Investing in Africa’s Equity: Balancing Risk, Return and Regret

LAGOS, Nigeria, Capital Markets in Africa: Broad-based performance of African equities in 2015 was something many investors like to forget, if they do not regret their investment decision in the first place. Investors following the herd and buying into the asset class for the first time in the heydays of 2013 can be regularly found in the latter category. Others, who remained on the sidelines so far, can now buy great African businesses at much lower valuations.

The three African equity indices published by MSCI (MSCI Frontier Markets Africa , MSCI Emerging Frontier Markets Africa ex South Africa, MSCI Emerging Frontier Markets Africa) posted total returns in 2015 of -18.0%, -19.2% and -24.5%, respectively. IPRO’s long-only African equity strategy African Market Leaders (i2 share class) returned -21.0% to investors.

Total return of the MSCI Emerging Market Index was -14.6% in 2015, outperforming the MSCI Africa index family and most long-only US Dollar denominated African equity funds. A wedge in performance between the African indices and broader emerging markets can also be observed for longer periods and rolling returns. It looks like elevated risk and liquidity premiums for African equities versus their emerging market peers have regularly weighed on returns of broad indices in the past.

Risk and return of African equities: A macro story in good and bad times?
African equities have been mostly marketed as a macro story to potential investors – typical buzzwords are demographic dividend and rising middle class. Coincidentally or not, the downfall starting in 2014 followed also the macro script. Main drivers identified by most observers are (1) the rout in commodities and (2) currencies. Let’s have a look at them.

Regarding commodity rout, a regression of aggregate or country-specific African equity indices over commodity indices, like the Bloomberg Commodity Index, does not reveal a strong linear relationship over longer periods. Correlation increases substantially when using weekly data points as from Q2 2015, but the number of observations is too low to make any meaningful inferences. It looks like African equities have been only affected by the (preliminary) last leg of the commodity bear market, which started in 2011. They are in good company with other asset classes, such as global high yield corporate bonds.

As it is well known, correlation is not causation. Correlation coefficients are volatile and biased through the selection of time period, frequency and number of observations. But the data at hand is clearly indicating that price action in commodity markets is not the main driver for African equity prices. The Bloomberg Commodity Index, which is skewed towards energy, dropped by 24.7% in 2015. The fact that this performance is close to the US Dollar performance of a diversified portfolio of African equities in 2015 is mere coincidence in my view. The residual link to commodities is most probably coming from the performance of local African currencies, which brings us to the second driver identified.

We first need to distinguish between currency attribution on the portfolio level and the direct impact of currency volatility on African companies. 2015 was the year of U.S. Dollar strength against most world currencies. The U.S. Dollar Spot Index (DXY) rose by 9.3%, while the trade-weighted US Dollar Index of the St Louis Federal Reserve Bank rose by 10.5%. Negative currency attribution for a diversified portfolio of African equities was higher, particularly for portfolios with a large allocation towards South Africa.

Competitive currency devaluations around the world and the fall in prices for export commodities in specific cases, such as Nigeria and Zambia, were driving African currencies lower in 2015. Negative currency attribution explains between 60% and 80% of the under performance of African equities against the S&P 500 in 2015, depending on country weights of the respective portfolio. Well understood that this does not give much consolation to (U.S.) investors, but if looking only at the equity delta, African equities have not done too badly. Unfortunately, currency hedging does not make sense for African equities, due to huge negative carry and illiquidity of currency forward markets. There is also a conceptual debate on whether currency hedging should be employed for a long-only equity portfolio, but let’s not go there for now.

Direct implications of currency volatility depends on the business model of the respective company. Most African economies are heavily import dependent. This partly explains the tendency of African currencies to fall, in order to achieve better terms of trade. This is particularly acute for countries depending on export of a single commodity, once prices and/or volumes for the commodity in question decline.

Companies whose costs of goods sold or financing costs are linked to the U.S. Dollar were suffering the most in 2015, as cost increases could not be transferred to the consumer. The consumer staples sector is here the prime example. Other sectors in Africa, such as financial services or real estate, include companies that generate revenues in U.S. Dollars. A lower local currency cost base also helped some of the otherwise struggling African commodity producers.

