Most African equity markets had a difficult 2016, generating negative dollar returns. The worst performers were Egypt and Nigeria, which fell 47% and 41% respectively, while the standout performer was Morocco, returning 26%. Kenya, the other large, liquid market, fell 9%.

After trying to plug the dyke for over a year, the Egyptian authorities finally let the pound float in early November. The magnitude of the move surprised most; including us (we were using a rate of EGP13.20/US$ to value the portfolio just before the devaluation). The Egyptian pound lost 52% of its value in eight weeks, moving from EGP8.88/US$ to EGP18.52/US$. The local equity market rallied 37% over the same period, for a net US$ loss of 35% for equity investors.

Close observers of the Allan Gray Africa ex-SA Equity Fund’s price series would have seen little price movement from the above volatility as by November 2016 we had already devalued the Egyptian pound rate used to value the fund assets, so the subsequent stock market and currency moves more-or-less offset one another.

We think the Egyptian pound is undervalued and may well recover somewhat, especially if the government adopts some sensible policies and cuts back on money printing. We are not net buyers of Egyptian equities, as there is less value after the rally. Our preferred exposure is still Eastern Tobacco. The Egyptian opportunity currently appears to be in local currency, fixed interest and cheap holidays.

The fund is a buyer of Nigerian banks, as these businesses look undervalued despite substantial risks. The Nigerian bank investments detracted 8.9% from returns over the past year. Nigerian consumer businesses are beginning to move into our valuation range, but we are not yet substantial buyers.

It would have been nice if rather than investing in Nigerian banks the fund had the equivalent sum invested in Moroccan equities – unfortunately this was not the case. We had zero exposure to Morocco over the year and, despite lots of looking, we have not found any businesses that we think are substantially undervalued.

The fund’s exposure to Kenyan equities is fairly modest despite the financial companies trading on depressed valuations. The Kenyan shilling is cause for concern. The shilling traded in a remarkably tight range around KES101/US$ over the past 18 months, despite a rapidly increasing fiscal deficit (now 10% of GDP) and a current account deficit of 6% of GDP. Private sector credit expansion has slowed recently, but a pegged currency and large twin deficits do not usually end well.

Unfortunately, the reason for the sharp rally in Zimbabwean equites over the past six months was not an improving economic situation, but rather a deteriorating one. The government has introduced so called “bond notes” in an attempt to solve the chronic dollar shortage, which could be the harbinger of another bout of money printing. It is very difficult to get dollars out of Zimbabwe, so investors with cash balances are looking to buy real assets, driving up equity valuations. In pricing the fund, we have devalued the Zimbabwean securities by 20% to reflect this anomaly.

Falling African equity prices and valuations over the past 30 months have laid the groundwork for better returns ahead. The fund owns a collection of undervalued equities that should reward long-term investors with pleasing real returns in the years to come.

The fund bought small positions in Kenyan banks, added to the position in Nigerian banks and sold Global Telecom, Safaricom and Credit Agricole Egypt.

Andrew Lapping joined Allan Gray in February 2001 as a fixed interest trader and moved to the research team as an equity analyst in February 2003. He was appointed as fixed interest portfolio manager in June 2006, began managing a portion of client equity and balanced portfolios in February 2008 and was appointed as chief investment officer in March 2016. He also manages African equities. This article was originally published by Allan Gray.