A Time to Invest in Africa
Nile Capital Management
By Larry Seruma
November 30, 2010
For the past two decades, the attention of investors around the world has been riveted on the emerging markets of Asia, which includes two of the four high-growth “BRICs” – India and China. Several emerging markets of Europe and South America, including the two other BRICs (Brazil and Russia), also have increased their capital flows and allocations in global investment portfolios.
However, some other high-growth emerging and frontier markets have been largely overlooked in this trend. Several are located in Africa, the world’s second largest continent by population and land mass, behind only Asia in both measures. With a population of more than one billion people, spread among 53 nations and almost 12 million square miles, Africa is becoming too big investors to ignore. Yet, its financial markets and expanding public companies remain shrouded in mystery for most foreigners.
Fortunately, events such as the 2010 FIFA World Cup soccer tournament, hosted by South Africa, have helped to emphasize the dynamic, modernizing side of Africa. Other visible trends also are helping to shift investors’ attention toward this vast continent and its diverse opportunities for economic growth and financial market rewards, i.e. African companies benefit from doing business in a place with many native advantages; cheap labor, fast growing population that is unencumbered by legacy technology or business models, rising commodity prices, market deregulation, favorable macro economic policies and improving levels of political stability and transparency.
In this report, I will summarize my answer to the often-asked question: “Why is this a good time for investors to focus on Africa?” I also will explain why the best way to participate in African markets and manage their risks is through an actively managed fund that offers “feet-on-the-ground” expertise in Africa.
Why This is The Right Time to Invest in Africa – A Dozen Reasons
1. A ground-floor opportunity with potential for high returns. Of all investors who migrated into the BRICs over the past two decades, very few caught the initial “ground-floor opportunity.” I believe Africa’s economic growth is just forming a powerful upward curve that will continue for several decades and perhaps become as rewarding as the BRIC markets over time. Already, we have seen the first wave of strong investment returns from Africa, as summarized in the table below.
Annual Returns – 1999-2009
MSCI World is the MSCI World Index. MSCI EM is the MSCI EM Index (Emerging Markets).
Source: Bloomberg; African Data Includes South Africa, Nigeria, Kenya, Mauritius, Ghana, Egypt, Morocco, Botswana, through 12/2009.
For the decade ending 12/31/09, the average annualized return for South Africa was 12.68%, which easily beat returns from U.S. stocks, global developed markets, and even emerging markets. An African Composite Index – consisting of South Africa, Nigeria, Kenya, Mauritius, Ghana, Egypt, Morocco and Botswana – performed even better, returning an annualized 13.83% over this period.
These returns underscore a fundamental rule of investing: The first investors to enter new high-growth markets often reap the highest returns over time, as a result of taking risk that other investors are not yet prepared to accept. Africa today is perhaps comparable to the American West in the early 1900s or Asia in the late 1900s. However, Africa also is taking advantage of more rapid changes, driven by globalization, communications and technology, than most “frontier markets” of the past century experienced.
2. Greater portfolio diversification. Emerging markets have offered investors opportunities to diversify into new countries, markets, companies and trends. Africa is rich in diversification potential because only a few of its stock markets or public companies are included in popular emerging market indexes or index funds.
Also, the portfolio exposures of large institutions and hedge funds to Africa are still relatively low, compared to emerging markets. This means Africa has not experienced the liquidity-driven inflows and outflows of capital that have been seen repeatedly over the past decade in Asia. You might say that African markets still “move to their own beat,” not the tides of systematic global market risk.
Perhaps the best measure of portfolio diversification potential is the correlation of investment returns, and African markets have historically had relatively low correlations with both developed and emerging markets.
Over a full credit cycle, from January 2002 through June 2009, an African Composite Index has had a correlation of just 0.59 with the S&P 500, 0.66 with the MSCI EAFE Index, and 0.60 with the MSCI Emerging Markets Index. Over the same period, the MSCI Emerging Markets Index has had correlations of 0.82 with the S&P 500 and 0.91 with MSCI EAFE.
3. Strong economic and market growth. According to World Bank projections, nine of the 15 countries in the world with the highest rate of five-year economic are in Africa. In addition, African is urbanizing at a faster rate than India, and is already nearly as urbanized as China, according to a recent report by McKinsey Global Institute. As shown in the graph below, Africa has as many large cities as Europe, and more than North America (the U.S. and Canada combined).
Rural vs. Urban Population
Source: United Nations; McKinsey Global Institute analysis.
