Jan. 20, 2014 4:02 AM ETGOLD, AU, GFI, SSL, FM, AFK, EZA, FRN, GAF, NGE, PMNA, EMFM53 Comments
Several acronyms have emerged over the past decades, notably the BRICs. In this paper, we coin an acronym for the Sub-Saharan African Frontier Markets.
Increasingly, investors refer to Sub-Saharan Africa (SSA) as the promising sweet spot found in high-growth Frontier Markets also known as “Pre-Emerging Markets” or the “next generation of Emerging Markets”. We define Frontier Markets as: nascent and illiquid capital markets with relatively poor structures and infrastructure where disposable income is low but rapidly growing, in an improved business environment.
Our original definition of Frontier Markets is crafted to meet the unique characteristics of this subset. Frontier Markets by nature are less integrated with Developed and Emerging Markets, therefore offering lower correlations across international portfolios and greater diversification benefits than Emerging Markets.
Several publications have established the potential benefits of these markets, making parallels with China and India two decades ago.
Beyond “Afro-Euphoria”
In Sub-Saharan Africa, the debate is no longer about how fast the continent’s economy is growing, but rather about how to benefit from this growth through successful investing while mitigating the inherent risks of its promising capital markets. In this article, we move away from the traditional debate around the “African growth story” to scratch the surface of a new layer: Sub-Saharan Africa’s sweet spots, hereby introduced as KING, an acronym for Kenya, Ivory Coast (UEMOA), Nigeria, and Ghana. This can be extended to KINGS to include South Africa. In this paper, however, we focus on the KING in SSA ex-South Africa.
A world of acronyms
Several acronyms have emerged over the past decades, notably BRICs. Others include: CIVETs for: Columbia, Indonesia, Vietnam, Egypt, and Turkey; MIKT for Mexico, Indonesia, South Korea, and Turkey; PIIGS for Portugal, Italy, Ireland, Greece, and Spain; the “Next Eleven” for Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, Philippines, Turkey, South Korea, and Vietnam; G7; G8; G20; the Asian Tigers; Chindia; the African Lions; and now the MINT for Mexico, Indonesia, Nigeria, and Turkey.
Below, we coin an acronym for the Sub-Saharan African Frontier Markets: the African KING. Our definition is purely market-based and our analysis focuses on the existing capital markets in these countries, the attractiveness they represent and the potential impact they have over the rest of the continent. Note that we refer to the Ivory Coast as the West African Economic and Monetary Union (UEMOA) hub, hosting the Bourse Regionale des Valeures Mobilieres (BRVM), and therefore “Ivory Coast” in our definition encompasses the 8 UEMOA member states, i.e.: Ivory Coast, Senegal, Burkina Faso, Benin, Mali, Togo, and Niger. The same could apply to Kenya at a later stage, when the East Africa Security Exchange Association finalizes the ongoing integration process of the East Africa bourse bringing the Kenya, Tanzania, Uganda, and Rwanda stock exchanges under one umbrella. This certainly depends on the outcomes of the planned EAC monetary union.
A useful exploratory matrix
We use a 5X5 matrix to explore and assess Frontier Markets using 5 key exploratory themes: Macro-elements, Socio-technological, institutions and governance, openness and trade, and more importantly in our context, stock market data.
The African KINGs exclude some viable markets such as Botswana, whose economy and stock market are more sophisticated than other African Frontier Markets; Zambia, due to the illiquidity of its stock market; Zimbabwe, for its lack of economic freedom and concerns over policies and politics; and Malawi, whose economy faces structural challenges as its currency has depreciated over 50% in recent months.
Note that Tanzania, Uganda and Rwanda are left out on the assumption that the ongoing integration process will absorb these 2nd tier stock exchanges to merge with the Nairobi Securities Exchange to form the East Africa regional bourse.
