‘How could they see anything but the shadows if they were never allowed to move their heads?’
Plato, The Allegory of the Cave
‘If I go crazy then will you still call me Superman?’
Lyrics to ‘Kryptonite’ by 3 Doors Down
‘… everyone tells a story with some addition of his knowing that his hearers like it.’
Aristotle, Poetics
‘I can’t count the number of times I’ve been in a meeting where all of the evidence is pointing towards a clear path when someone, usually someone in a senior position, offers up an anecdotal counter-example.”You want to quit smoking? Why? My grandfather smoked a pack a day and he lived till 92.” And that’s all it takes. The meeting is over. All the evidence in the world doesn’t matter anymore. This simple anecdote now has everyone ignoring the evidence and statistical distribution and focusing on the grandfather. The problem is stories don’t really encourage us to think. They make it easy to overlook evidence, fall prey to cognitive biases, and generally encourage bad decisions.’
Shane Parrish
Humans have told stories since the inception of communication. They’re inextricably linked to the evolution of humanity through their use as a means of transferring knowledge. Stories can be communicated via illustration, movement and voice. They help us to learn and understand language, culture, science, society, religion and by implication meaning. They fuel creativity as well as innovation and help us explain things we don’t understand.
Stories also create expectations. These expectations can become extremely powerful, especially if they’re linked to powerful concepts. Think about how stories fuel religion and how that links to society. Stories form the centre of our civilisation − without them there’d be no society, no science and no progress. Simply, they become part of our way of making sense of the world. This is also true in the investment world – we tend to latch onto stories to help us make sense of all the noise and uncertainty out there.
However, stories often also have a negative effect on the value of our investments. This article references Africa as an example of how stories fuel expectations, and drive up asset prices to extreme levels relative to their value. It also questions the narrative that Africa will turn out to be the investment destination superhero that saves the investment world’s long-term returns.
Africa was defined by the scramble for resources
During colonial times, Western powers viewed Africa primarily as a source of commodities in the form of labour and materials. At the Berlin Conference in 1884 and 1885, the major European powers divided Africa into arbitrary boundaries, throwing together different tribes − often enemies − and setting the context for future instability.
While various African countries gained their independence relatively shortly after this, they retained the colonial dominance of European languages such as English, French and Portuguese. At the same time, attention moved to the East and West, and Africa remained a dark continent in terms of investment. Capital inflows were limited largely to donations, infrastructure projects and commodity extraction.
Africa is currently a popular investment story
Now that the stories of the unlimited scope for growth in China and the ‘invulnerability’ of Western institutions − like AIG and Lehman Brothers − have faded, global interest has returned to the massively untapped African market.
As Chart 1 shows, Africa is an immense mass of land – the second largest continent on earth after Asia. It has a population of over one billion people – approximately one seventh of the world’s population. It also has one of the world’s richest sources of arable land and volumes of rare and valuable commodities. This reads like a superior investment opportunity, almost without limit. Many investors talk of the continent as the superhero that will push-start the locomotive of global growth.
In these times of low growth and even lower interest rates, most investors desperately want to believe this story and will invest in anything related to it as a result. This has a massive effect on their expectations, which fuels even more stories. But what is the reality?
Chart 1: The True Size of Africa
Source: http://flowingdata.com/2010/10/18/true-size-of-africa/
Table 1: A Sample of Strongly Entrenched Companies in Africa
Source: Thomson Reuters Datastream, Bloomberg, Company reports
We journeyed around Africa to make up our own minds
During the past 12 months, two of our analysts navigated through some of the rising African countries outside South Africa.
Our analysts set out to answer three questions:
1. What is the investment climate in those countries?
Tax regulations, legislation, politics, culture and tribalism are particular to each country and investors need to understand each country’s dynamics before attempting any investment. We also found financial reporting and governance standards in some countries to be poor. However, some African firms have excellent management and country-specific expertise or sites that make it difficult for foreign firms to compete in their territory. The companies in Table 1 show three such examples:
- Seed Company of Zimbabwe (Seedco) has significant intellectual property specific to the region’s environment, which took decades to develop. It would be very difficult for a competitor to come in and compete.
- Safaricom has built extensive telecommunication infrastructure over the years and has excellent management.
- Athi River Mining (ARM) Cement. Similar to South Africa, limestone deposits in Kenya are concentrated. More importantly, Uganda, Rwanda and Burundi don’t have significant limestone deposits, which make owning the only significant deposits in the region extremely valuable. However, as our sample of current versus historic multiples in Table 1 shows, the companies with quality characteristics are most often overvalued.
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’ 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$ 289 million stake in Dangote Cement, which is listed in Nigeria. In Table 2 we see 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.
Table 2: Implied Multiples in the Dangote Cement Deal
Source: Analyst calculations
Source: RE:CM , Thomson Reuters
The PIC alone represents more than US$ 117 billion and recent articles suggest it’s keen on further expanding its investments within Africa. One hopes they’re basing their 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 JSE daily trade of roughly US$ 1.8 billion to the Nigerian Exchange’s US$ 25 million and the Nairobi Securities Exchange’s US$ 8 million 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 US$ 71 billion (1,140 billion 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 five hundred Africa-focused funds. Combined they represent over US$ 87 billion 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.
As Chart 2 illustrates, ten years ago, investors were buying into the growth story of developed markets such as the UK and USA, which left South Africa and the rest of Africa very cheap. High profile firms all moved their primary listing and head office 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.
Chart 2: South African Stocks’ Price-to-book Ratio Relative to Total World Market Price-to-book Ratio
Source: Thomson Reuters Datastream
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.