4. Many African companies are generating strong cash flows, earnings and profits. Africa’s stock markets and public companies collectively represent approximately $1 trillion in market capitalization. Among Africa’s 53 countries, about 20 have active stock markets, on which about 1,500 companies are listed, in total. The largest and most active national stock markets are in South Africa, Egypt, Morocco and Nigeria.
Many of the public companies we have identified as investable opportunities in Africa are profitable with strong cash flows and dividend yields. A recent study by Oxford University economists Paul Collier and Jean Warnholz found that the average annual return on capital for the African companies they studied was 65% to 70% higher than that of comparable firms in China, India, Indonesia, and Vietnam. Because the cost of capital in Africa is relatively high, many companies have pricing power driven by a combination of price inflation and increasing consumer demand, and they have demonstrated strong rates of annual earnings per share growth.
5. Increased global demand for commodities. Africa holds an estimated 30% of the world’s mineral reserves, including 40% of proven gold reserves, 60% of cobalt, and 90% of platinum global reserves. In addition, it has 10% of the global reserves for oil and 6% of proven gas reserves. As the BRIC countries industrialize, their demand for natural resources will keep increasing, and they are turning to Africa as a source of scarce natural resources – especially energy and strategic and industrial metals.
6. Political risks have been exaggerated. The stereotype of an African country ruled by one-party or military dictators is outdated and exaggerated. More than 90% of African nations now have functioning democracies, compared to just 12% a quarter century ago. According to Freedom House, 63% of Africa’s population now lives in counties designated as “free or partially free.” This is comparable to the ratio in Asia (66%) and better than the ratio for all countries in the world (59%).
Several African countries once known for their unfavorable political or economic climates have learned from previous mistakes and become role models for political/economic stability. A case in point is Nigeria, which was mired war and military rule for 30 years after gaining independence from the United Kingdom in 1960. In 1999, Nigeria regained a democratic government and it has enjoyed political stability and a peaceful transition in political power ever since. In addition, Nigeria has paid off its external debts, enacted prudent fiscal policies, and cleaned up its banking system.
7. The China factor. Chinese trade and investment in Africa is a game-changer. According to Dr. Chris Alden, an author who monitors cross-border trade and investment in Africa, China alone has increased its trade with Africa from $10 billion in 2000 to $90 billion in 2009. Dr. Alden has written: “Led by Chinese petroleum companies flush with massive foreign currency reserves and a strong political mandate, Chinese businesses have been on an acquisition spree for resources across the African continent since 1996.”
8. Massive infrastructure development. Africa’s is expanding its network of roads and highways, ports and airports, electric and water projects, and communications infrastructure at a faster rate than any continent in history. Again, Chinese investment is driving the expansion. Recently, China has funded development of 10 major hydropower projects in Africa with a combined capacity of 6,000 megawatts and has built or rehabilitated 3,000 kilometers (about 1,900 miles) of African railroads.
China has committed to investing its growing reserves into real assets around the world. In particular, it seeks commodities to secure its future economic growth as an industrial power and consumer economy. To harvest commodities from Africa, China has been contributing vast amounts of money and expertise to the improvement of African infrastructure. This has had the side effect of reducing operating costs thus helping local companies grow. Looking forward, China’s participation in local economies forces African governments to improve property rights and reduce political risk.
9. Economies not mired in debt. Unlike Japan, the U.S., and many economies of Europe, African nations have reasonable levels of debt relative to GDP. For example, Nigeria has a debt-to-GDP ratio of only about 18%, compared to more than 100% for Japan, Italy and Greece. (See graph below.) In addition, the high rates of GDP growth of African nations gives them more flexibility to repay sovereign debts than many mature economies will have.
National Debt Vs. GDP
Source: IMF World Economic Outlook, April 2010, CIA Factbook 2009, Renaissance Capital
10. Steadily increasing capital flows. As investors discover opportunities in Africa, capital flows to the continent are increasing at a rapid pace. As shown in the graph below, capital flows to Africa now exceed those to three of the four BRIC countries, all except China. Capital flows and remittances to Africa more than doubled over just a three-year period (2005 to 2008), according to the United Nations Conference on Trade and Development (UNCTAD).
Capital Flows: Africa Compared to the BRICs (in $billions)
11. Valuations in African stock markets remain attractive. Leading public companies in Africa remain attractively valued, especially compared to their counterparts in the BRICs and other emerging markets. For example, an analysis by Renaissance Capital estimated 2011 multiples of enterprise value/EBITDA ranging from 7.2 to 3.1 for five African markets. Many companies in Africa also enjoy attractive pricing power and profit or EBITDA margins, as shown in the graph below.
