David Stevenson: Out of Africa

Wednesday 4 February, 2009

The carnage of the last year has been especially brutal on frontier markets and particularly Africa. One of the most successful African funds – New Star Heart of Africa managed by the excellent Jamie Allsop – has had to suspend trading as its managers have struggled to maintain liquidity in face of a flight from perceived risky assets.

I sense that this may all have got a little out of hand – Africa is undoubtedly risky and why should you buy a frontier blue chip when you can blue chips in the developed world for less than 7 times earnings and still get a safe yield of 7 per cent or more per annum? But a recent report from the London listed Africa Opportunity Fund added some useful perspective – some assets have been massively oversold even relative to their developed world, with fixed income securities collapsing in value.

First off some headline figures from AOF – the funds net asset value fell 34 per cent during the fourth quarter of 2008, from $0.79 to $0.52, bringing the year to date 2008 return to -42.5 per cent, ”completing one of the most difficult years in investing history” according to the managers.

”To provide perspective, in US Dollars, in 2008 the S&P 500 declined 39 per cent, Russia declined , 73 per cent, Brazil declined 55 per cent, China declined 60 per cent, and India declined 62 per cent. Africa experienced similar declines. The S&P South Africa 40 Index declined 50 per cent, South Africa declined 46 per cent, Nigeria declined 54 per cent, Kenya declined 47 per cent, and Egypt declined 56 per cent.”

But the really interesting bit is what’s been sold off. Here’s the AOF managers report back on the carnage.... ”A key disappointment in 2008 was the inability of the fixed income portfolio to preserve capital value during the market declines. The fourth quarter brought steep price declines in this portfolio. We believe the current prices represent an extreme level of pessimism. To illustrate by way of example, our Katanga Mining bonds have a YTM of 37 per cent, our Africa Offshore bonds have a YTM of 60 per cent, and our Ivory Coast bonds have a YTM of 85 per cent. The African Offshore bonds are particularly compelling, priced at 22 per cent of par even though we were repaid 20 per cent of the principal value of the bonds early at 108 per cent of par value in September.

Overall, the fixed income portfolio represents 42 per cent of net assets and the equity portfolio represents 53 per cent of net assets. The fixed income portfolio is valued at a 50 per cent discount to par value and has a 21 per cent current yield. The equity portfolio is comprised primarily of companies with a single digit PE and double digit dividend yield.

The portfolio overall is generating approximately a 16 per cent cash yield..... We are focused on investing in companies with minimal debt and little need to access the capital markets, with a particular emphasis on goods and services in short supply in Africa. Market leading, cash generative businesses are trading at historically low valuations, and where we can find companies offering a single digit PE, significant free cash flow, and a secure market position, we will look to deploy capital”.

Sadly I don’t see AOF’s pains – or that of New Star for that matter – easing any time soon. The market is only just beginning to rediscover the virtues of some of its more familiar developed world blue chip assets, so attention won’t be turning to Africa for at least another six to twelve months. Crucially I see sentiment continuing to turn negative – worries about falling commodity prices will feed back into panics about sovereign debt which will in turn be fed by continued hedge fund selling of risky assets to pay for accelerated redemptions.

But for the patient, long term investor I’d suggest that we may be fast approaching the time when we’ve got to take seriously AOF’s argument that these assets are hugely undervalued and that Africa’s conservative financial basis is being completely undervalued by the market.

David Stevenson is also one of the Four Wise Monkeys at the online TV investment programme www.4wm.co.uk

adventurous@ft.com