Weight of the African KINGs in major market indices:
| MSCI Frontier | S&P Frontier BMI | FTSE Frontier 50 | Russell Frontier | |
| Kenya | 2.9% | 1.8% | 7.23% | 2.2% |
| Ivory Coast | N/A | 0.5% | N/A | N/A |
| Nigeria | 12.8% | 9.8% | 23.08% | 8.3% |
| Ghana | N/A | 0.3% | N/A | 0.4% |
Source: MSCI, S&P, FTSE, Russell indices Oct 31st, 2013
A macro picture
With $807 billion in GDP and 345 million inhabitants, the KINGs make up 50% of SSA (excluding South Africa) GDP and over 40% of SSA population. Additionally, the Ivory Coast has about 1/3rd of UEMOA’s GDP and 2/3rd of the listed companies at the BRVM. Therefore, we note that the Ivory Coast has dominance amongst the other 7 member states of the West African Economic and Monetary Union.
The average per capita income is estimated at $2,400 across the KINGs, with Ghana ($3,500) and UEMOA ($1,500) at the highest and lowest respectively. Nigeria ($2,800) and Kenya ($1,800) rank in the middle. These countries are certainly far below SSA’s top 3 per capita countries: Equatorial Guinea ($25,000), Gabon ($19,000) and Botswana ($16,000). Yet, given their small size and resource-rich profiles, these countries are viewed as outliers within SSA. The KINGs, on the other hand, have an average per capita income of $2,400, which more closely reflects SSA’s average. More importantly, this matches our definition of Frontier Markets, where per capita income starts from a low base and experiences rapid growth. Thus, the KINGs present high growth opportunities that are sustainable in the long-term.
The average projected GDP growth for the year 2014 is above 7%, largely driven by Nigeria and Ghana that are expected to grow above 8%, according to joint estimates by the IMF and African Development Bank. (August 2013)
Specifically, we use IMF country reports to provide summaries of the KINGs’ growth drivers and some downside risks.
Kenya: The country continues to show strong economic performance despite a slowdown of exports to Europe and tourism revenue. International reserves are on the rise and the budget deficit has shrunk considerably. Coal was found in Eastern Kenya in addition to big oil discoveries in the Northern Turkana region. The country expects to start producing oil in 6 years. These natural resources discoveries further improve the country’s medium and long-term outlook.
Ivory Coast: In UEMOA, growth will be driven largely by a mix of public investments and FDIs; especially into post-crisis Ivory Coast. Investment in the mining, hydrocarbon and Infrastructure sectors will continue in Burkina Faso, Niger, and Senegal respectively. Projections also expect further recovery in the agriculture sector. The current account deficit is expected to decline going forward and inflation to remain below 3%.
Nigeria: Strong economic growth is projected and inflation is expected to fall to single digits. Downside risks involve the country’s vulnerability to a change in oil prices, as oil represents 75% of government revenues and 95% of exports. Other risk factors include difficulty in implementing reforms that could “durably strengthen the fiscal framework” of Nigeria. Examples include the removal of fuel subsidies and full implementation of the Sovereign Wealth Fund mechanism. Intensification of ongoing violence in the north could adversely impact growth.
Ghana: Strong GDP growth is expected to continue, although inflation is back above 10%. FDIs have good dynamics given the country’s strong democratic institutions and favorable prospects for oil and gas. However, significant stability risks exist. This is attributed to a large current account deficit, thin external buffers, and rising public debt. Moreover, energy sector problems could negatively affect growth, while heavy government borrowing is raising the cost of credit to the private sector.
Inflation and currencies
The KINGs’ 5-year average inflation is near double digits (9.8%), with UEMOA countries presenting the lowest average (3.46%).
To explain Kenya’s recent economic activity, we quote the World Bank country report:
Kenya’s economy was hit by several disruptive events over the last five years. The post-election violence of 2008 caused economic activity to plummet in fear of violence and political uncertainty. As the political situation calmed, the agriculture sector faced a severe drought in 2009, which continued to dampen economic output. The outlook improved in 2010, but 2011 brought signs of macroeconomic instability, fueled by expansionary monetary policy; and economic growth again slowed.
Events like those highlighted in the World Bank report have had a negative impact on the stability of the Kenyan shilling that witnessed a historical depreciation against the US dollar in Q4 2011, reaching 106 ksh to 1 USD from an 80 ksh-USD average.
In the Ivory Coast it is important to highlight the relative stability of the UEMOA currency, the West African Franc CFA (XOF) exchange rate, pegged to the euro. The XOF is fully convertible to the euro, with the convertibility guaranteed by the Banque de France (French Central Bank). This implies that foreign exchange fluctuations relative to other currencies (the US dollar, for instance) also depend on the state of the euro currency alongside country- and union-specific factors.
