kenya_equities ripe for a rebound

8/14/2019 Kenya_Equities Ripe for a Rebound

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KENYAFixed Income dominating, but weexpect a rebound in equities

East Africa (EA) has had a number of equity issuances in 2006 and 2007,

but there have been no equity issues in 2009 year to date (YTD). Rather

bond issues dominated the EA capital markets. The Nairobi Stock Exchange

(NSE) has three corporate bond issues YTD. Increased bond turnover

indicates augmented appetite for fixed income assets. Our key idea is:

Underweight fixed income: investors should avoid Kenyan fixed

income assets. Our main concern is the inflation rate in Kenya which

has been fairly high despite the global disinflation outlook and the

below potential GDP output; and

Overweight equities: investors should buy Kenyan equities. We

believe that between now and 1H10 the Kenyan equities will bottom

out. Domestic economic recovery uncertainty exacerbates the bear

trend, but in our view, the extent and duration of the downward trend

has matured.

Source: MoF Kenya, Legae Calculations

Africa

Peter Mushangwe

Zandisile Mabuya

+27 11 551 [email protected]

October 16, 2009

Fig 1: Our major fear for fixed income investors is the high inflation rate.

`

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Inflationremainnotorisoulyhigh...

Inflation

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...despiteanobviouspositiveoutputgap,RealGDPgrowth,%


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1.FixedIncomedominating,butnegativerealreturnswillpersistinourview

Bond issues have dominated capital raising activities in EA this year.

In Kenya, there was no IPO or rights issue. Bond issues raised

KES35bn (about US$470mn), which is more than 5X funds raised

through bond issues last year. In Uganda, no equity issuance took

place this year as well. Stanbic Bank raised UGX30bn through a bond

issue (about US$15mn) while PTA issued UGX40bn 7-year bond.

In Kenya, this year CFC Stanbic, KenGen and Safaricom had bond

issues of KES5bn, KES25bn and KES5bn respectively, at pricing that

provides less than 300bp above the 182-TB rate. Treasury bills

continue to be oversubscribed with the most recent 91-day TB issue

attracting a subscription rate of 145% at a weighted average rate of

7.28%.

The bond issues have broadly been well received, indicating strong

appetite from investors. We perceive two reasons why investors may

continue to buy Kenyan bonds and other fixed income instruments in

the short-term 1) the fear of Kenyan equities given the fact that the

past two years provide negative returns and have already lost 17.5%

YTD, and 2) potential currency bets by foreign investors.

The supply side could continue to strengthen. From an issuers

perspective, 1) locking in relatively cheaper cost of funds for a longer

period is most advantageous given the comparatively higher cost of

funds from banks and 2) equity issuances in such a weak market

would most likely leave some of current shareholders money on the

table.

Our view, however, is that the demand side will begin to weaken on

account of stronger negative real interest rates. Inflation rate in Kenya

has remained relatively high notwithstanding the deflationary outlook

of the world economy. Bond investors have endured negative real

interest rates since CY2003. The major difference, however, is that

real interest rates have worsened from -8.4% in CY2003 to -17.7% in

CY2008. Should interest rates go up (to improve real return), current

bondholders would incur capital losses.


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Page 3 of 15

Source: Kestrel Capital, Central Bank of Kenya, Legae Calculations

Fig 2 : Bond activity dominates the NSE

10,000

20,000

30,000

40,000

50,000

60,000

70,000

2007 2008 2009

Amountraisedthroughbondissuesmorethanquadrupledfromlastyear'sKES5.6bn

Bonds

Rights

IPO

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2007 2008 2009

Therehasbeen3bondissuesalreadythisyear,withnorightsissueorIPOIPOs

RightsIssues

BondIssues

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BondtradingnowdominatestheNSEBonds

Equities


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Page 4 of 15

2.Whywethinkinflationwillremainhigherrelativetopeers

In our view, conditions are in place for inflation to remain relatively high in

Kenya, particularly when compared to its peers i.e. regional and Sub Sahara

countries with fairly developed markets. Inflation may fall on base effect but

we expect it to remain high i.e. >6% and thus offering bondholders negative

real returns, particularly on an after tax basis. As the global economy

recover, the positive output gap for Kenya would close, building up more

inflationary pressures. A fall in unemployment rate would remove slack in the

labour markets and wage and demand pressures will build up in our opinion.

