At the core of our investment philosophy is a belief that markets are not always efficient or rational. We invest in businesses that we consider to be irrationally priced relative to our assessment of their intrinsic value. Unsurprisingly, nonconsensus investments that are out of favour can get much cheaper, and the time it takes for the storms to pass can be highly variable. Inevitably, by focusing relentlessly on generating superior long-term returns, we bear the risks of being different from our performance benchmarks and having to endure uncomfortable periods of underperformance.
The Allan Gray Africa ex-SA Equity Fund’s performance over the past year was downright disappointing. Overweight positions in Nigeria and Zimbabwe were significant detractors.
Negative investor sentiment in Nigeria
Nigerian equities underperformed on continued negative sentiment, with investors unnerved by the uncertain regulatory environment in the banking sector and dim growth prospects. The MSCI Nigeria Index was down 16% in US dollars, and the market’s dividend yield has increased to 7.7%. Local pension funds have shunned equities in favour of higher-yielding fixed income securities, and their allocation to domestic equities has dropped to below 5% from 9% at the end of 2017.
We are mindful of the headwinds in Nigeria. Still, we are excited about the prospects for generating attractive risk-adjusted returns from a low base of market expectations reflected in deeply discounted equity prices. Since February 2018, the aggregate market capitalisation of the top three banks (Guaranty, Zenith, Stanbic) has declined by 36% (in US dollars) despite growing earnings by 8% (in US dollars) over this same period. The top three banks are trading at an average 4.6x PE and 10% dividend yield. In our assessment, the leading banks are well positioned to navigate through the current challenges and maintain or continue to grow earnings in real terms. On this basis, long-term investors are still earning an attractive dividend yield while waiting for rationality to return to market prices.
Ongoing economic challenges in Zimbabwe
Zimbabwe’s macroeconomic challenges have persisted over the past year. The introduction of a new currency regime in June 2019 was a welcome relief. However, slippages in fiscal prudence and delays in implementing specific reforms demanded by international lenders held back much-needed debt relief. Forex shortages and the absence of international support pose a high risk of exchange rate overshooting, which has contributed to inflationary pressures. Further, a prolonged drought has caused food shortages and curtailed hydropower generation from Lake Kariba, where water levels have dropped to below 10% of usable storage, the lowest in more than two decades. Rolling electricity blackouts lasting 18 hours a day have negatively impacted manufacturing and mining output.
Consequently, the market is heavily discounting the risks in Zimbabwe. Using the official exchange rate, the top three largest listed companies in Zimbabwe are trading at an aggregate market capitalisation of US$796m, down 63% from the market value at the beginning of 2019 using the Old Mutual implied exchange rate, and down 62% using our carrying values at the time. In our assessment, these market prices are well below the intrinsic values for the dominant brewer (Delta), telecoms company (Econet), and mobile money platform (Cassava). The ongoing drought isn’t likely to lead to a permanent impairment in the intrinsic values of these businesses. However, the path to Zimbabwe’s recovery is a steep and uncertain climb which warrants a discount.
On the other hand, the positive contributors over the past year include Kenyan banks, which bounced back after the repeal of the interest rate capping law in Kenya. Access Bank in Nigeria delivered a pleasing performance from extremely depressed valuations. Zimbabwean mining-related stocks were strong performers – Zimplats (platinum) and Caledonia Mining (gold).
What lies ahead?
After a decade of lacklustre returns in Africa’s frontier equity markets, many investors are throwing in the towel or questioning the asset class’s long-term return prospects. Our core belief is that human nature hasn’t changed, and investor sentiment often drives markets to irrational extremes.
Today’s asset valuations are signalling stronger prospective returns and offering long-term investors ample compensation for the risks in African frontier markets. Periods of underperformance, accompanied by negative market sentiment and rock-bottom valuations, are often a compelling starting point for generating superior long-term returns.