In Nigeria, the high level inflation in recent years can be partially explained by a rise in food prices in 2008 coupled with the introduction of an import duty on wheat flour, grain, and rice in 2011, along with a partial removal of fuel subsidies and a hike in electricity tariffs. After a sharp depreciation against the US dollar in the midst of the Nigerian banking crisis in 2004, the Naira has appreciated, taking advantage of rising fuel prices, FDI inflows and macro-environment stability. This robust performance was halted in 2008 following the world financial crisis that led to massive outflows, with a negative impact on the local currency. The Naira exchange rate against the USD went from 126 in 2006 to 146 in 2009. Depreciation observed post the crisis is largely attributed to double-digit inflation and related causes, as highlighted earlier.
In Ghana, despite a drop in food prices, non-food inflation remains high, influenced by exchange rate volatility. The Ghanaian FOREX rate against hard currencies has been impacted by a deteriorating balance of payments and Ghana’s fiscal stance, as highlighted in the recent IMF country report. Going forward, the likelihood of double-digit inflation throughout 2014 remains high, as similar concerns are raised over depreciation of the cedi. A combination of these factors may have a negative effect on the projected economic growth.
Commodities and trade
All KINGs countries are commodity-rich, considering the recent oil discoveries in Kenya, oil-rich Nigeria, gold-rich Ghana and Ivory Coast’s global edge in cocoa production.
Kenya: Africa’s largest exporter of tea and horticulture products.
Ivory Coast: The world largest producer of cocoa beans. West Africa is the leading region of cotton production on the continent. UEMOA member states such as Burkina Faso, Togo, Mali, Ivory Coast. and Benin are all key production centers.
Nigeria: Africa’s largest oil exporter, and a leading producer worldwide. The country also has a good share of cocoa beans production, ranking 4th in the world.
Ghana: Africa’s 2nd largest gold producer after South Africa, and ranks in the top 10 globally. Ranks 3rd in world cocoa production and 2nd in Africa, after Ivory Coast.
Chindia, an acronym for China and India, appear to be the main export partners of the African KINGs, replacing the long-time Western dominance. Although the US, France, and the Netherlands remain significant export partners with the KING countries.
Machinery, including motor vehicles and equipment, manufactured goods and petroleum products, are the key imports from the KINGs. Again, Chindia is leading France, the US, and the Netherlands, whereas we note an increasing presence of Nigeria in West African (ECOWAS – A broader West African economic union, to which the UEMOA member states all belong) regional trade. The UAE’s (equipment & manufactured goods) share of trade with Kenya and the rest of East Africa is growing, as they take advantage of geographic proximity, with derived benefits in logistics and cultural ties.
Stock market data
The Sub-Saharan African Frontier Markets, ex South Africa and Mauritius, present the common characteristics of small market capitalization and very low liquidity. The average market cap/GDP ratio of the KINGs is 21%, with Ivory Coast’s BRVM the least penetrated. The West African regional stock exchange’s market cap represents only 6% of aggregate UEMOA GDP. This ratio would be around 22% if we compared the BRVM market cap to Ivory Coast GDP alone. About 2/3rd of listed companies on the BRVM have the majority of their operations in the Ivory Coast. We note, however, that SONATEL (SNTS), the blue chip and having the largest market cap on the BRVM stock exchange is a Senegalese company with extended operations in Mali, Guinea, and Guinea Bissau.
Below, we provide a summary of the top 5 stocks by market cap in the KINGs.
| Top 5 stock | % Mkt cap | |||||
| Kenya | (SCOM)-Telco, (EABL)-Brewing, (KCB)-Bank,(EQTY)-Bank, BBK (BCS)- Bank | 56% | ||||
| Ivory Coast | -Telco, (ETI)-Bank, (SOLIBRA)-Brewing, (SGBC)-Bank, (ONATEL)-Telco | 60% | ||||
| Nigeria | (DANGCEM)-Cement, (NB)-Bank, (GUARANTY)-Bank, (ZENITHBANK)-Bank, (FBNH)-bank | 40% | ||||
| Ghana | TLW (OTCPK:TUWOY), AGA (AU), (ETI)-bank, (SCB)- bank, (EBG)-bank | 77% | ||||
Source: Data compiled by Phase One Associates (August 2013)
With an over $100 billion of market cap, Nigeria leads the KINGs stock markets and the rest of SSA, ex South Africa. It has the 3rd largest market cap in the continent behind South Africa and Egypt. Among the KINGs, Ghana ($30 billion) is a distant second, followed by Kenya ($19 billion). Ivory Coast is the least capitalized, with nearly $10 billion.