The macroeconomic vulnerability of African economies, which finds its expression in the value of local currencies, is indeed a problem for African businessmen and foreign investors alike. Here, sound macroeconomic policies and strong institutions, such as independent central banks led by well-educated technocrats, are required. While more needs to be done in that area, nobody can deny the progress Africa has made on that front in recent years. It is also remarkable that many African companies remain profitable throughout the cycle, even under adverse macroeconomic conditions. To make money in such environments requires extraordinary entrepreneurial talent, creativity and resilience. Rather than focusing always on the inherent risks, we have to keep in mind how some well-managed businesses in Africa will take off, once external conditions improve.

Investments into African equities: The ‘hybrid private equity approach’
African stock exchanges, with the exception of the JSE, still offer investors a relatively poor market structure, which leads to elevated liquidity premiums. Investment pools with a certain size have to apply a buy-and-hold strategy. Any regret on investment decisions cannot be alleviated through stop-loss strategies. You need to get it right from the start. We like to call this mindset the ‘hybrid private equity approach’.

The core of this approach is a rigorous bottom-up analysis of the business and regular interaction with management, while macroeconomic and political research serves as a risk-management overlay. Another feature of this approach is adding to promising investment cases on lower valuations, once Mr. Market throws some decent opportunities. Since IPRO has its roots in the niche equity markets of Mauritius and later Botswana, we have internalized this approach and apply it to other African markets.

It is important to align liabilities of the investment pool with underlying assets when investing into illiquid securities. Investors into African equities have to take the long view, ideally 7 to 10 years, and tolerate elevated cash holdings, if market valuations are not compelling. On larger drawdowns, it is advisable to increase capital commitments to improve the entry point and rebalance towards a target allocation. Investors able to hold illiquid assets while taking a very long term view, such as family offices, foundations or endowments, are natural investors for African equities. If investors follow a momentum-driven strategy in African equities, it is often a recipe for disaster.

At IPRO, we focus predominantly on market leading companies in Africa. Such companies are able to compound capital at sustainably high rates throughout the cycle, typically enjoying a quasi-monopoly or having a business model which represents a disruptive force in an otherwise competitive market.

I like to give some examples of how strongly some leading African companies have compounded over the years. Investors who bought shares of Equity Bank at its listing in August 2006 realized an annualized total return of 28.8% in March 2016. Another Kenyan company, East African Breweries, returned 24.6% per annum to investors who bought shares in January 1998. Despite current depressed valuation, Econet of Zimbabwe yielded 10.9% since May 2009. In Botswana, Choppies returned 15.7% annually to investors since January 2012. Sonatel from Senegal produced an annual return of 18.6% since December 1999. To emphasize, all returns stated are in U.S. Dollar and assume no reinvestment of dividends.

Of course this is cherry-picking, so let’s look at some of the more mediocre examples. Nigeria’s Dangote Cement returned only 8.0% since October 2010. Zanaco of Zambia yielded 5.9% to investors who bought shares in November 2008. Maroc Telecom had an annual return of 8.2% since December 2004. It is hard to find stocks of market leading companies in Africa that produced negative returns for investors over longer periods.  It is also worth highlighting that practically none of the listed market leaders in Africa went out of business over the years.

We believe that investors into African equities have to focus much more on the intrinsic dynamics of the respective business, rather than focusing overly on macroeconomic and political drivers. It is important to understand those drivers for risk management purposes, and at times refrain from investments into otherwise sound companies when the external environment is rapidly deteriorating. But the most important aspect for investments into African equities remains the understanding of the underlying business, and patience in allowing capital to compound at superior rates of return.

Contributors Profile:
Philippe Koch (Head of Fund Management, iPRO Fund Management, Mauritius) has over 16 years of experience in the financial services industry. He is responsible for the management of Pan African equity and fixed income portfolios at IPRO Fund Management. Philippe is also the lead Fund Manager of the African Market Leaders fund, a long only Pan African equity fund with a track record of about eight years. Setup in Mauritius in 1992 and present in Botswana since 2007, IPRO manages a small range of investment funds dedicated to the African Continent and its home markets Mauritius and Botswana, both in equities and bonds.