Below we specify the reasons that make us less optimistic on the inflation

outlook.

Strong money supply: Money supply grew aggressively in 2008,

peaking at 25% y-o-y. Early this year, the growth declined to 11%

before starting to pick up again to around 17% by mid-year. Growth in

Money supply as indicated by the M3 will rise from 4.2% in CY2000 to

12.8% that is expected this year. While this could have been

motivated by the need to stimulate the economy during the global

recession, the relationship between high money supply growth and

inflation rate is well documented.

Widening budget deficit: The budget deficit widened to its worst level

since CY2000, at 6% of GDP. In our view, the deficit could be cyclical,

but we remain concerned with the crowding out effect as government

borrowings in the local market increase notwithstanding the

improvements in domestic debt/GDP ratio that has reduced to 17.3%

from 20.4% in CY2000. Government expenditure continues to grow at

a higher rate (average 34% since CY2000) than revenues (average

18% over the same period).

The shilling is stable, but not strong: We avoid the fallacy of

forecasting the shilling exchange rate against the US$, but we note

that 1) high inflation rate expectations and 2) lower Treasury yields

would not lend support for a stronger shilling. A weaker shilling often

comes with higher inflation rates. Remittance and portfolio inflows

could pick up as the economy recovers, mitigating the downside risks

though.


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Page 5 of 15

The oil price is stable but not weak: While current oil price is stable,

it is not weak in our view. In 2005, oil price averaged US$52.6 with a

low of US$37.7. The current price is 38% higher than 2005s average.

Global economic recovery could result in higher oil prices than the

current, compounding inflationary fears.

Bank loans remain expensive: In our view, bank loans remain

expensive with lending rates around 17%. The higher costs of working

capital would feed through to higher prices.

Higher food inflation will persist: Droughts in the region often result

in stronger demand for food from neighbouring countries. Kenya itself

faces inadequate rainfall this year. Pockets of political tensions,

especially in the Western part of the country which is the bread basket

of Kenya, could negatively affect yields and output.

Source: Central Bank of Kenya, Bloomberg, Legae Calculations

Fig 3: Inflation remained high and rising oil prices aggravate the risk

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InflationremainhighdespiteareductioninmoneysupplyM3Growth

Inflation

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...andoilpricesaregainingtraction, whichcouldnegativelyaffectinflation


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Page 6 of 15

Source: MoF Kenya, Legae Calculations

Fig 4 : Real interest has been negative for a while, and local investors should at some pointshift to inflation protective assets

Fig 5: Expansionary monetary and fiscal policies are supportive of relatively higher inflationrates

3.5%5.0%

6.4%

8.4%

3.3% 2.2%

8.6%

1.1%

17.7%20.0%

15.0%

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Moneyillusion?RealinterestratehasbeennegativesinceCY2003

CPI

T.Brealinterestrate

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Monthlyrealinterestrateshavebeenlargelynegative

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2000 2001 2002 2003 2004 2005 2006 2007 2008

M3 growth:Moneysupplyhasbeenstrong,andcouldsupport

higherinflation amongotherreasons

7%

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2000 2001 2002 2003 2004 2005 2006 2007 2008

Budgetdeficitexpansioncouldbetechnical (cyclicaldeficit)duetothe

globalrecession, butitstillnegatively affectinflation


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Page 7 of 15

Source: Central Bank of Kenya, Legae Calculations

Fig 6: Bank loans remain costly, providing companies motivation to source cheaper fundsthrough bond issuances

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...butlendingratesremainfairlyhigh

Deposit

Lending

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91DayTBrateshavereduced,andremainedfairlylow...


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Page 8 of 15

3.Whywethinkequitieswillrebound.We do not see an immediate catalyst for a rebound as risk appetite will not

take a sharp upturn due to expected steady recovery of the global economy.

However, between now and 1H10 we see five major variables influencing

the rebound:

Money flow: Frittering volatility and uptake in risk appetite should

result in money flows into the Kenyan equities. Kenya is one of the

most important SSA Frontier markets alongside Nigeria. Anecdotally

information indicates that foreign participation on the buy-side which

has virtually dried up during 2008 has resumed to levels around

31.2% of total market turnover. Local investors who have become

stronger on the NSE currently under-own the market (see Fig 7).

