Stock market fundamentals:Are Nigerian equities still undervalued?

2017.06.19

The stock market rev up had witnessed three bucks since the two months long rally. In this special report, Afrinvest West Africa, Nigeria’s leading investment house, has done a review and prospects of the market which we hereby present.

PRIOR to recent rally on the Bourse, most stocks quoted on the Nigerian stock exchange were trading at deep discount to analysts’ valuation as the major players (Pension Funds Administrators, Mutual Funds, and Insurance Firms etc.) held short-term views.   The re-entry of foreign players coupled with the ongoing positive sentiment in the economy presents a possibility for a year-long bull market. The NSE All Share Index price-to-earnings ratio stands at 14.2x, which is relatively cheaper compared to frontier and emerging market peers – South Africa FTSE/JSE (18.9x), MSCI FM index (15.0x) and BRICS (16.5x).

Moreover, company scorecards have remained resilient in recent times as companies exposed to the downside risk of macroeconomic headwinds were able to navigate the choppy terrain by leveraging on scale, non-core earnings growth strategy, operating cost optimization, local input sourcing, usage of deferred tax assets as well as individual proficiencies to stay profitable.

We remain optimistic on corporate earnings for 2017, forecasting Earnings Per Share (EPS) to grow 18.5% for companies within our coverage as we expect the recent improvement in foreign exchange (FX) liquidity – which has resulted in the appreciation of parallel market FX rate – to positively impact cost of sales for manufacturers, while improvement in fiscal revenue for the Sovereign and Sub-nationals is also positive for consumer spending and earnings growth. Nonetheless our general bullish view of the market, our assessment of different sectors differs as we highlight below:

Banking Sector:   

You will also enjoy reading:
Stockbrokers seek government’s understanding of market challenges

The Banking sector has benefitted the most from the bullish run, with the NSE Banking index Year-to-Date (YTD) return (at +42.4%) outperforming the benchmark. Valuation multiples have also improved – sector P/E and P/BV ratio have risen to 6.3x and 0.8x from 4.3x and 0.6x in January respectively. However, investors’ interest has largely been centered on Tier-1 lenders with P/E and P/BV for these banks at 7.1x and 0.8x respectively compared to average P/E and P/BV for Tier-2 lenders (ex-STANBIC) of 5.7x and 0.2x respectively.

Nonetheless, we note that most of the Tier-2 banks (DIAMOND, SKYE, FCMB, UBN and UNITY) are still recording below-trend level of fundamental returns (measured by ROE) whilst facing capital adequacy challenges. Hence, it will take more time for value to be unlocked in the stocks. This informs our preference for Tier-1 banks still trading below pre-crisis valuation multiples and recommend Tier-2 banks for investors with longer holding period.

Industrial Goods Sector:

The Industrial Goods sector has returned +25.1% YTD with sector P/E now at 12.9x. Cement companies – which dominate the sector index weighting – have largely driven the rally as challenges which had weighed on their earnings in FY:2016 (gas pipeline vandalism, aggressive price competition and high external leverage) have been largely surmounted with earnings now set to improve remarkably in FY:2017. The improvement in industry fundamental was reflected in Q1:2017 results of CCNN, WAPCO and DANGCEM but the short-term upsides to these stocks are limited following the recent rally.

Insurance Sector:

Despite weaknesses in Nigeria’s macroeconomic fundamentals in 2016, performance of the insurance sector was largely positive, albeit modest. The Insurance index has however underperformed the benchmark with current Year to Date return of 14.0% largely driven by gains in MANSARD. One of the factors dragging sentiment towards the sector is the renewed drive towards risk based supervision and capitalization rules via the shift to Solvency II and ORSA (Own Risk and Solvency Assessment) guidelines. Solvency II is a Risk Based Supervision (RBS) – similar to the BASEL II guidelines for Banks – which is expected to increase pressure on capital as it specifies how the capital requirement and resources are set, assessed and determined. Consequently, many insurers are in the process of raising additional capital with potential dilution of shareholders’ equity. Hence, we are neutral on the sector.

