Africa’s equity markets delivered disappointing returns in 2018. The MSCI Africa index was down -24%, while the MSCI Africa ex-SA index was down -13%. None of the continent’s largest markets provided a safe refuge, with respective MSCI country indices posting negative US dollar returns: South Africa -25%, Egypt -14%, Nigeria -14%, Kenya -13%, and Morocco -10%.
After the strong positive performance in 2017, a significant pull-back in 2018 reinforces the common perception that African markets are volatile and prone to risks lurking in the background. These risks include exchange rates overshooting, unpredictable regulatory regimes, commodity cycles, disputed elections, autocratic leaders, endemic corruption and erratic weather patterns.
As it turns out, excess market volatility is not unique to Africa’s financial markets. The fundamental approach for determining the fair value of an asset entails estimating the present discounted value of future cash flows. Unfortunately, forecasting the future is an imperfect tango with uncertainty. The aggregate of investors’ estimates, reflected in stock prices, can vary wildly from a fair value trend line based on “perfect foresight”. In essence, the long-run trajectory based on underlying value drivers is more stable than the market thinks.
The Allan Gray Africa ex-SA Equity Fund’s exposure remains concentrated in bottom-up opportunities where we believe the long-run value drivers remain intact despite recent market volatility and depressed valuations. In Nigeria, investor sentiment has turned more bearish over the past year, but top tier banks are: steadily growing their base of cheap deposits, ramping-up transactional volumes and related fees, and adopting digital distribution channels. Banks’ profitability measures have recovered after the 2014 oil slump and they have boosted provisioning buffers. The perennial concern is the lack of a diversified base of credit-worthy borrowers. The short-term respite is that banks are generating attractive yields on government securities, currently above 17%. Long term, there will be eventual winners and losers; successful management teams are deftly balancing loan growth with asset quality risks. Despite the anomalies in Nigeria, the banking sector appears cheap. The country’s top seven banks by market capitalisation are trading at average multiples of 4.8x price-to-earnings and 6.5% dividend yield.
The Fund also has a material holding in Seplat, a Nigerian oil producer. Forecasting the trajectory of oil prices isn’t our forte. However, Seplat is increasingly a key gas supplier to the growing demand for gas-powered electricity generation. The present discounted value of this stream of cash flows is far less volatile than the oil price swings.
In Zimbabwe, early optimism has been replaced by the hard reality of digging out of the post-Mugabe rubble. The implied discount rate for a dollar in Zimbabwe has increased from 36% in January 2018 to 80% at the end of December 2018. This suggests that rampant money creation continued well after Mugabe’s exit, further worsened by a directive in October to split foreign currency accounts into those carrying real US dollars and those for electronic dollars. Ultimately, the new administration needs to curb fiscal excesses. We have no better insights on how the future unfolds, but our core holdings in Econet and Delta are real assets which can preserve or even increase in value – despite the challenging macroeconomic conditions.
We have been underweight Egyptian and Kenyan equities, but the correction in asset prices is increasingly discounting our concerns. In addition, over the past quarter, we have added modestly to the Fund’s exposure in the West African regional stock exchange.
Periods of volatility are unnerving, but can present long-term investors with attractive buying opportunities. Patient capital and maintaining a focus on fundamental value drivers trumps paying attention to short-term market fluctuations.
Since the Fund’s inception, this investment approach has yielded 4.7% in US dollars, compared to -4.0% benchmark returns.