Does Britam Kenya Still Have Room to Run?

British American Investments Company – Kenya (BRITAM) has made investors very happy of late. The stock is among the Nairobi Securities Exchange’s best performers this year, posting a dazzling 94.7% return.

Now the shares trade a shade below 2.5x their book value. Is that too rich a price? Or is there upside left here?

Let’s take a look at earnings (and Kenya’s long-term bond rate) to give us a clearer picture.

British American Investments Company – Kenya (BRITAM) has made investors very happy this year. The stock is among the Nairobi Securities Exchange’s best performers, posting a dazzling 94.7% return.

Now the shares trade a shade below 2.5x their book value. Is that too rich a price? Or is there some upside left?

In order to answer that question let’s begin by taking a closer look at the business and how it makes money.

Insuring East Africa

While it does operate a small asset management business, Britam Kenya is, first and foremost, an insurance company. It sells everything from life insurance to fire, marine, and medical policies. Kenya is its primary market, but it also operates in Uganda, South Sudan, Rwanda, and Malawi. Over the past five years, the company has grown its net premium revenue at a 22.7% clip.

Like all insurance companies, it invests the cash that it receives from customers until it needs to pay it out in the form of claims or other expenses. This investment capital is known as float, and it’s where the real magic happens.

Britam invests its float in a combination of real estate, government securities, and stocks. It also owns a 21% stake in Housing Finance Company of Kenya (HFCK).

When these investments perform well, Britam becomes the virtual equivalent of a cash machine. Such has been the case over the past 12 months. After accounting for the change in fair value of all the company’s property and equity investments, the company generated comprehensive income of Ksh3.48 per share. That’s a 30.1% increase over the prior 12-month period.

Value Check on Britam Kenya

One way that I quickly assess the value of a stock is to imagine that the underlying company suddenly stops growing. Forever.

Britam Kenya: Room to Run?
Photo by Wayan Vota

What’s the most that I would be willing to pay for a stock if it continued to generate the same level of earnings per share in perpetuity?

In such a case, the stock’s earnings can be viewed very much like the interest payment on a long-term bond.

The stock’s earnings should “yield” as much as a long-term bond would. Otherwise, there’d be no point for me to buy the stock. Thus, the prevailing long-term bond rate is my required rate of return.

To illustrate, let’s assume that Britam’s growth stagnates. Year after year for the foreseeable future, it averages comprehensive income of Ksh3.48 per share.

To find out how much such performance would be worth, we can simply divide the annual earnings (Ksh3.48 per share) by Kenya’s 10-year bond rate, which currently hovers around 12%.

If we do so, we arrive at a value of Ksh29.00 per share.

Kshs3.48 / 0.12 = Ksh29.00

So, in the event that Britam’s earnings froze at current levels, investors who buy at a price of Ksh29.00 per share would realize a 12% annual return.

Priced for Stagnation

How does this calculated value compare to the current price of the shares on the Nairobi Securities Exchange?

Well, as of this writing, you can buy Britam for Ksh29.50 per stub. Interesting, huh? So, essentially, Britam is priced for zero earnings growth in perpetuity.

I’ll gladly take that bet.

Even if the company’s earnings were exceptionally high over the past 12 months, I’m guessing Britam, with its steadily rising premium income and a large investment portfolio (which it could simply invest at a 12% rate of return if it chose to), will find ways to grow earnings over the long-term.

Thus, for patient investors, the shares appear to offer value — even after nearly doubling in price over the past ten months.

What Do You Think?

I’d love to hear your thoughts on Britam Kenya. Am I too enthusiastic about its prospects? Or do you agree that it looks like a bargain? Share your take in the comments!

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Here’s Why Co-operative Bank of Kenya Stock Popped 12%

When Co-operative Bank of Kenya (COOP) announced last week that they were hiring global consulting firm, McKinsey & Company, for advice on improving operational efficiency, investors took notice. The stock has jumped 12.4% since the news appeared.

So why are investors so excited? How much scope does COOP have to streamline its operations? And how might such restructuring impact the bottom line?

When Co-operative Bank of Kenya (COOP) announced last week that they were hiring global consulting firm, McKinsey & Company, for advice on improving operational efficiency, investors took notice. The stock has jumped 12.4% since the news appeared.