Note that Ghana’s dominance over Kenya on market cap is due to the largest capitalization of Tullow Oil Plc and AngloGold Ashanti (ADR), both commodity stocks that make up nearly 80% of the total capitalization of the stock exchange.
Kenya, however, is more liquid and diversified, with the top 5 stocks representing “only” 56% of total market capitalization across a broad sector dominated by banks and consumer-related stocks, but that also includes agri-commodity stocks (Mumias Sugar, Kakuzi, Sasini, etc). Liquidity-wise, Nigeria remains the most liquid among the KINGs, with nearly 200 companies listed and an estimated $450 million traded monthly. With about 20% of total market capitalization, Dangote Cement (DANGCEM) dominates the stock exchange. Ivory Coast is the least liquid among the 4, with only $15 m value traded monthly.
Founded in 1954, Kenya has the oldest stock exchange among the KINGs, followed by Nigeria (1960) and Ghana (1989). The Ivory Coast transformed the country’s stock exchange to form the regional bourse in 1998. This was a move that inspired CEMAC, a monetary and economic union of 6 Central African countries using the Central African Franc (XAF), to launch the Bourse des Valeures Mobilieres d’Afrique Centrale (BVMAC) headquartered in Gabon. Founded in 2008, the BVMAC has encountered little success, with only one stock listed in early 2013 (SIAT Gabon).
Aware that SSA stock markets are too fragmented with the related costs and inefficiencies that go with it, several economic blocks, notably the East African Community, have been considering regionalization rather than merging the existing stock exchanges. Such a move is expected to address, among other things, the very low liquidity that characterizes SSA stock markets.
Overall, the stock exchange environment is improving in SSA, particularly in the African KINGs that have implemented electronic trading platforms and settlement dates which have come down to T+3 from T+5. We also note that there is a growing number of professional, local licensed brokers who are supervised by competent and responsible capital market regulators. Corporate governance and accounting standards are rising to global standards influenced by practices of subsidiaries of global multinationals also listed on local stock exchanges.
Strong performance despite volatility
In our analysis of returns, volatility and correlation, we studied a 10-year data patterns of main (All share or composite) index returns. We use the MSCI Frontier Markets as the main benchmark and add data from MSCI Frontier Africa, Emerging Markets and the S&P 500. Doing so enables a cross-comparison of the KINGs’ performance among the African peers and Frontier Markets. Then, a comparison is made with the Emerging and Developed Markets’ performance from 2003-2012. Note that within the 10-year time frame, we further split the timeline into two periods: from 2003-2007, that is pre-crisis, and from 2008-2012, following the 2008 world financial crisis.
The key finding is that pre-crisis, there was a low intra correlation among the African KINGs (and by extension the Frontier Markets). However, we note that as the Frontier Market indices were launched in 2007, by the S&P/IFC index then the MSCI, intra correlation among Frontier Markets, notably the KINGs, has been growing. This is particularly true of relatively developed and liquid Frontier Markets that attract a significant number of foreign institutional investors.
Mean-Variance Summary from 2003-2012:
| Kenya | Ivory Coast | Nigeria | Ghana | |
| Arith Mean | 18.88% | 11.48% | 15.59% | 23.35% |
| Volatility (STD) | 40% | 29% | 40% | 69% |
| Sharpe Ratio | 0.37 | 0.27 | 0.3 | 0.28 |
Source: Compiled from local stock exchanges, world stock exchanges factbook, investinginafrica.net. Sharpe Ratio using average 10 years US T-bond as Risk free rate.
For comparison, we provide a further Mean-Variance analysis of the KINGs against Frontier, Emerging, and Developed markets in the sub-section “Volatility of returns” ahead.
