Our investment approach does not change even during periods of extreme market volatility. As always, we carefully consider investment opportunities where risks may be mispriced and we are only prepared to act when we believe we can preserve capital and when the odds of generating superior risk-adjusted returns favour long-term investors. The Allan Gray Africa ex-SA Equity Fund’s overweight position in Nigeria reflects this approach.
New exchange rate regime
In late June 2016, the Central Bank of Nigeria (CBN) was forced to devalue the naira by about 40%. Nigeria had maintained a fixed currency peg since March 2015 despite the sharp fall in oil prices and recent disruptions in oil supply from the Niger Delta. To achieve its policy objective, the CBN had imposed restrictions on access to US dollars, which resulted in an official exchange rate that was not freely tradeable and businesses struggling to source dollars for imported raw materials. Consequently, equity valuations were heavily discounting the uncertainty and currency convertibility risks.
We believed that the currency peg was unsustainable and were incorporating a naira devaluation over our investment horizon. The new exchange rate regime may experience some teething problems, but it is an important step in the right direction for the economy. We are also encouraged by the structural changes the government has undertaken, such as reforming the oil sector, eliminating fuel subsidies and increasing electricity tariffs to boost investments in power supply. In due time, as these changes take hold, we believe that the elevated country and equity risk premiums will unwind.
How is the Fund positioned in Nigeria?
Rising inflation and stretched consumer spending power will likely constrain revenue growth for consumer goods companies. We are also likely to see margin pressure if companies are unable to pass-through their higher costs. We believe that current valuations for most consumer goods companies do not yet offer us a sufficient margin of safety.
On the other hand, most Nigerian banks can withstand and even thrive in a higher inflation environment. Most banks have low funding costs, while yields on treasury bills are rising to counter inflation. Fee income will also benefit from a higher nominal GDP base and the gradual resumption in foreign exchange-related trading volumes.
In our assessment, the major banks are well capitalised and are generating adequate profits to withstand the 40% devaluation and our prudent estimates of potential impairment charges. We have not yet seen a sharp deterioration in asset quality across the entire sector, except for a few company-specific credit losses related to the oil sector. In addition, the recent devaluation was widely expected and a number of the banks have built-up net long US dollar positions to cushion the impact of the naira devaluation on their capital buffers.
In estimating the intrinsic value of a bank, we seek to establish a sustainable return on equity that the bank can generate through the cycle. There will be short-term fluctuations in returns, but the long-term drivers are predicated on the strength of the banking franchise to withstand competition; a stable, low-cost funding base; and prudent risk and cost management. We have been increasing our exposure to the leading Nigerian banking franchises at a significant discount to our estimate of intrinsic value.
The Fund was down 1.4% over the second quarter. There were no other major position changes in the Fund.