
specific recommendations on de-mutualization of exchanges such as, an
appropriate mode/structure for the de-mutualized exchanges and a plan of
action for its implementation.
3.3 Sectoral Performance
During the first nine months of the outgoing fiscal year, the KSE share
index and aggregate market capitalization of 12 different sector’s have increased
by 50.1 percent and 80.3 percent respectively, as against their increase of 53.4
percent and 44.7 percent in the same period last year. Total turnover of shares
on the KSE was 65.2 billion in the first nine months of 2003-04 as compared to
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36.2 billion in the same period last year. Funds mobilized by the KSE during this
period amounted to Rs 61.7 billion as compared to Rs 23.8 billion in the same
period last year. All the 12 major trading groups on the KSE (cotton and other
textiles, pharmaceuticals & chemicals, engineering, auto & allied, cables and
electric goods, sugar and allied, paper and board, cement, fuel and energy,
transport and communication, banks and other financial institutions, and
miscellaneous) witnessed record growth in their share indices, ranging from 15.7
percent (sugar & allied) to 65.2 percent (cement). During the calendar year 2003,
total profit before taxation of the 12 trading groups amounted to Rs 136.8 billion
as compared to their before taxation profit of Rs 90.9 billion in 2002. The
performance of leading trading groups and companies for the first nine months of
the outgoing fiscal year is discussed below (Table 3-5).
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Cotton and Other Textiles:
In this group, there are three sub-groups: (a) textile spinning, (b) textile
weaving & composite, and (c) other textiles. There were 229 companies listed
with the KSE under this group in December 2003. The share index of cotton and
other textiles recorded a growth of 37.4 percent during the first nine months of
the current fiscal year as compared to a growth of 5.0 percent in the same period
last year. Its market capitalization increased by 28.8 percent or by Rs 19 billion
during July-March 2003-04 as compared to a rise of 16.6 percent (Rs 6.8 billion)
in the same period last year.
Chemicals & Pharmaceuticals:
A total of 38 companies were listed with the KSE under this group at the
end of December 2003. During the first nine months of the current fiscal year, its
share index increased by a record 54.3 percent as compared to an increase of
27.0 percent in the comparable period of last year. Its market capitalization stood
at Rs 160.2 billion on 31st March 2004, showing an increase of 48.1 percent over
June 2003 and 73.7 percent over March 2003.
Auto and Allied:
A total of 25 companies were listed with the KSE under this group at the
end of December 2003. Its share index increased by 50.1 percent, while its
market capitalization increased by 42.8 percent.
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Sugar and Allied:
Under this group, a total of 38 companies were listed with the KSE with a
market capitalization of Rs 8.6 billion. The sugar and allied group is a minor
player in the stock market although it has a weight of 8.6 percent in the
production index of major industries. During the first three quarters of the current
fiscal year, the share index of sugar and allied posted a growth of 15.7 percent
as compared to a rise of 24.9 percent in the comparable period last year.
Cement:
At the end of 2003, there were 22 cement companies listed with the KSE.
The cement industry was one of the best performing sectors in the stock market.
During July-March 2003-04 its share index grew by 65.2 percent, which was the
highest among the 12 trading groups. Its market capitalization increased to Rs
57.2 billion on March 31, 2004 from Rs 33.5 billion in June 2003, recording a
growth of Rs 23.7 billion or 70.7 percent.
Fuel & Energy:
A total of 25 companies were listed with the KSE. It is the most dominant
group in the stock market. While its share index grew by 24.5 percent during the
first nine months of the current fiscal year, its market capitalization increased by
a huge Rs 314.4 billion to Rs 506.0 billion in March 2004 from Rs 191.5 billion in
June 2003. Its market capitalization constituted 37.6 percent of the aggregate
market capitalization in March 2004. A swelling fuel and energy sector is one of
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the major market players in the current year along with transport and
communication, banking and finance and cement. The energy sector has been
identified as an engine of growth along with 3 other sectors, (agriculture, small
and medium enterprises and information technology) by the government and its
unprecedented growth is expected to further promote investment activities in the
country.
Transport & Communication:
At the end of 2003, there were 11 companies of this group listed with the
KSE. Its share index and market capitalization increased by 37.2 percent and
47.9 percent respectively during July-March 2003-04 as compared to their rises
of 58.5 percent and 43.5 percent in the same period last year. Its market
capitalization at Rs 182.4 billion constituted 13.5 percent of the aggregate market
capitalization (AMC) in March 2004 making it a major player on the KSE. The
combined market capitalization of fuel and energy, and transport &
communication was Rs 688.3 billion on March 31, 2004, which constituted 51.1
percent of the AMC as compared to their share of 44.8 percent on the
corresponding date of last year.
Banks & Other Financial Institutions:
In December 2003, a total of 184 companies were listed with the KSE.
There are 4 sub groups in this group: banks & investment companies,
modarabas, leasing companies, and insurance. During the current fiscal year, the
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share index and market capitalization of this group has increased by 55.1 percent
and 85.8 percent respectively. Its market capitalization increased from Rs 99.7
billion in June 2003 to Rs 185.2 billion in March 2004.
Miscellaneous:
The miscellaneous group includes five sub-groups: jute, food & allied,
glass & ceramics, vanaspati & allied, and others. In December 2002, a total of 98
companies were listed with the KSE, which came down to 92 companies at end
December 2003. Its share index and market capitalization posted growth of 33.5
percent and 37.6 percent respectively in the first nine months of the current fiscal
year, as compared to their growth of 23.1 percent and 16.9 percent respectively,
in the same period last year.
In December 2003, a total of 701 companies were listed on the Karachi
Stock Exchange, including 229 companies in cotton and other textile, 184 in
banks and financial institutions, 92 in miscellaneous group etc. In the calendar
year 2003, the number of dividend paying companies increased to 312, from 307
companies in 2002. As compared to 429 companies in 2002, 431 companies
were profit making in 2003. During 2003, 170 companies were shown as loss
making as compared to 195 in 2002. In 2002, the total before taxation profit of
the 12 trading groups, listed with the KSE, amounted to Rs 90.9 billion, which
increased to Rs 136.8 billion in 2003, showing a growth of 50.5 percent.
Transport and communication, which was the most profitable industry during
2003, earned a pre-taxation profit of Rs 41.4 billion compared to its pre-taxation
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profit of Rs 33.9 billion in 2002. Banking and other financial institutions recorded
the second highest pre-taxation profit of Rs 37.1 billion in 2003 as compared to
Rs 20.1 billion in 2002. Other sectors which earned higher pre-taxation during
2003 profits were; fuel and energy (Rs 20.5 billion); chemical & pharmaceuticals
(Rs 10 billion); auto and allied (Rs 9.2 billion) and cotton and textiles (Rs 6.8
billion). The group wise number of companies and their performance is given in
Table 4.
The KSE is primarily influenced by some big blue chip companies
including; Hub Power, PTCL, Pakistan State Oil etc. During the first three
quarters of the current fiscal year, the combined turnover of shares of ten big