Finding opportunities where others fear to tread 

By: Andrew Lapping, chief investment officer at Allan Gray

A few years ago investors were excited about investing in Africa outside of South Africa. People spoke of Africa Rising, the growing middle class, financial deepening and less reliance on commodities. Now the popular refrain from investors is, “How do I get my money out?” However, Allan Gray questions this mentality, believing there is value is to be found in Nigeria.

The time to buy a share is when earnings are low, those earnings are on a low multiple and the currency the asset is denominated in is weak. This situation usually arises when there are risks aplenty. Nigeria is a case in point: there are plenty of risks, but there is a point when the risks are fully discounted as is the case with many Nigerian companies. Consider:

  • Beta Glass, a Nigerian glass bottle business. In May 2015, a bid by GZI, a private equity company, valued the company at US$265m. Today it is valued on the Nigerian stock exchange at US$33m.
  • Nestlé Nigeria, a very well-run business and the blue chip of the Nigerian stock market. In December 2013, investors valued Nestlé at 40X historic earnings on expectations of growth for years to come. At that time Nestlé’s market capitalisation was US$6.2bn. Yet three years later, investors think Nestlé is worth just US$1.6bn, despite the investments the business has made in additional plant and machinery.

Focus on financials

Allan Gray’s primary area of interest in Nigeria is the financial sector, where sentiment is truly extreme. The price level and valuation are one measure of sentiment, the very low volumes traded are another, but the best indicator is the incredulous looks on people’s faces when you mention buying Nigerian banks.

Banks are an important part of any economy and tend to do better in good times rather than bad. The Nigerian banking sector is well developed and far more consolidated than ten years ago. The quality of lending and oversight is vastly improved from pre-2008 when margin lending seemed to be the core business.

Investors dislike Nigerian banks for several reasons. Until very recently it was not possible to get money out of Nigeria. When investors can’t get their money out, it is unlikely they will invest new money, regardless of the equity valuations. On the banks specifically, there is a mistrust of their balance sheets. Given the tough economic times and low oil price, Nigerian banks’ non-performing loans (NPLs) seem to be understated. Zenith, the largest Nigerian bank, discloses NPLs of only 3% and took a bad debt charge of just 1.5% last year. In comparison Stanbic IBTC, a subsidiary of Standard Bank and probably the most “trusted” bank, disclosed NPLs of 6.4% and took a bad debt charge of 5.6% in 2016. Despite this substantial charge Stanbic was comfortably profitable and trades on 7 times historic earnings.

Some of the issues are more self-inflicted, when dollar funding was readily available many banks made the mistake of taking dollar deposits and term lending these dollars. As the dollar shortage developed the banks had to pay back the dollar deposits but could not get the dollar term loans back, leading to an acute funding squeeze.

The investment case

There is clearly a lot not to like, so why do we own Nigerian banks? Clearly we think the businesses will survive. Consider Zenith, our largest position. Zenith’s total loans are only 3.3 times that of its equity. This is an extremely low ratio by global standards. In South Africa the ratio is closer to eight. The low advances-to-equity ratio means Zenith can take a huge bad debt charge and still have a substantial equity buffer. The large Nigerian banks are also very profitable, which allows for a wide margin of error.

A further positive is that the founders own around 9% of both Zenith and Access Bank, our two largest positions. When the founder owns a large percentage of a business they usually care more about long-term sustainability. Furthermore, the tough times in Nigeria are culling some of the weaker banks leading to a better, more consolidated industry.

Even without economic growth, the banks have plenty of growth potential. The Nigerian mortgage and retail lending market is practically non-existent and the vast majority of transactions are still cash rather than electronic. This will change as a biometric ID system is introduced. According to the World Bank, Nigerian bank loans equate to 23% of GDP, compared to 179% in South Africa and 45% in Kenya.

Zenith’s return on equity (ROE) has averaged 16.5% over the past ten years, which includes the recent down cycle and difficult 2009. We think the ROE will be similar in future, if this is the case, the bank will earn NGN3.63/share. Zenith pays out 50% of its earnings as dividends, indicating a dividend yield of 10% at the current price– an attractive prospect.

What investors are willing to pay for a unit of Zenith’s net asset value (NAV) has fallen from 1.4 to 0.75 despite Zenith consistently growing its NAV.

A reasonability check

The ten largest banks in Nigeria, which account for almost the entire sector, have a market capitalisation of US$6.5bn. Yes, some of these banks may be insolvent, but if they close down the deposits and customers will move to one of the other top 10 banks. These banks have value for a few reasons: they hold US$50bn in customer deposits; they have significant infrastructure and generated US$1.5bn in profits over the past 12 months. To me, US$6.5bn seems fairly cheap. In 2008, investors thought these ten banks were worth US$35bn when they were much smaller, inferior businesses.

For context, Capitec, a bank that offers low-cost transactional banking and microloans to the low- and middle-market segment in South Africa, is valued at US$7.5bn, 15% more than the entire Nigerian banking sector. Capitec generated US$240m in profits in the year to August 2016, only 16% of the profits of the top ten Nigerian banks. Either Capitec is somewhat expensive or Nigerian banks are very cheap. Will Capitec or the sum of the current largest 10 Nigerian banks be worth more in 2027?