So why are investors so excited? How much scope does COOP — Kenya’s fifth-largest bank in terms of market capitalization — have to streamline its operations? And how might such restructuring impact the bottom line?

First, it’s important to note that COOP isn’t the only Kenyan bank to call in “The Firm.” Less than a month ago, Equity Bank (EQTY) also revealed that it had asked McKinsey to advise it on strategy. And, in 2011, KCB Bank Group (KCB) brought them in to assist with a restructuring that eventually slashed the bank’s management payroll by 42%.

Quite simply, McKinsey is very good at what it does, and its growing roster of blue chip clients in East Africa is testament to this.

To get a sense of what they might be able to do for COOP, let’s take a look at how well Kenyan banks presently manage the cost of doing business.

The chart below shows each Kenyan bank’s cost-to-income ratio over the first six months of 2014. We calculate the cost-to-income ratio by dividing total operating expenses by total operating income.

Kenya’s Most Efficient Listed Banks

[table id=198 /]

Judging from the data above, it would seem that McKinsey’s consultants have lots of fat to trim at COOP.

The bank keeps less than 42 shillings as pre-tax income for every 100 shillings it generates in the form of net interest income and fees. Meanwhile, the lean, mean banking machine that is I&M Holdings (IMH) keeps nearly 61 shillings for each 100 shillings of operating income.

If COOP could cut its cost-to-income ratio to 50% (a level that remains well above its most efficient peers), it would result in a 20.1% boost to pre-tax profit. That’s nothing to sneeze at.

Co-operative Bank of Kenya
Photo by Meaduva

But how realistic is it to expect such a reduction in expenses?

Salary Costs at Kenyan Banks

Well, for most banks, the biggest cost of doing business (apart from interest expense) is staff compensation. Thus, this is what McKinsey will likely try to slash first.

The table below compares the proportion of operating income that each Kenyan bank spends on staff salaries and compensation.

[table id=199 /]

As you can see, COOP’s wage bill isn’t nearly as bloated as that of National Bank of Kenya (NBK), but it’s not exactly svelte either.  The leanest banks on the list reap more than five shillings of operating income for every one shilling they pay out in the form of salaries. COOP gets just four shillings.

Look for this gap to narrow over the next year or two. If McKinsey can help COOP bring staff costs down to 20% of operating income, downsizing alone could boost pre-tax earnings by nearly 12%.

This will doubtless mean hardship for some of Cooperative Bank of Kenya’s 4,177 employees, but it will also give the bank more flexibility to lower its lending rates, putting growth capital within reach of more Kenyan households and businesses.

What Do You Think?

Did it surprise you that Co-operative Bank of Kenya ranks as one of Kenya’s least efficient banks? COOP shares now trade at a price-to-book ratio of 2.7. Considering the potential impact of cost-cutting, does the stock look like a good buy to you at today’s prices? Let’s hear your thoughts in the comments.

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10 Unloved Kenyan Stocks That History Bets Will Beat the Market

Ah, the humble price/earnings ratio.

It’s one of the crudest tools in an investor’s toolbox. But there’s no denying that the simple act of dividing a company’s share price by its earnings consistently reveals stocks poised for powerful performance.

Here we examine the recent performance of low P/E stocks on the Nairobi Securities Exchange and list 10 Kenyan shares with the lowest earnings multiples.

Ah, the humble price/earnings ratio.

It’s one of the crudest tools in an investor’s toolbox. But there’s no denying that the simple act of dividing a company’s share price by its earnings consistently reveals stocks poised for powerful performance.

Consider this.

If, at the start of each year, you invested equal amounts in the US stocks with the best P/E ratios (the lowest 20% of the market), your total return since January 1, 1999 would be 1881% — a gain of just over 21% per year.

The S&P 500 index’s annualized return over the same time period was just 3%.

That’s a huge difference. It’s a difference that could quickly transform a nest egg into a small fortune.

Low P/E Shares and the NSE

To test whether a similar dynamic is at play on the Nairobi Stock Exchange, I assembled mock portfolios comprised of the ten Kenyan shares with the lowest P/E ratios as of the beginning of August of each year, stretching back to August 2007. I then calculated the share price performance for each of these seven portfolios over the following 12 months.

Here’s what I discovered:

  • The low P/E portfolios posted an average annual return of 14.9%. The benchmark NSE-20 Index’s average rate of return was only 1.8%.
  • The low P/E portfolios outperformed the NSE-20 Index in five out of the seven years.
  • The majority of shares included in the low P/E portfolios (54%) outperformed the index.