Increasing intra correlation among the KINGs:
| Returns correlation matrix from 2003-2007 | ||||
| Kenya | Ivory Coast | Nigeria | Ghana | |
| Kenya | 1 | -0.69 | 0.19 | 0.52 |
| Ivory Coast | 1 | 0.33 | -0.32 | |
| Nigeria | 1 | 0.48 | ||
| Ghana | 1 |
Source: Data compiled from local stock exchanges, World Stock Exchange fact book, MSCI, Standard&Poor and Investinginafrica.net.
We note a very low correlation between Kenya and Nigeria pre-crisis, whereas Ivory Coast’s negative correlation with other KINGs countries was largely due to the civil war that devastated the country in early 2000s.
| Returns correlation matrix from 2008-2012 | ||||
| Kenya | Ivory Coast | Nigeria | Ghana | |
| Kenya | 1 | 0.80 | 0.89 | 0.34 |
| Ivory Coast | 1 | 0.90 | 0.56 | |
| Nigeria | 1 | 0.20 | ||
| Ghana | 1 |
Post-crisis, the correlation was much stronger among the KINGs, with the exception of Ghana that takes advantage of the dominance of Tullow Oil plc and AngloGold Ashanti – all commodity stocks – on the value weighted GSE composite index.
Decreasing correlation with Emerging and Developed Markets post-crisis:
| Correlation table 2003-2012 | ||||
| KINGs | Frontier Markets | Emerging Markets | S&P 500 | |
| KINGs | 1 | 0.52 | 0.35 | 0.39 |
| Frontier Markets | 1 | 0.70 | 0.59 | |
| Emerging Markets | 1 | 0.87 | ||
| S&P 500 | 1 |
On a 10-year timeframe, KINGs’ correlation with other Frontier Markets has been considerable. The key observation, however, is the nearly similar correlation coefficient between KINGs and Emerging Markets on one hand, and KINGs and S&P 500 on the other hand.
| Correlation table 2008-2012 | ||||
| KINGs | Frontier Markets | Emerging Markets | S&P 500 | |
| KINGs | 1 | 0.43 | 0.02 | 0.18 |
| Frontier Markets | 1 | 0.81 | 0.94 | |
| Emerging Markets | 1 | 0.89 | ||
| S&P 500 | 1 |
Post crisis, KINGs’ correlation with other markets, particularly the Emerging Markets and the S&P 500, has dropped considerably.
Overall economic freedom has been above the symbolic pass mark of 50 (0 being the lowest and 100 the highest). On a 10-year time frame, from 2003 to 2012:
Kenya’s score has been relatively strong and stable, from 58.6 in 2003 to 59.3 in 2008 before a sharp decline to 55.9 in 2012. According to the Heritage Foundation, the decline in 2012 could be attributed to: “declines in half of the 10 economic freedoms including labor freedom, monetary freedom, and business freedom.” Ivory Coast’s data declined from 56.7 in 2003 to 53.9 in 2008 and then 54.1 in 2012. This drop is largely explained by the macro-environment instability observed after the 2000s’ coup till the 2010 disputed elections leading to post election violence that ended in 2011 with a new government.
Nigeria has shown significant progress, with an overall score below 50 in 2003 to 56.8 in 2010, before dropping down to 55.1 in 2012. Here, we refer to the Heritage Foundation’s assessment:
an increase in the minimum wage has undercut productivity, and the structural changes that are critical to broad-based development have not emerged…with the judicial system susceptible to political interference, the rule of law is weak throughout the country. Growing social unrest further threatens wider stability.
Ghana’s ranking has been consistently strong, the highest among the KINGs. Its score went from 58.6 in 2003 to 57 in 2008, before a jump to 60.7 in 2012. This can be attributed to strong democratic institutions, as highlighted earlier.
Overall, these scores are above SSA’s 2013 average that stands at 53.05, with Zimbabwe (28.6) the lowest and Botswana (70.6) the highest.