Mean reversion process: With the Kenyan equities continuing to go

down to what we perceive as increasingly undervalued territory, some

mean reversion process should ultimately take place, and we expect

the process between now and 1H10. The Kenyan equities which lost

55.4% in CY2008 have shed off 17.5% YTD in local currency. The

MSCI Frontier has gained 21.2% YTD. The underperformance is

more pronounced if one takes into account the fact that Kenya is part

of the MSCI Frontier Index.

Possible improvements in the cost of equity (CoE) of Kenyan

equities: Risk has reduced as indicated by the slowing volatility. The

50-day standard deviation has reduced to 2005 levels which is around

10% (see Fig 12). The spread between the US Treasury and the SA

10Yr Govnt bond (which we used as a proxy) remain high though, but

better global liquidity and recovering macro-data should compress the

spread, positively moving the CoE. The average spread between

2005 and 2007 was 3.5% while currently the spread is 5.2%. Political

risks are still at unacceptable levels, but indications are that theGovernment of National Unity is holding up. As carried by various

media houses, the invitation of the ICC prosecutor to discuss and map

the way forward for the trial of key suspects of the 2007 violence is an

example. In our view, the three variables should lead to improvements

in the Kenyan CoE.


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Page 9 of 15

Equities should enjoy a stronger benefit from global economic

recovery than bonds: The global economy is expected to recover in

CY2010, with emerging markets lifting up global demand. Confidence

and PMIs have improved across most regions despite lacklustre

industrial performance in the developed world. Most of the Kenyan

companies derive their revenue from the local market, but trade

expansion and GDP growth will support endogenous growth factors

like employment and per capita incomes. By 2010, GDP growth rate is

expected to revert to 4%, (IMF forecast) and profit margins will expand

on economic improvement.

Attractive valuations: Comparing the current market PER to its

historical levels does not make much sense to us as we also admit

that in 2007 the NSE was overvalued. Comparing Kenya against other

EM shows that the NSEs PER is on the lower end (see Fig 10). Using

IMF forecast for GDP growth in 2010, we note that a number of

countries like Mauritius, South Africa, Argentina, Poland etc trade at

higher PER despite expected lower growth rate than Kenya. We are

unsure whether the difference could be explained by political risks

and/or liquidity risks, but in our view valuations are attractive

especially in light of the clear visibility of profitability (see Fig 11 and

Fig 13). An average dividend yield of 3.9% for the top 20 companies is

fair in our opinion.

Fig 7: Local investors now under-own Kenyan equities.

Source: Central Bank of Kenya, Legae Calculations

0

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NSEIndex

MoneySupply(M2)

In ourview,theKenyanmarketis

"underowned"by localinvestors.

ThewideninggapbetweentheM2

moneysupplyandtheNSEindex

supportsourview.


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Page 10 of 15

Source: Bloomberg, Legae Calculations

Fig 8 : Money flow should catalyse a rebound in 2010

Fig 9:CY2009 will be third consecutive year of negative returns on the NSE. Currently the NSEunderperforms the MSCI Frontier by 38.7pp

1500

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6500

3Jan05

3Jul05

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Fromitspeakof6125.28theNSE20haslost61.2%toitslowestof2379.86in2007.Atcurrent

levelstheNSEhaslost49.04%fromitspeak.

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Equityturnover isbelowitsaveragesinceJuly2004

NSEEquity turnover

Average

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2003 2004 2005 2006 2007 2008

theNSEsignificantlyunderperformed otherfrontier marketsin2007,investors couldhavestartedpricing in

risksearlierthaninothermarkets

Kenya

MSCIFrontier

Nigeria

35.7%

42.1%

3.6%

35.3%

17.5%

71.6%

10.8%

38.6%

55.4%

21.2%

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2005 2006 2007 2008 YTD

Localinvestorshaveenduredtwoconsecutiveyearsofnegative returns, andonlyastrong

performance wouldreversethetrendthisyear

Kenya MSCIFrontier


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Page 11 of 15

Source: Bloomberg, Kestrel Capital, IMF, Legae Calculations

Fig 10: Attractive risks-reward profile in our view

Nigeria

Egypt

KenyaTurkeyBrazil

PakistanMorocco,

PhilippinesMexico

Indonesia

Chile

India

PolandSlovenia

ArgentinaSouthAfrica

Mauritius

Venezuela

1.0

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P/Eratiosversus2010GDP growthforecasts.HorizontalaxisshowsP/Eratio

