The Big Picture: African equity returns expected to be driven by earnings growth rather than re-ratings

As frontier markets continue to outperform emerging markets, a fund manager, who is riding this promising wave by investing in African equities, explains what is driving economic growth in Africa (excluding South Africa), and gives a short and long term outlook for this market.
The Pangaea Africa Fund of Funds is an equity Fund launched in June 2011 by 27four Investment Managers, a firm based in Johannesburg, South Africa, named after a date, 27 April 1994, when South Africa saw its first democratic election. It invests in five to ten Africa (ex South Africa (S.A.)) focused mutual funds at any one time.

Frontier markets continued to outperform emerging markets in 2013, a trend seen in the second half of 2013 when US Fed taper talk saw emerging market (EM) currencies weaken substantially while most frontier market currencies held firm. Africa (ex S.A.) was the best performing frontier region for the last quarter of last year, driven by Egypt, and for the year 2013, sub-Saharan African markets had the best performance, after a strong 2012. From the beginning of 2012, these markets have returned 86% as measured by the MSCI FM Africa Index (54% in 2012, 31% in 2013, and currently down -7% YTD).

Economic growth view
According to 27four, over the last decade, many African countries have enjoyed economic growth in excess of 6% per annum – twice the average growth rate of the developed market economies and many emerging economies. According to the IMF, over the next five years, nine out of the top 20 fastest growing economies in the world may be in Africa.

There are two broad factors at play, which are driving this growth in economic output across many African countries, says 27four:

• Demographics – a young and growing urbanised workforce that is more literate and healthier than previous generations.

• Broad economic reform – a result of improving institutional and political governance.

The managers at 27four compare Africa now to what the Asian tiger economies were like in the 1970/80s. The opportunity that the continent offers, they explain, is in the incremental improvements (governance, infrastructure, etc.) taking place across most of the continent that are making it easier to do business there.

Africa (ex S.A.), currently hosts 17 investable stock markets, with more than 600 listed companies and a combined market capitalisation in excess of US$200bn. Also, many companies that offer exposure to African assets are listed on foreign market exchanges (Toronto, London, Australia, etc.) The managers at 27four expect that, as African countries move up the development curve, the breadth and depth of its capital markets will increase as well.

One should also note on African equities, the Fund’s focus, have historically displayed a low correlation (<0.6x) to world markets. Thus the fund can claim to offer risk diversification.

How to invest in Africa
The Fund, which does not use leverage, has the following mandates for its underlying funds: only invest in equity of listed companies with significant business in Africa (ex S.A.), no matter where the stock exchange is; use a long-only equity strategy; employ active or passive strategy; and must be an open-ended fund. Most funds invest in Nigeria, Egypt, Kenya, Morocco, Mauritius and in cash.

Investing in Africa is investing in frontier markets, the managers at 27four note, so it is risky. They cite risk factors such as commodity prices, political conflict and regulatory changes. In addition, in times of global capital market stress, frontier markets may often significantly underperform developed and emerging markets as investors flee to perceived safe haven assets, they add. Liquidity is also significantly lower than that of emerging markets as the capital markets go through their development phase and investing across regions introduces currency risk.

Picking funds in Africa is more challenging than elsewhere too, partly due to short track records and the lack of a common benchmark.

2014 outlook for African equities
To quote 27four, “consensus amongst analysts and fund managers is for further gains in African equity markets in 2014, but not to the same extent seen over the past two years. Africa ex SA equities has been “the” asset class to be in. From the beginning of 2012 the market returned 57% versus 9% for emerging markets and 41% for world markets as measured by MSCI. Frontier Africa (i.e. excluding Egypt and Morocco) has returned 86% while frontier markets as whole have only done 27%. Further outperformance by African markets is considered unlikely.

“In no measure though do valuations look stretched with the exception of some multi-national consumers. Positive disposition to Africa continues to build with Africa’s weightings increasing in important frontier market indices and growing media and analyst coverage (e.g. Jim O’Neill’s latest acronym: the MINTs – Mexico, Indonesia, Nigeria and Turkey).

“The underlying fundamentals for key economies in the region remain favourable and translate into earnings growth outperformance compared to world markets. As Africa is no longer a story of cheap growth but now more of a reasonably priced long term growth story, returns are expected to be driven by earnings growth rather than re-ratings. While 2013 saw increased involvement by foreign investors, domestic African institutional investors generally still remain underweight equities.”

Fatima Wawda, 27four’s managing director, told Opalesque that the markets with the expected highest earnings growth (in local currency) are Egypt (20-25%, expected recovery in earnings and investment); Kenya (20% as economy is doing well, low real interest rates); Ghana (25% with high inflation, high government deficit spending); and Malawi (25% with high inflation). The best opportunities in the short term, according to her, are to be found in Egypt, where there is a continued market momentum; Morocco, with the lowest ratings relative to historic levels; and resources (if China’s credit concerns subside). In the longer term, the best opportunities are to be found in Nigerian banks; junior resources; insurance; telco and Zimbabwe.

Risks in the short to medium terms are in currency depreciations arising from general high deficit spending, rising inflation, rising proportion of external debt and China’s demand that may slow down.

“On broad level, there is risk of unexpected policy reversals or delays in policy implementations due to political populism,” she adds. “In general, institutional governance and independence is still developing across Africa and key institutions remain vulnerable to political interference.”

The Pangaea Africa Fund of Funds was up 0.68% (net, US$) in February, down -0.91% YTD and up 10.50% since inception, compared to 12.9% for the MSCI Emerging Frontier Markets Africa ex South Africa Index, its benchmark. The latter is currently down -3.7% YTD. The Fund has annualized 3.7% since inception and the benchmark 4.5%. It currently has around $40m in assets under management and is expected to double in size by the end of next quarter.

The managers at 27four perform the usual task required for an actively managed fund of funds: they screen the underlying funds, perform qualitative and quantitative due diligence, travel extensively in search of managers, construct the Fund with sophisticated tools and apply ongoing risk monitoring.

The Pangaea Fund is domiciled in Malta and administered by IDS Fund Services Malta Limited. It is a distinct sub-fund of the Knights of Malta Investment Funds SICAV plc, a part of Scotstone Investments Ltd., IDS Group’s Malta-based company that assists emerging or non-EU domiciled fund managers gain access to the European market. 27four also invests in hedge funds, Shari’ah funds, money market funds, global funds, and runs a black asset manager incubation program.

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Benedicte Gravrand, Opalesque Geneva