Challenges remain
Beyond the traditional political risk, five challenges can be associated with African Frontier Markets and notably the KINGs. These are:
Liquidity
Frontier equity markets are characterized by a small market capitalization, a few listed companies, low trading volumes and values, wide Bid-Ask spread, and a risk of price distortion when high transaction volumes are made. In the article “Trading Liquidity In Illiquid Sub-Saharan Africa“, we made the following observations:
From available market data, most SSA stock markets respond to what we call the 5-95 status i.e.: 5% of listed stocks make up 95% of market capitalization (free float adjusted). Average daily traded values for the most part are around or below $50,000 USD. However the average institutional investor demands for a “long” position which is twice as much at a minimum. This supply and demand imbalance naturally leads to block trades and premia/discounts (5% on average) to be paid in various transactions. More challenging is the difficulty to find a buyer in case of an “emergency” exit. This may take up to a quarter, depending on stock attractiveness and seller’s flexibility on the price. Such environment has made us think of SSA listed equities as an “improved version of Private Equity” where deal sourcing is done at the stock exchange and negotiations are conducted OTC.
This reality also applies to the KINGs. However, the top 5 stocks within KINGs stock exchanges represent 60% of the total market cap, compared to the SSA average of 95%.
Short selling is prohibited whereas risk management through the use of derivatives and futures contracts will become available in Kenya and Nigeria in 2014, with similar plans in BRVM. The implementation of derivative trading will certainly boost trade in these commodity-rich countries.
In the past, Sunshine Trading has been practiced in pre-opening sessions to boost liquidity formation. This has now been replaced by continuous trading in all KINGs stock exchanges, with the BRVM implementing such measures in mid-September last year.
Moving forward, some actions have been taken by local policy makers to improve liquidity. This includes privatization of state-owned enterprises through IPOs, incentives for multinationals to list locally, launching a segment dedicated to SMEs, introducing derivatives trading and integration of stock exchanges regionally to achieve economies of scale, cost reductions, and an increase in volumes and values traded.
FOREX risk
Risk of political instability translates into FOREX risk, as political turmoil would lead to massive outflows and/or reduced FDIs, which may lead to depreciation of currencies. Moreover, some KINGs stock exchanges, particularly Nigeria and Kenya, are very attractive to foreign investors given the relative high liquidity of these markets. This exposes their currencies to fluctuations driven by flight to quality, as is observed now, with concerns over shifts in the US QE program.
Among other FOREX risk factors, we highlight trade deficits. As illustrated in the table above, the top 3 imports in these countries are equipment, manufactured goods, and fuel (except Nigeria). They mainly export commodities. Though terms of trade have improved with high prices of commodities (compared to the price of imported goods), the KINGs have consistently run trade deficits, i.e. their imports (in values) are more than their exports, which is translated into a higher demand for FOREX than FOREX earned through exports. Some investors take advantage of this situation to build natural hedges in their portfolios, i.e. holding export-driven and import-oriented companies in approximately the same weight in an attempt to be FOREX neutral.
The KINGs are therefore vulnerable not only to macro-economic conditions in partnering import countries, but also to changes in fuel and food prices that often trigger an increase in cost of production, a cost-push inflation that exerts pressure on their currencies’ stability. A recent example is Kenya, where inflation reached 20% in Q4 2011, leading the Kenyan shillings to low historical levels against the USD (106 ksh for 1 USD).
Going forward, the outlook is positive, with declining public debt ratios, better managed current account deficits, larger FOREX reserves, and single-digit inflation expectations.
Volatility of returns
As illustrated in the tables below, we observe a high volatility for KINGs returns over a 10-year period compared to Emerging and Developed Markets. However, in a 5-year time frame starting from 2008, we note that the KINGs’ volatility, as measured by the Standard Deviation of returns, has been lower than the Emerging Markets. Yet, the low volatility observed during this period is associated with relative underperformance (-3.16%) when compared to Emerging Markets (8.8%), largely driven by China.
