Inefficiency Can Make You Rich: The Case of African Stock Markets

Most fund managers would have you believe that they possess the skill to consistently outperform the market.

This makes sense, right? Otherwise, why would you pay for their services? The problem is that most fund managers come about as close to consistently outperforming the market as my scrawny self would come to consistently pummeling UFC middleweight champ, Anderson Silva. In other words, their track record — as a group — is pretty poor. Actually, let me not sugar-coat it. It’s abysmal.

Most fund managers would have you believe that they possess the skill to consistently outperform the market.

This makes sense, right? Otherwise, why would you pay for their services?

The problem is that most fund managers come about as close to consistently outperforming the market as my scrawny self would come to consistently pummeling UFC middleweight champ, Anderson Silva. (But don’t get too comfortable, Silva!)

In other words, their track record — as a group — is pretty poor. Actually, let me not sugar-coat it. It’s abysmal.

Take a look at this study if you don’t believe me. The authors looked at the recent performance of 2,076 actively-managed domestic equity mutual funds and found that only 0.6% of them bested the market after adjusting for luck, commissions, and management fees. That’s so small as to be statistically insignificant.

Why is their performance so terrible?

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Well, one reason is because U.S. stock markets are very efficient. This means share prices react to new information in a flash. When a US company’s prospects change for the better or worse, the company’s share price reflects the impact of this change very quickly – sometimes within minutes.

The aggregate opinions of hundreds of thousands of financial analysts ensure that stock prices rarely stray far from intrinsic value. Thus it’s very difficult for one manager to gain an analytical advantage that would allow him/her to consistently outperform the market – especially after adding management fees and sales loads to the equation.

So, with low-cost ETFs and index funds available, there’s very little reason to invest in actively-managed US mutual funds.

African markets, on the other hand, are much less efficient. Relatively few analysts cover the continent, and those that do tend to look only at the largest, most liquid stocks. This means that many African companies remain virtually undiscovered outside of their home countries.

Therefore, when a company releases news that could alter the intrinsic value of its shares (e.g. a dividend increase, earnings forecast, or new business development), African markets tend to react much more slowly to the changed circumstances. An informed and skilled fund manager can spot these mispricings with comparatively little effort. The challenge after spotting them is to be patient and wait for the rest of the market to catch on to the opportunity.

Consider this. As of the end of 2011, the MSCI Frontier Market ex-GCC Index, which includes seven fast-growing African markets, sported a trailing Price/Earnings Ratio of 8.5. The S&P 500 Index’s trailing PE stood at 12.3.

I think it’s pretty safe to assume that this disparity reflects a familiarity bias toward the US and not an accurate measure of the added risk and trading friction associated with frontier investing.

Still skeptical? Check out the recent performance of two fund manager friends of mine.

Larry Speidell scours African stock markets for hidden gems for his Frontier Market Select Fund. Since its inception in October 2006, this fund has returned 65.4% net of fees. The S&P 500 returned just 5.4% over that same time frame and did so with much greater volatility.

Sean Riskowitz is an expert at spotting inefficiencies on the Johannesburg Stock Exchange. His Riskowitz Value Fund netted an eye-popping 68.7% last year (its first year of operation) while the Johannesburg All Share Index dropped 16.1% in US dollar terms and the S&P 500 barely broke even.

Performance like this may merely be anecdotal evidence, but, in my view, it supports the notion of inefficient African markets. Do you agree? Let us know in the comments.

Related Reading

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3 thoughts on “Inefficiency Can Make You Rich: The Case of African Stock Markets”

  1. While this is true, it is also true that such markets can hide adverse information about a company that will later the affect the stock price. In such markets, companies don’t release quaterly results. This means that you may be using information as old as 11 months to value a company’s share price.

    What you highlighted, works in both ways. You have to be mindful of that.

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