Africa is back on the map for equity investors

By Cavan Osborne, Old Mutual African Frontiers Fund manager, Old Mutual Investment Group

A vast and largely untapped region, Africa has, for many years, been heralded as the final frontier when it comes to economic and investment opportunities.

Key drivers such as its youthful demographics, increasing urbanisation, consumer demand and ongoing opportunity for technological innovation have buoyed expectations for its economic outlook.

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However, in recent years, the number of challenges facing the region have hindered investor sentiment. For the last four years, Africa has experienced strong headwinds driven by currency devaluations, which have blown away the positive earnings growth and dividends African companies have achieved over the past decade.

During this period, the MSCI Africa (excluding South Africa) benchmark has gone nowhere in dollar terms and even if you invested in some amazing businesses, the returns got smashed by currency movements.

What the last 10 years have taught us is that currencies matter. More than most think.

The currency moves in the largest four markets reflect challenging positive dollar returns. The Nigerian currency lost 88% of its value in 10 years and Egypt lost 85%. Over the same period, the South African rand declined 44%, and Morocco’s dirham is off around 20%.

The post-Covid sentiment on Africa has evolved to look very different to 10 years ago, with many investors turning to other regions, having underestimated Africa’s foreign exchange risks, which comprise both volatility and liquidity risk, as well as risk of repatriation.

But the tide is turning

However, currencies are now reflecting all the bad news. We therefore don’t expect currency exchange to dominate performance over the next two years.

For the short to medium term, we expect a stable currency exchange across Africa – and even the possibility of currency gains. This will allow returns to be driven by dividends, growth and rating change.

• Dividends have been consistently around 4% for the index. The Old Mutual Africa Frontiers Fund’s expected dividend is currently around 7%.
• Earnings growth expectations are expected to grow 21%.
• The rating change is trickier as currently the fund trades at around 5.7x price/earnings (PE). This compares to the index at 10x. Over the last few years, the fund’s PE has averaged around 7x, peaking at 11x and bottoming at 4.5x. Given that Africa is back in favour, we think that the PE can at least drift back toward the 7x. A move to the average PE will add 20% to performance.

Using this framework, our portfolio could deliver a return over 40%.

Chart 1

Source: Old Mutual Investment Group, Factset

Back in favour

However, for the rating (or PE) to improve, Africa needs to be back in favour. While African equity markets tend to lag developed markets by six to 12 months, fixed income investors respond to news and information instantly.

Fixed income investors keep a very close eye on macroeconomic and political developments; therefore, they are the best barometer of African sentiment.

In the first quarter of this year, newer eurobonds were issued than in the whole of 2023, with all of Kenya, Cote d’Ivoire and Benin having issued successfully. This suggests that portfolio investors are back.

Chart 2

Source: Bloomberg

Chart 3

Considering this confidence that the top-down arguments are pointing in the right direction, at a stock level, we are also feeling confident:

1. Around 50% of our portfolio is invested in banks – banks are benefitting from elevated interest rates at this time, and even when rates start rolling off, it will take some time for the loan book to reprice.
2. The telecommunications sector represents 13% of the portfolio. Africa is largely a pre-paid market, with people buying data or minutes each day, or each week. Therefore, most users don’t have unlimited contracts. Social media data usage continues to go up, which drives data revenue. And imagine how data-hungry AI will be. At the same time, mobile money continues to grow and develop in most markets.
3. The consumer staples sector has had a difficult period. The weaker exchange rates have put big pressure on raw materials and operating costs, such as fuel. While these high costs still have to work through the system, margins will normalise in the next 12 months.    

As a collective result of all of the above, we are the most confident about investing in Africa over the short- to medium-term that we have been since the start of the Covid-19 pandemic.

The top-down story (dominated by our view on currency stability) and the bottom-up opportunities we are seeing from the ground level, combined with fixed income investors giving Africa the heads up, are all pointing to favourable returns ahead.

With the Old Mutual African Equity Fund trading on a 6x PE, it is currently offering an expected dividend yield of 7%. It is an opportune time for investors to turn to Africa again in the pursuit of investment returns.

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