The table below shows how the portfolio stacked up against the index each year.

[table id=194 /]

Why Does This Work?
Kenyan shares on sale
Photo by Simon Greig

Low P/E stocks are typically companies that investors love to hate. They typically aren’t growing very quickly. They rarely make exciting products. Whenever they make the headlines, the news is usually mediocre at best.

But there’s a  nice feature of ugly stocks like these — low expectations. When they fail, nobody is terribly surprised. Therefore, their share prices don’t often fall through the floor. Bad news was already priced in.

The slightest improvement in business outlook, however, can send them soaring.

High P/E stocks reflect investors’ (often unrealistic) hopes and dreams. They are priced for perfection, and when these stocks inevitably report less than perfect earnings, the share price has a very long way to fall.

Low P/E Kenyan Shares

So, which Kenyan stocks are currently so out of favor with investors that their P/E ratios rank among the lowest ten on the market?

Here’s the list with P/E ratios calculated as of August 8, 2014 by Kestrel Capital.

[table id=193 /]

What to Do Next

You may not want to replicate my little experiment in your “real money” portfolio, but screening for low P/E ratios is an excellent way to identify reasonably priced candidates for in depth research and analysis. If the company’s earnings look like they’re not only sustainable but likely to grow, then there’s a good chance you’ve uncovered a market-beater.

What Do You Think?

Do you think these 10 stocks will beat the market over the next 12 months? What criteria do you use when selecting shares? Let’s hear your thoughts in the comments!

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Is the NSE IPO a Bargain?

The long-awaited Nairobi Securities Exchange IPO is finally here. The Kenyan stock market is offering the public a 34% stake in the business to raise cash for expansion and to reduce mortgage debt.

The IPO price has been set at Kshs9.50 per share. Is this a bargain opportunity for Kenya investors? Let’s take a quick look at the prospectus to find out.

The long-awaited Nairobi Securities Exchange IPO is finally here.

A 34% stake in the business is now on offer to the public as the Kenyan stock market looks to raise cash for expansion and to reduce mortgage debt.

The IPO price has been set at Kshs9.50 per share.

Is this a bargain opportunity for Kenya investors?

Let’s take a quick look at the prospectus to find out.

How Does the NSE Make Money?

We’ll start by gaining an understanding of how exactly the NSE makes money. Page 84 of the IPO prospectus breaks it down nicely.

NSE IPO operating income

The table in the middle of the page shows that transaction levies are the NSE’s primary source of operating income. In 2013, these levies amounted to more than Kshs405 million.

Transaction levies are fees charged on share trades. Currently, this levy is fixed at a rate of 0.24% of total trade value.

So, if you bought 10,000 shillings worth of Safaricom shares, the NSE would collect 12 shillings from you plus another 12 shillings from the seller for a total of 24 shillings.

Kshs10,000.00 x 0.0024 = Kshs24.00

Thus, the NSE makes money from each shilling’s worth of shares traded.

In the same table, we also see that the NSE collects annual listing fees. These are fees charged to each company that lists its shares for trade on the market.

Note that this income has been relatively stagnant over the past five years. This is because only a few new companies have joined the exchange during this time frame and some others have exited for one reason or another.

Page 85 of the prospectus shows some other sources of income. These range from interest on investments to rental income.

How Much Money Does the NSE Make?

Now that we have a bit of an idea how the NSE makes money, let’s try to figure out how much it earned from recurring sources in 2013. We want to derive a baseline earnings figure – one that we can be confident that the NSE will collect year after year even if the business stops growing.

The income statement on page 80 of the prospectus indicates that the NSE earned Kshs379,341,000 before taxes in 2013.

NSE IPO pre-tax income

We need to adjust this figure to account for income and expenses that aren’t likely to occur again next year.

Further up the income statement, we see that the NSE reported Kshs115,574,000 from the recovery of doubtful debts in 2013. That’s great for the NSE, but it’s probably not going to happen again next year. So, let’s subtract it from pre-tax earnings. We’re left with adjusted pre-tax earnings of Kshs263,767,000.

Kshs379,341,000 – Kshs115,574,000 = Kshs263,767,000

Now, let’s go back to page 85 to see if any of the income reported there looks like it’s unlikely to be repeated.