2003-2012
| KINGs | Frontier Markets | Frontier Africa | Emerging | S&P 500 | |
| Markets | |||||
| Arith Mean | 17.32% | 14.49% | 24.90% | 23.08% | 7.04% |
| Volatility (STD) | 45% | 36% | 43% | 37% | 18% |
| Share ratio | 0.3 | 0.3 | 0.49 | 0.53 | 0.18 |
2008-2012
| KINGs | Frontier Markets | Frontier Africa | Emerging | S&P 500 | |
| Markets | |||||
| Arith Mean | -3.16% | -5.50% | -0.50% | 8.80% | 2.70% |
| Volatility (STD) | 38% | 31% | 41% | 49% | 25% |
| Sharpe ratio | -0.14 | -0.24 | -0.06 | 0.14 | 0.03 |
Source: Data compiled from local stock exchanges, World Stock Exchange fact book, MSCI, Standard&Poor and Investinginafrica.net. Sharpe Ratio using average, 5-years US T-bond as risk-free rate.
Logically, Emerging Markets have outperformed the KINGs and other Frontier Markets, as illustrated by their respective Sharpe Ratios. Going forward, we expect the dynamics to shift as liquidity improves in the KINGs compared to saturation and shrinking returns in the Emerging Markets.
A key point we would like to highlight in this section is that volatility of returns is also a factor of the unstable macro-environment that may be influenced by politics, policies, economic performance, or change in terms of trade, especially pertaining to commodity prices. On this issue, Nigeria appears to be the most exposed, as oil represents 75% of the government revenues and 95% of exports.
To conclude, volatility is often a short-term phenomenon and might be viewed or dealt with differently depending on an investor’s profile and investment horizon.
Note that the performance analysis highlighted above is based on gross price returns that do not account for dividends, effects of exchange rates and transaction costs, typically higher in the KINGs and other Frontier Markets.
High transaction costs
As illustrated in the paragraph discussing the liquidity challenge, block trade is often practiced, thus leading to price distortions that converts into a premium or a discount depending on which side of the transaction investors are at. In sum, the Bid-Ask spread is significantly high, on average.
Fragmented, SSA stock markets are unable to achieve economies of scale that would significantly reduce transaction costs. This is further affected by a lack of liquidity (frequent trading), poor infrastructure, and limited technology.
According to research by Marshall et al, transaction costs in Frontier Markets are at least threefold those of the US, on average. This is confirmed by our study on transaction costs in each of the KINGs stock markets.
The standard transaction cost in KINGs markets will continue to narrow and move closer to their Emerging Market peers. The catalysts for these improvements start with the upcoming integration of stock exchanges, which is likely to achieve economies of scale. Additionally, improved liquidity and frequency of trading, combined with an adoption of standard trading technologies will all contribute to more competitive transaction costs.
Operational inefficiencies
These include limited trading hours, (trade) execution risk associated with poor stock exchange infrastructure, limited disclosure and/or difficulties to access market information, and historical data. The time lag between information and price adjustment is considerably longer than that in developed markets. The level of information asymmetry is high. Moreover, most companies in the KINGs report annually as opposed to quarterly reports in the Developed and leading Emerging Markets. This often translates into a mismatch between trailing data and current facts.
In sum, the KINGs provide a good sample of Frontier Markets found in East and West Africa or from Anglophone and Francophone Africa if viewed from a linguistic and legal regime angles. They are what we call Tier 1 of the Sub-Saharan Africa Frontier Markets, where market depth and breadth is relatively deeper than the other African Stock Exchanges.
In Tier 2, we group other East African stock exchanges of Tanzania, Uganda, and Rwanda, then add Zambia in the South. These markets may provide better bargain opportunities than Tier 1, as they are “the road less traveled” within African Frontiers.
Following concerns over economic freedom (the lowest in Sub-Saharan Africa) and increased implementation of indigenization laws, Zimbabwe is currently not recommended to foreign investors as concerns over risk of expropriation, political interference, and restrictions on capital movement remain.
In Tier 3, we group Malawi, Swaziland, Namibia, Mozambique, and Gabon (BVMAC), whereas Tier 4 is made up of the new or non-operational stock exchanges of Sierra Leone and Cameroon respectively. Angola is expected to launch its long-awaited stock exchange in 2015 and could join Tier 2 before moving up to Tier 1, depending on liquidity and economic freedom criteria.
US investors’ access to African KINGs
US investors seeking exposure to the African KINGs shall consider one or a combination of the following paths:
– ADRs: Companies listed on the New York Stock Exchange whose majority of operations and revenues are generated from the African KINGs. Among others, these include South African gold giants Anglogold Ashanti and Goldfields (GFI) with operations in Ghana, Randgold (GOLD) with operations in Mali and Senegal, and Sasol (SSL) with operations across the continent.