Consumer Goods Sector

Activities in the Consumer goods sector have been majorly hampered by the economic downturn which dragged revenue while lingering FX liquidity challenges pressured profitability. These factors weighed on sentiment towards stocks in this sector. However, the recent improvements in the general economic condition as well as increased FX supply is expected to boost performance of companies in the sector this year with market prices already reflecting this expectation. NESTLE and NIGERIAN BREWERIES have advanced 19.1% and 7.5% YTD. Likewise trading multiples – NESTLE (P/E: 79.9x) and NIGERIAN BREWRIES (P/E: 41.7x) – indicate that investors continue to place premiums on pricing of these stocks. Our top picks in the sector are NESTLE and NIGERIAN BREWERIES, based on the fact that foreign players have started to return to the market and “pre-FX crisis trading trend” suggests that these counters are investors’ choice picks in the sector.

Oil & Gas Sector:

The sector has come under a lot of pressure having been hit hard by militancy and liquidity challenges in the power sector which has constrained the performance of sector large-caps such as OANDO, SEPLAT and FORTE. Downstream companies which outperformed in 2016 have not enjoyed similar sentiment save for MOBIL which is a subject of an M&A transaction. Consequently, the sector is the weakest performer of all sector indices we track with a YTD return of 1.8%. However, we believe the sector should record improvements in subsequent quarters in terms of earnings and valuation, due to restoration of peace in the Niger Delta, reopening of the Forcados terminal which is the major export routes for upstream indigenous companies and efforts being channeled into solving the liquidity crisis in the power sector.

Risk Factors in the Horizon

The CBN’s approach towards the management of FX remains a downside risk to equity market performance as past and current developments indicate that sentiment towards equities have been anchored by FX liquidity. This is not surprising as investors are typically wary of participating in the equities market when the economy faces FX liquidity challenges or inconsistent management policies that do not provide an assurance for convenient repatriation of funds. The recent rally in domestic asset prices since the launch of the I&E FX window attests to the importance of a market determined FX rate and exchange regime. Thus, the CBN’s ability to maintain its stance of non-interference in the I&E window regardless of the direction in which the naira trends, is highly essential, as a breach on the CBN’s part will almost certainly retard participation by investors in the equities market.

However, the ability of the CBN to sustain its timely interventions which have significantly boosted FX liquidity in the economy remains susceptible to shocks in the global Oil market.

Shocks in the global oil market

The possibility of lower global oil prices and reduced production levels – that could come about through an OPEC quota limit extension to Nigeria or acts of sabotage – remain key points of concern as they could stymie oil export earnings which account for a major share of total foreign exchange earnings and consequently pressure the external reserves. Oil prices seem to have stabilized around the US$50.0/b mark post-extension of oil production cuts whilst production level is set to go back to peak level following lifting of Force Majeure on the Forcados Terminal. Going forward, we expect factor drivers of FX liquidity – domestic crude oil production, oil prices and CBN policies on FX – to affect sentiment in the equity market.

The Value of Technical Analysis

Although the Nigerian equities market has been largely shaped by macroeconomic and company fundamentals post-2009 financial market crisis, technical study of trends, momentum, volume and volatility have also dictated the direction of stocks especially when market is considered overbought or oversold. Whilst technical analysis suggests that investors begin to book profit as the Relative Strength Index (14D-RSI) hits the overbought threshold (70 points) and rebounds as RSI hits the oversold region (30 points), our study of trend shows that technical analysis between 2014 and 2016 – period of capital control and FX management inflexibility – has lagged the performance of NSE ASI given the more fundamental leading indicators that drove equities. We hold a strong view that technical indicators are beginning to lead the direction of the index since the launch of I&E FX window but trend is not evocative of support and resistant levels for the RSI yet as we have seen the market sustain a bullish run for days within the overbought territory.

We believe that the Nigerian Bourse is currently being driven by Fundamentals (improving macroeconomic condition, particularly regarding FX) and technical analysis may not be the best methodology in calling the future performance of the Nigerian Bourse in the near term, largely because the market is in transition as stocks begin to break previous resistance levels and try to attain new support and resistance levels.

Conclusion

Nigerian equities as a basket are currently the 2017 goldmine of the emerging and frontier markets following the improved flexibility in the administration of FX. The on-going repricing of the market suggests investors are playing “catch-up” with resilient company fundamentals, which market has lagged, having reduced the premium on macro risk. Whilst we noted in our 2017 Outlook that the equities market will rebound northward of 15.6% if the FX challenges are addressed, the current structure of FX administration and the response rate of the equities market reinforces our conviction that the market is set for a “year round bull run”.