The only doubtful income stream I see is the “Market Access Fee” of Kshs40,000,000. It suddenly appeared in 2013, and I don’t know what it is. To be safe, let’s subtract it from our total.

After removing the market access fee, we’re left with adjusted pre-tax earnings of Kshs223,767,000.

Now, we must account for taxes. Kenya’s corporate tax rate presently stands at 30%. After applying this to the pre-tax amount, we are left with net income of Kshs156,637,000.

Kshs223,767,000 x 70% = Kshs156,636,900

How much is this per share?

The prospectus tells us on page 19 that the NSE’s total share count will be 194,625,000 at the conclusion of the IPO, assuming that the offer is fully subscribed.

Divide our adjusted net income by this figure, and we’re left with earnings per share of Ksh0.80.

Kshs156,637,000 / 194,625,000 = Ksh0.80

This EPS is the amount of income we can reasonably assume the NSE will collect year after year even if its growth stagnates.

So, on a normalized basis, the NSE IPO is set at a Price/Earnings ratio of 11.8.

Kshs9.50 / Ksh0.80 = 11.8

How Fast Will the NSE Grow?

This is where things get tricky.

We want to make a good guess as to how quickly the NSE will grow its earnings in order to determine whether Kshs9.50 is a fair share price.

If the NSE’s earnings stagnate right now, we’d receive an adjusted earnings yield of 8.4%.

Ksh0.80 / Kshs9.50 = 0.084

That’s not great – especially when Kenyan bond yields are hovering around 11%.

So, we’ll need the NSE to grow earnings to make the IPO worthwhile.

Over the past four years, the NSE grew its adjusted earnings at a yearly pace of 113%. That’s an exceptionally rapid rate, and it’s not likely to be sustainable much longer.

What might be a more reasonable expectation of earnings growth over the next five years?

One way to moderate our forecast is to consider growth in operating income instead of net income. Operating income tends to be less volatile than net income, and, therefore less likely to be skewed by abnormal events.

If we return to the income statement on page 80, we can see that operating income rose from Kshs164,387,000 in 2009 to Kshs488,766,000 in 2013.

Plug these figures into this calculator, and we find that the NSE’s operating income rose at a rate of 31.31% over the past four years.

Is this a sustainable earnings growth rate over the next five years? It may be considering that trade volumes are reportedly up 37% through the first half of 2014.

But let’s be extra conservative and assume that a reasonable earnings growth rate over the next five years is the nice round figure of 20%.

Is the NSE IPO a Bargain?

If the NSE’s adjusted earnings per share grew at an average rate of 20% over the next five years, they would equal Kshs1.99 in July 2019.

Ksh0.80 x 1.20 ^ 5 = Kshs1.99

Let’s conservatively assume that the market will value the shares at a P/E ratio of 10 at that time. This seems reasonable considering the NSE’s growth rate and the fact that shares of the Johannesburg Stock Exchange presently trade at a P/E of 16.

A P/E ratio of 10 gives the shares a value of Ksh19.90 in 2019.

Kshs1.99 x 10 = Kshs19.90

So that means they will have more than doubled in value from their Kshs9.50 IPO price. Not bad!

Plus, we mustn’t forget dividends!

According to page 19 of the prospectus, the NSE paid out a dividend of Kshs49,000,000 in 2013. This is equivalent to Ksh0.25 per share after the IPO is complete.

If we conservatively assume that the IPO will pay a dividend of Ksh0.25 per year for the next five years, holders of the stock will collect total dividends of Kshs1.25.

Now, let’s put it all together.

If NSE shares are priced at Kshs19.90 in 2019, and the company pays out a total of Kshs1.25 in dividends over the next five years, then investors will reap a total return of 122.6% – an annualized return of 17.4%.

(Kshs19.90 + Kshs1.25) / Kshs9.50 = 122.6%

122.6 ^ 1/5 – 1 = 17.4%

Is 17.4% a decent annual return? I believe it is, and, therefore I think the NSE IPO is one that Kenya investors can feel good about.

What Do You Think?

Now, it’s your turn. Have I been too optimistic or pessimistic in my assumptions? Are there other factors to consider when investing in IPOs? Let’s hear your thoughts in the comments.

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Will Kenyan Bank Stocks Sizzle or Fizzle in 2014?

