Africa: it's time to invest

As the world's equity markets take a battering, investors have good reason to look to Sub-Saharan Africa, says Dr Ayo Salami

With the threat of a, world recession creating a subdued outlook for equity markets, investors may ask where you can still make money. One region overlooked by many investors is Sub-Saharan Africa (SSA), and yet SSA equity markets have recently enjoyed an unheralded renaissance. Although the region is classified as "third-world", the vast majority of African countries have legal environments and commercial infrastructures in terms of banking, insurance and tertiary services that compare favourably with those of more developed countries.

SSA has a population of 750 million and nominal GDP of US $650 billion. The region contains a disproportionate share of the world's most valuable commodities – approximately 90% of its diamonds and phosphate, 50% of all gold and 40% of platinum, 12% of its natural gas and 8% of oil reserves. Yet it would be incorrect to view Africa as simply an option on commodity prices. During the 1990's many countries undertook deep institutional, economic and political reforms that form the bedrock of current growth.

Since 1995, real GDP growth has exceeded population growth resulting in the thirteenth consecutive year that living standards have risen – the longest period of economic growth in Africa's recorded history. As recession looms in most advanced economies, the consensus is that Africa will maintain growth in 2009.

The latest IMF World Economic Outlook in October concluded that the rate in SSA will still reach 6.1% in 2008 and 6.3% in 2009. The impact on SSA of the turbulence in global financial markets appears to have been contained so far, and is not expected to change substantially in the near-term. African banks have been little affected by the problems of those in advanced economies largely because they tend to hold loans on their own balance sheets, the inter-bank market is small, while the market for securitised or derivative instruments is virtually non-existent. The recent positive macroeconomic performance of SSA has not been export-led, but anchored on rising domestic demand, increased infrastructure spending and increased private capital flows to the region in the form of direct investment and remittances from Africans abroad.

Excluding South Africa, there are 14 stock exchanges in the region with a combined market value of US$96 billion. Since 1995 there has been at least one African equity market among the world’s top 10 best performers. In 2007 it was Zambia, posting gains of 127% in US dollar terms, followed by Malawi (up 114%), Cote D'Ivoire (up 105%) and Nigeria (up 90%).

Benefits of reform
These returns are not an aberration, but reflect positive fundamental changes in the macroeconomy. In the 1990's many African countries restructured their economies and adopted liberal market reforms reducing their budget deficits, implementing sound money policies, bringing down inflation and freeing their exchanges rates. These policies are bearing fruit.

For the first time since the early 1980's, real GDP growth exceeds population growth by a reasonable margin and living standards are rising, budget deficits have been brought under control (an average 2.2% of GDP), currency exchange rates have stabilised and corporate profits and return on investments are relatively high.

Arguing the case for SSA as a region experiencing positive change is not helped by the fact that the Western media focuses on the problems of Dafur, Zimbabwe, Congo and AIDS in Southern Africa. While factually correct, a constant diet of these types of news item creates a very negative impression of the whole region.Although economic and institutional reforms are now translating into macro-economic success, foreign private capital is not yet returning to Africa partly because change has been evolutionary rather than revolutionary. In Central and Eastern Europe (CEE), western investors rushed in after political changes in the early 1990's. The decisive break with its political and economic past established the reforming credentials of governments in CEE. Investors were reasonably certain that the reforms would not be reversed. Hence despite almost 40 years of central economic control and restrictive market practices, CEE attracted substantial foreign investment within a very short time of changes to its economic system.
Reforming countries in Africa lack the same credibility with investors. The perceptions of history and geography remain difficult obstacles for governments to overcome. Investors fear a reversal of the new liberal policies. Even where African governments have demonstrated a commitment to sound economic management for a number of years, and where change is beginning to yield positive benefits (eg. Uganda, Botswana, Guinea, Mozambique, Ghana) they find progress is hampered by what economists dub the "poor neighbourhood" effect (something property owners will recognise, when the market value of your exquisitely decorated and well -kept house is diminished by the eyesore of your neighbour's garden).

In addition to economic changes, the political environment also witnessed lasting change with the majority of countries substituting authoritarian, undemocratic governments with multi-party democracies These political reforms have unleashed economic freedom and growth on the continent. The fact that Africa teems with well-managed highly profitable companies is one of the best kept secrets of the investment world. Based on Return on Equity (ROE), African banks are probably the world’s most profitable in (average ROE is about 35%). Among industrial and consumer companies sustainable ROEs above 30% are not uncommon with extreme examples like Nestle Nigeria with ROE of 110%. Multinational companies such as Diageo, Heineken, Lafarge, GlaxoSmithKline, CocaCola and Julius Berger have been quietly making a fortune in Africa. The paradox is that most multinationals tend not to publicise their African successes.

A true picture
It is difficult to accurately assess the true state of African economies from statistics. Officially 80% of Nigerians exist on an income of less than US$1 per day. This level of poverty is difficult to reconcile with the massive boom experienced in the Nigerian telecom sector and has exposed a vast consumer sector with substantial purchasing power along with the inherent profitability of the market. In most African countries, the informal economy is usually bigger than the formal economy and thus official statistics tend to understate the true position.

In addition to higher returns, African equity markets also offer a low correlation with other equity markets offering opportunities for diversification and reducing portfolio risk. Globalisation has resulted in most of the world's stock markets performing a line dancing routine and moving together. African equity markets are unrelated to the rest of the world, while the correlation between equity markets in different countries is low.

Given the potential universe, the number of pension funds that have specifically allocated any of their portfolios to Africa is extremely small. A lack of suitable investment vehicles is likely to be a hindrance to institutional investors. The Duet Victoire Africa Index offers institutional investors an efficient low cost vehicle for gaining exposure to the growth and returns from African equities. The DVAI is a proprietary index designed to track all SSA companies with a market capitalisation above $250 million. An index fund may not initially appear to be the ideal vehicle for investing in frontier markets. Investors generally believe that frontier markets are inefficient and provide an ideal opportunity for active managers to generate alpha. However the empirical evidence is very strong that active managers cannot outperform well constructed indices even in frontier markets.

Significant challenges face active managers seeking alpha in frontier markets. Those in Africa are compelled to use a bottom-up approach to stock selection with liquidity and market size as key screening criteria. By the time a stock meets the minimum size and liquidity constraints used by most active fund managers, the stock is not likely to be under-valued. Given size and liquidity constrains, the investment universe for active managers is likely to be confined to the same stocks that are covered by the DVAI. Higher transaction costs in SSA equity markets combined with high turnover can represent a significant performance hurdle for active managers. For the large relatively liquid stocks in Africa, a passive investment strategy will prove effective. Even in the search for alpha, you are more likely to find beta and sigma.

There are many reasons to explain why institutional investors have ignored African equity markets. Yet these markets are more stable and viable than the uninitiated would perceive them to be. With future returns from equities in developed countries projected to be lower than historical levels, investors prepared to move up the risk curve may find Africa a rewarding destination.

WRITTEN BY DR AYO SALAMI, CHIEF INVESTMENT OFFICER, DUET VICTOIRE AFRICA INDEX FUND