– ETFs: To date, the main ETFs tracking a KINGs country is the Global X Nigeria Index (NGE) and the Van Eck Market Vector Nigeria (LGOS).
More generally, investors could gain exposure to African KINGs through the Market Vector Africa ETF (AFK), which tracks the performance of the largest and most liquid companies in Africa, including several Nigerian companies such as Guaranty Trust Bank (GUARANTY), Zenith Bank plc (ZENITHBANK), Nigerian Breweries (NB), and First Bank Nigeria Holdings (FBNH).
Other ETFs include: the Lyxor Pan Africa ETF (PAF:FP), which tracks the performance of the Societe Generale Pan African index; the iShare South Africa Index (EZA) that includes several South African companies (MTN, Standard Bank, Shoprite, Sanlam) operating in one or several African KINGs. In this category, investors may also consider the T-Rowe Price (TRAMX) ETF, which includes the MTN Group and Shoprite. The same applies for the SPDR S&P Middle East and Africa ETF (GAF) that has over 90% weight on South Africa, including the MTN group, the Standard Group and Sanlam; companies with significant operations in Kenya, Ivory Coast, Nigeria, and Ghana.
– Mutual Funds: This gives investors the possibility of instant and diversified access to the KINGs through outperforming, Africa-focused open-ended funds such as: Renaissance SSA fund (RAMSSAA:LX), Templeton Africa Fund (FTAFAAE:LX), Arisaig Africa consumer fund (ARIAFRI:MP), Standard Master Fund (STMAEAU:ID), Imara Africa opportunity Fund (IMARAAF:VI), to name a few.
– Direct access on local stock exchanges by buying:
a) Multinational companies listed on local KINGs stock exchanges. Here, investors have access to a universe of over 50 stocks with the world’s brands spanning across multiple and diverse sectors such as:
– Consumer: With leading consumer brands like Nestle (OTCPK:NSRGY), Unilever (UL), and PZ Cussons (PZC), all listed in Nigeria, Ghana, and Ivory Coast.
– Brewers: Diageo’s (DEO) EABL is listed in Kenya and its trademark Guinness listed in Nigeria and Ghana. SABmiller (OTCPK:SBMRY) has direct operations in Ghana and Nigeria and indirect operations in Ivory Coast’s SOLIBRA through a partnership with the French group Castel, whereas Heineken has stakes in Nigerian Breweries and Consolidated Breweries, and Guinness Ghana.
– Telcoms: South African MTNs are operating in Nigeria, Ghana, and Ivory Coast, the Indian Airtel operating in Nigeria, Ghana and Kenya, Vodacom operating in Ghana and a significant stake in Kenya’s Safaricom (SCOM), Orange (ORA) – formerly France Telecom- and Etisalat operating in most UEMOA (BRVM) countries and Nigeria.
– Banks: Foreign banks such as Standard Bank (SBK), Barclays, and Societe Generale (GLE) listed locally.
– Other multinational brands listed in the KINGs include Lafarge’s (OTCPK:LFRGY) Bamburi Cement in Kenya and WAPCO in Nigeria; British American Tobacco (BTI) listed in Kenya, and the list goes on.
b) Local blue chips: These are large cap stocks with relatively good liquidity. They often dominate the local index. Such stocks include: Dangote Cement (DANGCEM) in Nigeria, Safaricom (SCOM) in Kenya, Sonatel, a Senegalese company listed on the BVRM, and the Ecobank Group (ETI) a pan-African bank cross-listed in Nigeria, Ghana and Ivory Coast capitalizing on the ECOWAS common market protocols.
Winners in the long run!
Beyond diversification benefits they provide in international portfolios, the appeal for KINGs is justified by the “first mover” advantage that positions the long-term, liquidity-tolerant investor to benefit from sustained economic growth and the ongoing structural changes that will, in our opinion, reduce risk and improve liquidity in these markets. Needless to say, today’s Emerging Markets are yesterday’s Frontier Markets.
In other words, today’s African Frontier Markets – the KINGs in this case – are undoubtedly the African Emerging Markets of tomorrow.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
