Nigerian Equities Could Rise, But Upside Is Capped
Nigerian equities are not especially exciting from a U.S. investor's perspective. NGE is a fund that enables U.S. investors to access the Nigerian equity market, but this market is nevertheless undeveloped. With only 20 holdings (little diversification), and with higher local "risk-free rates", and a necessarily larger equity risk premium, NGE is not easily able to grow into larger earnings-based valuations. Even if we price in longer-term earnings growth expectations, upside is probably capped even in a sanguine scenario (also assuming no FX risk). Nigeria's long-term economic prospects are quite exciting, but I would not recommend NGE to a public equity investor.
Global X MSCI Nigeria ETF (NYSEARCA: NGE) provides predominantly U.S. investors with the chance to gain direct access to the Nigerian equity market. Nigeria is an interesting market, as valuations are low, but there are reasons for this as we will briefly explore.
Since my last article covering NGE (in mid-March 2021), the fund has underperformed; the fund has risen by only 0.67% while the S&P 500 index increased by 6.62%. This was largely expected. I concluded:
With certain developed equity markets appearing undervalued, it makes little sense to invest in a far less developed equity market with no margin of safety.
Nigeria is less developed, but it is certainly “emerging”. Three- to five-year earnings growth is predicted by analysts (on a consensus basis; data provided by Morningstar) of 30.65% at the time of writing, and long-term demographics favor plenty of more growth. For instance, according to projections from The Lancet (see AAAS graphic below), Nigeria’s population is set to hit around 791 million by 2100, second only to India, and ahead of other countries including China, and the United States. If that’s the first time you learned of this, you are probably rather surprised (as I was).
While a growing population is not necessarily a guarantee of future prosperity, generally speaking it means that the country’s population is likely to remain younger on average versus other, more developed countries. Perhaps it would be inaccurate and misleading to call Nigeria the future China of Africa, but it is an exciting prospect.
Nevertheless, Nigeria’s markets have performed rather poorly. NGE is a straightforward instrument to invest in Nigeria, but the country’s equity market is undeveloped, just as the country is, and therefore you are only getting access to 20 holdings (at the time of writing).
As you can see, NGE shares almost look like some kind of leveraged instrument, or ETN suffering from roll yield drag. With a price history such as this, it helps to establish ‘where we are’, and we can make that assessment with some guesstimations of future earnings and equity risk premia.
As before, I revert to Morningstar, which provide a (forecast) forward price/earnings ratio of 5.31x. (This is based on operating earnings; note that the Nigerian corporate tax rate is 30%, and it would naturally include the effects of interest expenses and so forth.) If we divide 1 into 5.31, we find a forward earnings yield of 18.83%. This sounds high, and it is, but we have to compare this to local risk-free rates, and ensure that we have a handle on our cost of equity, which is going to be high for a riskier emerging market.
The local 10-year bond yield is currently 13.21%. According to Professor Damodaran, the recent equity market risk premium for mature markets such as the United States (e.g. the S&P 500 index, or Dow Jones) is 4.10% for June 1, 2021. With that ERP for June, we should make an adjustment for the risk involved, to find an appropriate ERP for Nigeria. Without paid-for data sources, I have found a Nigerian circa 10-year (maturing 2032) bond denominated in USD with some transactions in late 2020 valuing it at a premium over par (based on data from London Stock Exchange). The implied coupon against the price of $106.25 suggests a yield of about 7.4%, compared to the current 10-year U.S. bond yield of circa 1.6% (a spread of 5.8%).
Damodaran previously indicated an appropriate ERP spread of 5.33% in January 2021. If we look at relative equity and bond market volatility, and factors such as imperfect maturity date comparisons, etc., I think we are in the right ballpark. If we take 5.50%, and apply this to our mature market ERP of 4.10%, we find a Nigerian ERP of 9.60%. We must also add the local 10-year bond yield (“risk-free rate”) of 13.21% to find our cost of equity; in this case it comes to 22.81% (call it 22.80%). This means that we do not want to pay more than $4.39 for every $1.00 of Nigerian corporate earnings.
However, the 30.65% longer-term earnings rate predicted does enable us to price in a slightly higher valuation. If we took $1 of earnings, grew it by 30.65% over five years (for instance), we would land with $3.81 after five years. If we discount that back to present by 22.80% per year, it would be worth $1.36 today (i.e., the effect of longer-term earnings growth beating our current cost of equity). So, $3.81 divided by 22.80% is $16.71 capitalized in year five, and if we discount it back to today, it would be $5.98, which is slightly higher than Morningstar’s forward P/E of 5.31x (10-15% upside).
But, given our data is likely not taking into account all factors such as interest and taxes, and so on, this is really the best we can do in the medium term. I understand the long-term trajectory for Nigeria is constructive, but that does not make it exciting unless you have a 100-year investing horizon. The current equity market is undeveloped locally. So, while Nigeria might boom, even in the medium term, it is likely that private equity will benefit from this kind of boom, and/or exporters to (or other businesses growing off the back of) Nigeria’s economy. The public equity market on the other hand, does not look incredibly exciting, unfortunately.
Based on our simple workings above, I can really only see 10-15% upside in the medium term, in a somewhat sanguine scenario. This also assumes no FX risk, something I touched upon in my last article.
In my chart above, the blue box illustrates prices that represent up to 15% upside (at the top of the shaded box). As you can see, recent moves into this area have been met with supply, as sellers have hit these bids and sent the shares back down. I cannot see fair value being materially higher than these prices for the time being.
I also previously looked at the fair value of the Nigerian naira (currency) in terms of USD, and estimated a range of circa 230 to 260 naira to the U.S. dollar. This is not a liquid market, but the price is nevertheless presently 413, a “slight” uptick (>8%) in USD since my last article. What this means is that the naira is probably “undervalued”, but inverted commas are appropriate given that this is a far, far riskier currency to hold than the U.S. dollar; we would absolutely expect to see a risk premium built into the price. Longer term, as the economy develops, etc., we could see a slow reduction in the FX risk premium, but this is not something that will be easy to time.
In short, sure, I see some upside potential. But I don’t think NGE is going to attract large inflows any time soon. I believe it is appropriately priced, and I don’t think being long NGE is going to enable anybody to capture any material ‘alpha’ (outperformance) in the medium- to long-term. (As always though, I will be happy to revisit this, and possibly one day change my mind.)