0 5 10 15 20 25 30

Venezuela

Pakistan

Turkey

Kenya

Brazil

Egypt

Mauritius

SouthAfrica

Morocco

Israel

Chile

Philippines

Indonesia

Argentina

Mexico

Slovenia

India

Poland

The higherdividendyieldand lowerP/Eratioprovidesanattractiveriskreturnprofile

Div.Yield

PER


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Page 13 of 15

Source: Bloomberg, Legae Calculations

Fig 12: Falling volatility provides room for improvement of the CoE.

Spread against US Treasury still high, and compression will improvevaluations as well.

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NSE 20VolatilityhasreducedHistVol(100D)

HistVol(50D)

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Thereisroomfor thespreadtocompress. CoEwouldbenefitfromspreadcompression


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Page 14 of 15

Source: Kestrel Capital as at cob 12.10.09

Fig 13: Top 20 companies by market capitalisation

Company Sector Year End

Market

Cap,US$mn

Price

KES YTD PER Div.Yield PBV ROESafricom Telecom March 1971 3.7 2.8% 14 2.7% 2.9 20.6%EA Breweries Brewery June 1432 136 -5.6% 14.2 5.9% 5.2 36.6%Barclays Bank Banking December 809 45 -11.4% 10.6 4.5% 2.8 26.3%Bamburi Cement Cement December 754 156 -5.5% 12.5 2.4% 3.3 26.4%Equity Bank Banking December 661 13 -23.9% 14 2.3% 2.4 16.8%KCB Bank Banking December 582 20 -16.2% 10.5 5.1% 2.1 19.6%Standard Chartered Banking December 511 141 -11.9% 9.6 7.1% 3 31.6%Co-operative Bank Banking December 409 8.45 -20.3% 11.9 1.2% 2.1 17.6%KenGen Power June 322 11 -30.6% 4.5 8.2% 0.4 8.0%BAT Kenya Tobacco December 234 176 34.4% 9.9 9.7% 3.9 39.3%Nation Media Media December 226 119 -17.4% 13.2 4.6% 3.9 29.7%CFC Stanbic Banking December 193 53 -11.7% 19.3 0.5% 0.8 4.1%Diamond Bank Banking December 152 70 2.2% 10.6 2.0% 1.8 17.4%Mumias Sugar Sugar June 135 6.65 -1.5% 6.3 6.0% 1 16.0%

NIC Bank Banking December 134 31 -29.3% 9.1 2.1% 1.7 18.6%Kenya Airways Airline March 132 21.5 -24.6% N/M 4.7% 0.6 -23.8%Kenya Power & Lighting Power June 131 124 -8.8% 4.3 4.0% 0.4 9.0%Athi River Mining Cement December 122 93 2.2% 18.5 1.3% 3.5 18.8%KenelKobil Oil December 97 50 -25.0% 31.4 12.1% 0.8 2.4%EA Portland Cement Cement June 96 80 0.6% 3.9 1.6% 1.2 30.0%


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P.O Box 87277, Houghton 2041, Johannesburg, South Africa

Tel +27 11 715 3700, Fax +27 11 715 3701

Web: www.legae.co.za email:

[email protected]

Analyst Certification and DisclaimerI/we the author (s) hereby certify that the views as expressed in this document are

an accurate refection of my/our personal views on the stock or sector as covered

and reported on by my self/each of us herein. I/we furthermore certify that no part

of my/our compensation was, is or will be related, directly or indirectly, to the

specific recommendations or views as expressed in this document

This report has been issued by Legae Securities (Pty) Limited. It may not be

reproduced or further distributed or published, in whole or in part, for any

purposes. Legae Securities (Pty) Ltd has based this document on information

obtained from sources it believes to be reliable but which it has not

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representation or warranty and accepts no responsibility or liability as to its

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kenya_equities ripe for a rebound

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