Bank stocks made Nairobi Stock Exchange investors much richer in 2013.

A stable political environment, regional growth, good profits, and a relatively steady interest rate environment kept the bulls running.

But all of that’s in the rear view mirror. What we really want to know is whether these stocks are worth banking on this year. Will their shares pop or drop? Sizzle or fizzle? Jump or slump? Rise or… Well, you get the idea.

Bank stocks made Nairobi Stock Exchange investors much richer in 2013.

A stable political environment, regional growth, good profits, and a relatively steady interest rate environment kept the bulls running.

All bank shares ended up in positive territory, most outpaced the NSE’s All Share Index, and a couple even doubled in market value. What’s more, they paid out some of the most generous dividends on the exchange.

Here’s a closer look at how each bank stock performed during the year.

[table id=189 /]

But all of that’s in the rear view mirror. What we really want to know is whether these stocks are worth banking on this year. Will their shares pop or drop? Sizzle or fizzle? Jump or slump? Rise or… Well, you get the idea.

To help answer that question, I asked for some help from three local experts — one bold bull, one cautious bull, and one bear.

Here are each of their arguments in turn:

The Bull Case
Bullish
Photo by Bernard DuPont

Alistair Gould, Head of Trading at Old Mutual Securities (Kenya)

I’d say that the majority of bank shares aren’t overvalued as we are anticipating strong performance for the 2013 fiscal year, which, coupled with decent dividend payouts, will continue to keep our banks attractive and push the stocks to higher levels.

Moreover, the performance of the banking sector going forward will be driven by increased economic activity from the mining, oil & gas, and construction sectors. We also foresee more uptake of private sector credit in the new year which still leaves room for banks to grow further in 2014.

However, with competition increasing within the Kenyan banking sector, we believe that the performance of each individual bank will be driven by innovation, product development and well-planned geographical expansion. There are still some good picks that investors should try to get in on early in the year. In particular, we like Coop Bank, National Bank, and Equity Bank.

The Wary Bull Case
Photo by Carol von Canon
Photo by Carol von Canon

Isaac Njuguna, Head of Investment at Zimele Asset Management

Listed banks are currently trading at a trailing p/e ratio of 10 times against the average market trailing p/e ratio of 15 times. This suggests they’re undervalued in spite of their recent gains, especially if they report sustained performance in profits in 2013.

However, despite favorable economic growth projections in 2014, one of the sector’s main challenges is the threat of regulation of interest rate spreads.  Various government task forces are investigating why spreads in Kenya are high in relation to banks elsewhere. Regulation of spreads could limit banks’ earnings growth to single digits, and if it were to become reality, one could say banks are over-priced.

If controls on interest spreads don’t materialize, I’m bullish on KCB, Equity, and Co-op Bank.

The Bear Case
Bearish
Photo by Chris Sgaraglino

Vimal Parmar, CFA, Head of Research at Burbidge Capital

With the banking sector trading at a weighted average price/book ratio of about 2.8, roughly 30% of bank stocks are quite overvalued, especially the leading retail banks. Just two of the listed banking stocks trade less than their intrinsic value — CFC Stanbic and National Bank (assuming its recent restructuring yields results).

Going forward, growth in the sector may not be high enough to justify the higher valuations owing to increasing competition not only within the sector but also from the telecoms sector, which has rolled out innovative mobile banking services like M-Shwari.

However, from a technical perspective, investor demand may keep the stock prices in range (if not increase) because they don’t see better alternatives elsewhere.

My Take

When trying to unearth value in banks, I like stocks with low price/book ratios and high returns on equity (ROE).

As you can see in the chart below, such bank stocks are scarce as hen’s teeth in today’s market.

P/B vs. ROE for Kenyan Bank Stocks
P/B vs. ROE for Kenyan Bank Stocks

While the sweet spot in the upper left hand corner of the chart is empty, there’s a bunch of outliers  in the upper right hand corner. These are very profitable banks, but their price is steep. Look for them to underperform the sector as a whole in 2014. Co-operative Bank, NIC, and Housing Finance look like better values.

In sum, I expect most Kenyan banks to finish 2014 higher than where they started, but I don’t expect the sizzling performances of 2013.

Your Turn

What do you expect from the Nairobi Stock Exchange’s bank stocks this year? Do you fall in with bull, wary bull, or bear case? Or another case entirely? Let’s hear it in the comments!

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