Searching for value amid Africa’s disappointing equity returns

Lagos, Nigeria

International equity markets have recovered sharply from the March lows, however, African markets made only a modest recovery. As the continent’s leaders face the extensive task of guiding an economic recovery in the months to come, Rory Kutisker-Jacobson, portfolio manager at Allan Gray, discusses African equities’ disappointing year-to-date returns and highlights some of the areas where he sees value.

At the end of June, the MSCI World Index was down 6% year to date, compared to declines of 23% for the Egyptian market, 13% for Kenya and 17% for Morocco. The Standard Bank Africa Index (SBAI) had done well as gold shares, which account for 27%, performed exceptionally.

Across our portfolios we have a wide range of companies that are exposed to a variety of different risks dependent on industry and geographic location. For some of the businesses, it is far from “business as usual”, as they – or their clients – have been exposed to significant hardship under lockdowns of varying degree. Other businesses, whose earnings are defensive in nature, have been largely unaffected, while some businesses, such as grocery retailers, have been thriving in the current environment. The common theme is that all are trading at a significant discount to our estimate of fair value.

Despite the broader economic challenges, we are finding compelling value

Within our African funds, Nigerian banks are 2020’s biggest detractors by some margin. We touched on the valuations in April, and we still think there is exceptional value. Unfortunately, the Nigerian regulator is steadily adding to the regulatory burden, which flows through to profitability and investor sentiment. We think the current burdens, and more, are reflected in the valuations.

Two companies we have not previously discussed are telecommunications company Sonatel and energy provider Umeme. Sonatel is an Orange subsidiary operating in Francophone West Africa. Its share price has halved since 2017, despite earnings only falling 6% and steady revenue growth. We think earnings will grow from here and the 7.5 price-to-earnings (PE) multiple could rerate sharply. If there is no rerating, the 9.5% dividend yield will provide a decent return. Unlike many telcos, Sonatel has very little debt – net debt to earnings before interest, tax, depreciation and amortisation (EBITDA) is only 0.2 times.

Umeme administers the Ugandan power transmission grid on a 20-year concession, expiring in 2025. If the contract is not renewed, Umeme has the right to sell the assets back to the government at 105% of book value. The share trades at 50% of book value, three times earnings and yields 11.5%. We think it is likely that the concession will be renewed, and the risk/return profile is strongly skewed in our favour at this valuation.

Opportunities in Zimbabwean resources

The political and economic situation in Zimbabwe seems to reach ever-lower lows and country-specific risks dominate the investment decision for many investors. This creates compelling opportunities for long-term investors. One such example is Zimplats.

Listed in Australia, Zimplats is 87% owned by Impala Platinum and the largest PGM miner in Zimbabwe. The mine itself is one of the best platinum assets globally: relatively shallow, low cost and long life. The domestic risks have historically been, and continue to be, well navigated by management, despite the ongoing turmoil in the country and the additional complexities as a result of the Covid-19 pandemic. Indeed, management recently revised production guidance that was towards the top end of guidance previously provided. On our estimates, at spot PGM prices, Zimplats is trading on less than 3 times free cash flow (FCF). The company has net cash on the balance sheet and has historically returned the majority of FCF to shareholders. At this price, we think shareholders are being more than adequately compensated for the country-specific risks.

Uncertainty abounds, but our approach hasn’t changed

We continue to be very excited about the long-term returns on offer across the African and Frontier universes. Our expectation is that markets are likely to continue to be volatile while Covid-19 is with us, as we have yet to fully understand the long-term ramifications and second-order effects. What can investors do in a highly volatile and uncertain environment? As always, the right thing to do is to focus on underlying business fundamentals and the price you pay.

Further reading

[June 2020] Due Diligence: Doing deals in Ethiopia – investor shares lessons learnt
[May 2020] Interview: Why AgVentures is betting on agrifood tech in Africa
[May 2020] Investment firm Accion explains why it backed Nairobi-based Apollo Agriculture
[April 2020] Investor shares an honest account of what it’s really like fundraising a VC fund in Africa
[April 2020] After a decade of building and investing in African companies, Emilian Popa explains why he is bullish on these five industries