Investing in Africa: What is the Right Approach?

story_images_south-african-mountain-roadAfrica presents a broad range of investment opportunities for a diverse set of investors. They can be accessed through direct investment in productive assets, such as infrastructure projects or through the use of financial market instruments. But while most foreign governments or sovereign funds are able to access these opportunities through direct investment, for investors such as pension funds without the size or capability to actively monitor such direct investments, Africa can be more challenging.

The alternative for plan sponsors is to use financial market instruments including listed equities, debt instruments and private equity. African listed equity markets and debt markets can be more easily accessed by investors globally via passive or active strategies in three ways: emerging market (EM) funds, frontier market (FM) funds or directly through a more niche Africa focused strategy.

The challenge with passive strategies is that they require liquid and investable benchmarks, as well as accessibility to reliable and frequent data. Unfortunately, in Africa you face liquidity constraints, a lack of suitable benchmarks and a general lack of reliable data. This makes the use of passive strategies difficult.

A quick look at a sample of Africa ex-South Africa Equity strategies, for example, will show the use of LIBOR + x% benchmarks, which is unusual as these cash benchmarks do not give a true reflection of the risk and return inherent in investing in listed African equity. The MSCI EFM Africa ex-SA Index has returned 25% on an annualized basis since the beginning of 2012, which compares favourably to the returns from cash over that period. However, it goes without saying that the return stream from African listed equities has been considerably more volatile. Based on a sample of 38 Africa Equity Funds it is also evident that there is a large dispersion in the returns. Over a one-year period, the performance across these funds ranges from a high of 43.7% to a low of -5.5%.  Over a three-year period, the annualized performance ranges from a high of 14% to a low of 2.6% (source: Bloomberg).

Many investors use emerging markets strategies to access Africa, but investors who want more exposure may find that this approach is limited because these strategies often contain only a small portion of African investments. By way of example, as at 30 June 2014, African listed equity constituted just 7.7% of the MSCI Emerging Markets Index, with 7.5% of this being exposure to South Africa alone.

Another popular way to access Africa is via frontier market funds but, again, the African exposure is predominantly to the more liquid Nigerian and Moroccan stocks. As at 30 June 2014 the MSCI Frontier Markets Index had exposure to only five African countries constituting 32.6% of the index. Of this 32.6% exposure, Nigeria alone accounted for 19.7%.

Because of the limitations in these approaches, we believe that in order to gain meaningful exposure to African investments one would have to invest in an African-focused strategy, although this is probably more niche.

Investing in Africa has its constraints, which include higher brokerage and market impact costs, complex cross-country custody issues, illiquid markets, lack of credit ratings for debt instruments and an ever-changing regulatory environment, amongst other things. However, the positives seem to outweigh the constraints.

Volatility for example is one of the great benefits of investing across the African continent, as it means outcomes are less certain than in more developed markets. The volatility results in dislocations between fair value of companies and the prices they trade at. The uncertainty may cause investors to shun a country, giving the more diligent and patient investors the chance to buy cheap assets.

Most investors in Africa also invest through the lens of liquidity and are biased towards the more liquid stocks with larger market capitalisations. This often results in the highly liquid stocks trading at a premium to their intrinsic value.  Further to this, the more illiquid stocks tend to be under-researched, which increases the likelihood of uncovering very compelling investments. Hence, investors should focus on analysing businesses and the industries in which they operate, to build a clear picture of the business value, rather than chasing liquidity.