Executive Summary
How much should our Naira investments return?
When we talk with investors two concerns frequently come up. One is inflation: “How can our investments beat inflation?”. The other is Naira devaluation, not so much because of its direct impact (devaluations do not directly impact Naira investments) but because of the business disruption that devaluations cause.
In this report, we treat these two problems as essentially the same thing. It is the difference between US dollar inflation and Naira inflation that drives periodic Naira devaluations. Therefore, the first job of a Naira investment is not to beat inflation as such but to beat the difference between US dollar inflation and Naira inflation. This creates a return which, in the long run, is the equivalent of a zero return in US dollars.
Once an investment can do that, the next task is to provide a US dollar return, which is conveniently provided by Nigeria’s sovereign Eurobonds. Add the two rates together and we come to the following conclusion for Naira investors:
You should start by insisting on a 14.70% per annum risk-free return.
Do Nigerian T-bills return enough?
T-bills come remarkably close to delivering our desired risk-free return, at least over the long term. They only fall a little way short of it. And, to the satisfaction of inflation-focused investors, they beat inflation over the long term (though that is not the point, in our view).
Why do T-bills come so close to delivering a sovereign US dollar return? It may be the case that Nairabased investors have been able to access US dollar-denominated Nigerian sovereign Eurobonds for long enough that a close yield relationship has been established.
Or some other invisible hand may be at work. At any rate, the T-bill rates seen during the first half of 2020, like those in 2010, appear to be an aberration – very different from the long-term pattern.
What should the Nigerian equities return?
Nigerian equities have not been an inspiring story, and it is easy to show how poorly they have underperformed other equity indices around the world. All the same, it is worth digging into why this is so. Clearly, there must be a benchmark, in terms of profitability, which listed Nigerian companies fail to match (in general – there are always exceptions).
What is this benchmark? Following on from our desired 14.70% risk-free return, we add an equity risk premium (equities are risky) and come to the following conclusion:
The Return on Equity (RoE) of Nigerian companies should average at least 20.53% per annum, over time.
Do listed companies have 20.53% RoE?
For the most part, the major listed companies of the Nigerian Stock Exchange All-Share Index (NSE ASI) do not return what we consider an adequate – 20.53% – RoE. There are notable exceptions and several bank stocks deliver returns above this level, while other bank stocks are trending towards this level.
By contrast, many industrial companies have reported steeply declining returns over the past 10 years, disappointing a generation of investors in the Nigerian industry. If, 10 years ago, we had adopted the maxim ‘Invest in industrial companies with high RoEs’, we would have lost a sizeable part of our investment. Lack of growth destroyed RoEs and stock prices.
Stock price returns
Therefore, strong stock price performances have been like hen’s teeth over the long term. While in each year there are usually a few strong performances driven by corporate finance activity (takeovers, recapitalisations and the like), over the long term – and we chose the 10 years from 2010 to 2019 inclusive – stock performance has been hard to find.
And there is something sinister going on. We would expect a consistent 20.53% per annum RoE to be rewarded with roughly commensurate 20.53% stock price appreciation. But many companies with high shareholder returns have failed to deliver stock price returns of the same order.
This is because the market has been de-rating these stocks, over time paying lower and lower multiples for their earnings. We cite several bank stocks as examples.
This either means that Nigerian companies will continue to de-rate, or that a slew of Nigerian bank stocks are an outstanding value, assuming that the market will in future rate them as highly as they have been in the past. Given the post-2008 decline in bank ratings and the threat of FinTech to the sector, this assumption is open to challenge.
Nothing for it but to trade
All is not lost. Investors have enough faith in the earnings of several NSE-listed companies (not just banks but telecoms and some industrials) to buy them when economic recovery and rising future earnings are in prospect, and to sell them when prospects worsen. Buying those stocks with strong RoEs when their valuations are depressed is still a reasonable, and potentially money-making tactic. The current period is a good example.
So, we set out our stall. Understand the importance of receiving a 14.70% risk-free rate; look for equities to have a RoE of 20.53%; buy good stocks when their valuations are depressed. There is no guaranteed formula for making money: these are our guidelines.
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