Don’t follow popular stories when investing in Africa, says analyst

Due to the difficulties of driving rapid organic growth, foreign firms find it easier to acquire local businesses. This is often a dangerous way to grow.

2. What do local firms in those African countries think about foreign firms entering their markets?

We found that good local African businesses welcome foreign competition. We’re also seeing some of those businesses actively expanding beyond their home borders into other African markets.

3. How well are foreign firms performing in these markets?

It isn’t only individual investors that become enchanted with stories that fuel their expectations − businesses also love to buy into stories. Two examples of acquisitions that have encountered difficulty are:

– Altech’s acquisition of Kenya Data Networks and its foray into Nigeria.
– Tiger Brands’s acquisition of a large stake in Nigerian-listed Dangote Flour.

So the story continues. South Africa’s Public Investment Corporation (PIC) is also on the acquisition trail in Africa and recently announced the acquisition of a US$289m stake in Dangote Cement, which is listed in Nigeria. However, the implied multiples of this deal are far above the long term median deal multiples for the sector. In our experience, higher deal multiples relative to the long term median deal multiples of the sector signify that the acquirer has overpaid. The higher deal multiples also imply that the PIC expects significant growth from Dangote Cement.

The PIC alone represents more than $117bn and recent articles suggest it’s keen on further expanding its investments within Africa. One hopes it is basing its expectations on solid business fundamentals rather than overly optimistic growth stories.

There is significant danger in buying overvalued assets

Every African stock market we visited is extremely illiquid. The Lusaka Stock Exchange in Zambia consists of one room with a couple of television monitors manned by a handful of staff. Comparing the average Johannesburg Stock Exchange (JSE) daily trade of roughly $1.8bn to the Nigerian Exchange’s $25m and the Nairobi Securities Exchange’s $8m makes the relative size and illiquid nature of these markets clear.

The Nigerian Stock Exchange is one of Africa’s two largest exchanges after the JSE. Its listed securities represent a combined market capitalisation of $71bn (1,140bn Naira). In addition to the relatively small size of these exchanges, African pension funds hold much of the equity in listed companies indefinitely, making them even more illiquid.

Despite these limitations, there’s no shortage of offshore funds looking for a home in Africa. Morningstar lists over 500 Africa-focused funds. Combined they represent over $87bn in assets under management and there are many other funds that focus on so-called ‘frontier markets’. The combined effect of meaningful amounts of capital chasing extremely illiquid markets can push prices of individual businesses beyond their value. Significant demand chasing limited supply raises concerns.

We find the odds are more tilted in favour of finding cheap businesses where demand is less than supply, not where demand exceeds supply.

Ten years ago, investors were buying into the growth story of developed markets such as the UK and US, which left South Africa and the rest of Africa very cheap. High profile firms all moved their primary listing and head offices to London or New York. Such firms included Investec, Old Mutual, Anglo American and Dimension Data. As a group, these companies have on average performed very poorly, subsequent to the change in their geographic strategy. Today we find the reverse is true. High profile firms are all acquiring assets and offices in Africa. We wonder if the outcome will be similar.

Looking through the story reveals the opportunity

As humans, we’re hardwired to create and believe in stories, which fuel our expectations. The key to investing success lies in becoming aware of this tendency and then using it to our advantage.

Most investors are focused on the African growth story. They want businesses that are expanding into Africa, supporting and fuelling their stories of African growth. In the process, some businesses have been overlooked or ignored in countries with unpopular stories associated with them. These assets have a higher likelihood of being cheap and offering better long-term investment prospects as a result.

We have no doubt that Africa will remain an exciting growth story for some time. But our work has shown there are large barriers to prevent outside passive minority investors – such as fund investors – from making money from this growth. Additionally, there’s evidence that corporate buyers are systematically overpaying for African assets, as they too are ‘drinking the Kool-Aid’.

The work we’ve done in our investigations has helped us identify certain assets that show a strong divergence between what the market is willing to pay and what they’re actually worth. By critically evaluating the facts, rather than following the popular stories, we can take advantage of those divergences that offer genuine opportunities.

Amédi de Klerk is an investment analyst at RE:CM.