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Analysis > Analysis and Strategy

Surprisingly low valuations in Africa

Cornelis Vlooswijk, Portfolio Manager, Emerging Markets, Robeco
Feb. 6, 2020, 10:09 p.m.
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Word count: 1030

African equities in general have not been a success story in the last ten years, at least not when compared to other regions. The MSCI US and the MSCI Developed World index rose 232% and 159% respectively in the last ten years, while the MSCI South Africa and MSCI EFM Africa ex. South Africa only gained 33% and 23% respectively in USD terms. Did African equities lag because of volatile politics, falling commodity prices, currency problems and/or economic mismanagement? Not really. Of course, such factors have a negative impact on earnings and currencies, but corporate earnings growth has been quite similar in Africa versus the rest of the world. The big gap in equity returns is almost entirely caused by an expansion of valuation differences.

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African equities in general have not been a success story in the last ten years, at least not when compared to other regions. The MSCI US and the MSCI Developed World index rose 232% and 159% respectively in the last ten years, while the MSCI South Africa and MSCI EFM Africa ex. South Africa only gained 33% and 23% respectively in USD terms. Did African equities lag because of volatile politics, falling commodity prices, currency problems and/or economic mismanagement? Not really. Of course, such factors have a negative impact on earnings and currencies, but corporate earnings growth has been quite similar in Africa versus the rest of the world. The big gap in equity returns is almost entirely caused by an expansion of valuation differences.

Rerating in US and emerging markets but not in Africa

Developed markets stocks (especially driven by the US) have seen a significant upward rerating. The US stock market rerated from 11.4 times actual earnings in Sep-2011 to 19.6 times in Nov-2019. The average price/earnings in emerging markets has also increased, both since the 2011 through and the start of the corresponding graph. The outlier is Africa with no valuation uptick for South Africa or the rest of Africa.

Valuation differences between countries and sector peers

As per the end of November there are significant differences in price/earnings ratios between countries, while banks tend to be cheaper than the market average. It is also important to note that these multiples reflect the valuation of MSCI constituents, which are the bigger companies in each country. In most cases the small caps in these countries are much cheaper. Among ignored African small caps there appear to be some very nice bargains. There are various small cap banks in Egypt, Ghana and Nigeria trading as low as 2 or 3 times earnings for the current year!

African banks: very cheap versus global peers

Figure 3 is the result of an analysis we performed on banks using data from Robeco’s proprietary  quantitative research database. Bank analysts often simply compare Return-On-Equity (ROE) versus Price-to-Book but that would give some African banks an unfair advantage as they are active in countries with relatively high inflation. Hence we adjusted the ROE for inflation. Even after that adjustment the chart clearly shows that banks in Egypt, Ghana, Kenya and Nigeria are clearly above the regression line indicating average valuation. For a few banks in Egypt and Ghana it is very strange they trade below book value while they generate a high ROE adjusted for inflation.

In some countries we also see big differences in valuation among banks, probably partly driven by stock market liquidity and inclusion in certain indices. For example, in Egypt the biggest listed bank trades at 11.5 times actual earnings while other banks trade at between 2 and 6 times actual earnings.

Fund flows and investor choices must have played a big role in Nigeria

An example of a country with persistently low valuations is Nigeria. The country came out of recession in 2017, the banking sector showed progress with a clean-up of non-performing loans and many banks reported reasonably good or even solid earnings for many quarters in a row. Still, most bank stocks trade far below book value and at 2 or 3 times actual earnings. A lack of demand from both domestic and foreign investors has probably played a role. Various Africa equity funds have been liquidated due to a lack of interest from European and US investors. Furthermore, there are many international fund managers who are momentum-driven and most of them have left the Nigerian stock market as Nigerian stocks have lagged most other markets in the last few years. A positive factor for share prices should normally have been the Nigerian pension funds with their steadily increasing assets under management. However in the last five years they have significantly reduced the % invested in local equities. Instead, they have chosen to invest more in government bonds. With Nigerian pension funds currently investing only around 5% of their assets in local equities, it is fair to say there is more upward potential than downside risk for this particular factor.

Sustained period of strong earnings updates and stock performance needed for a rerating

Given the current low valuations, investors in African equities are likely to achieve good returns in the long run. However history has shown that patience is required. Strong earnings updates are not automatically followed by share price increases, especially in periods when there is selling pressure from foreign investors withdrawing money. Big 

inflows in African equity markets from foreign investors are only likely to happen after a sustained period with African equities beating developed and emerging market returns.

 

What can Africans do?

Those initial strong investment returns can only happen if most companies report solid earnings for at least one year, triggering local investors to drive prices higher. Overall, earnings reports have not been bad, but management teams could focus more on cost efficiencies and shareholder value creation. Examples of the latter could be higher dividend payouts and not raising fresh equity just to become bigger. Governments, stock exchanges and stock brokers could also help making African equities markets more appealing by cutting stock-trading related taxes and fees. This would probably give a boost to trading volumes and hence would not have to lead to lower revenues. For investors it would be appealing to have lower transaction costs and higher trading volumes.

Conclusion

With very low equity valuations, little foreign interest and the local equity component of African pension funds at historic lows there appears to be relatively little downside risk from a valuation or sentiment perspective. There is a lot of upwards potential if management teams improve their focus on costs and shareholder value creation and if all stakeholders make stock market investing more appealing. In the end foreign investors will always come if the prospects are appealing enough. Hopefully in a few years’ time people will look back at the 2018-2019 period wondering why many African stocks were extremely cheap.

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