African Non-financial Companies in 5 Markets – 2011 Estimated EV/EBITDA
African Non-financial Companies in 5 Markets – 2011 Estimated EBITDA Margin
Source: Renaissance Capital
12. Africa is a young and vital continent with vast opportunities for growth. As populations in the U.S., Japan and western Europe grow increasingly older, Africa’s population pattern (by age) resembles that of the United States at the start of the post World War II Baby Boom. In Nigeria, Africa’s most populous nation, the median age of the population is just 19 years, compared to 37 in the United States, 40 in the U.K., and 45 in Japan.
As a result, Africa’s population is not limited by low birthrates or the burdens of providing pensions and care for the elderly. Most young people in Africa yearn for a better life and middle-class comforts, and their aspirations are driving a powerful wave of urbanization, infrastructure development and consumer markets growth.
The Value of Active Management in African Investing
Although the dozen reasons listed above make a compelling case for investing in Africa, caution is prudent. In most Africa stock markets with the exception of South Africa, trading liquidity is fairly thin by developed market standards. In addition, African markets, like other frontier or emerging markets, tend to have less developed regulatory structures, and there are additional risk that investors should consider should as the high cost of capital, relatively high inflation rates, and currency fluctuations. In general, it’s a good idea to consult your financial advisor before investing in Africa or any other frontier or emerging markets.
For many investors, a wise “first step” into Africa can be taken through a diversified, professionally managed fund that focuses on stocks of the highest quality companies. As the portfolio manager for such a fund, I travel extensively to Africa on a quarterly basis, mainly to visit companies. Of course, I am also touring and studying the countries in which these companies are located. Because Africa is changing faster than just about any other place on earth, I need to keep updating my knowledge and “feel” for its macro, political and social structures.
Based on personal experience, here are a few attributes I believe you should look for in selecting an African fund or manager:
- Big-picture vision – In addition to developing in-depth knowledge of how specific African companies are run, we focus on company leadership and vision, the business model, and how it fits into the bigger picture of African infrastructure and consumer market developments.
- Feet-on-the-ground research – Our company, Nile Capital Management, employs a dedicated analyst based in Cape Town, South Africa, who organizes and conducts our research coverage on the continent in a structured way. We work together to develop a 360-degree view of the continent, its national economies and leading public companies. In addition, we have a vast network of local contacts in all the markets we invest.
- High-growth countries – Nile Capital Management combines top-down macroeconomic analysis and bottom-up fundamental analysis. The first step in our investment process is to develop a macroeconomic view and ranking of all 53 African countries. This analysis helps to identify countries with sustained growth, political stability, sound governments, strong economic policies and reliable regulatory/ governance frameworks. Based on this analysis, most of the companies we currently like are in Africa’s “big four” economies – South Africa, Egypt, Morocco and Nigeria. These four countries also represent geographic diversity, including southern, western, and northern regions of the continent. Although we are value investors we do not ignore the macro environment in which we in invest.
- Enduring themes – We believe in participating in Africa’s most compelling themes including commodities, infrastructure growth, and consumer growth. The urbanization theme also is powerful because it is a measure of upward mobility in emerging markets. It means more people can move off farms or rural area and into jobs, and this in turn creates upward mobility and opportunities for companies to sell to a variety of consumer market segments.
- Long-term focus – Finally, Africa represents an opportunity for patient investors who want to diversify among a wider band of companies and are looking for long-term capital growth. Some stocks in a diversified African portfolio will exceed expectations and others will not, and that is the nature of all high-growth emerging and frontier markets. For most investors, it makes sense to work through a mutual fund, because researching Africa is more challenging than in most other parts of the world, including other emerging markets.
In conclusion, it’s a good idea to invest through a company that understands Africa and has made a commitment to helping investors manage its risks and reap its rewards.
I am a native of Uganda who has spent most of my career managing global hedge fund assets as an investment professional. In this line of work, I have been able to compare high-growth opportunities all over the world, especially in global emerging markets.
I believe Africa is the world’s next great “BRIC-equivalent.” For that reason Nile Capital Management has made the commitment in investment talent and resources that is essential to help you invest successfully in Africa.
Larry Seruma is the Chief Investment Officer and Managing Principal of Nile Capital Management.
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(c) Nile Capital Management