Look Sharpe: Do the Rewards of African Stock Markets Outweigh Their Risks?

I talk a lot about the rewards of investing in African stocks. And it’s (in my entirely biased opinion) with very good reason.

Most of the African stock markets outperformed the S&P500 quite handily over the past five years and appear bargain-priced for the next five.

But astute investors consider the risks when assessing these potential returns. So, how can we determine whether the reward is worth the risk?

The Sharpe Ratio helps analysts to determine exactly this.

I talk a lot about the rewards of investing in African stocks. And it’s (in my entirely biased opinion) with very good reason.

Most of the African stock markets outperformed the S&P500 quite handily over the past five years and appear bargain-priced for the next five.

But astute investors consider the risks when assessing these potential returns. Currencies can depreciate. Political crises can erupt. Commodities can nose-dive. Stuff like this can make the price charts of some African indexes look like something out of The Perfect Storm.

Take a look at the below chart. The percentages in the “Volatility” column indicate the monthly standard deviation of each index over the past five years. You’ll note that while most African markets outperformed the benchmark S&P500 index, most (with a few interesting exceptions) also traveled a much more bumpy road to get there.

Index Total Return (1/2007 – 1/2012) Volatility of Monthly Returns (1/2007 – 1/2012) Annualized Sharpe Ratio
MSCI Botswana Index (4.6%) 5.2% (0.16)
MSCI Kenya Index (30.8%) 11.1% (0.24)
MSCI Mauritius Index 72.3% 9.9% 0.26
FTSE JSE Namibia Local Index 135.5% 5.2% 0.85
MSCI Nigeria Index (44.4%) 12.0% (0.33)
iShares MSCI South Africa Index Fund 36.2% 9.1% 0.13
Tanzania All Share Index 9.7% 3.5% (0.01)
Uganda SE All Share Index (34.3%) 9.3% (0.32)
Lusaka SE (Zambia) All Share Index 65.6% 9.3% 0.25
S&P 500 Index (8.1%) 5.7% (0.19)

So, how can we determine whether those juicy returns were worth an extra queasy stomach?

Photo by MikeBaird

The Sharpe Ratio helps analysts to determine exactly this. It measures risk-adjusted returns by subtracting the risk-free rate from the return and dividing by the standard deviation. The higher the Sharpe Ratio, the more worthy the investment.

As you can see, all the markets above outperformed the S&P500 on a risk-adjusted basis except for Kenya, Nigeria, and Uganda where political instability and currency volatility conspired to create some very unhappy investors. Mauritius, Namibia, South Africa, and Zambia, on the other hand, utterly crushed US stocks.

So, the results are mixed. But I believe this analysis helps demonstrate that African stocks merit a close look from international investors.

Related Reading

Correlation (or Lack Thereof) Between African Stock Markets

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?

Photo by Voxphoto

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

How to Screen for Good African Stocks

5 Reasons to Invest in African Stocks

Investing in African stocks strikes many investors as impractical or foolhardy.

Here are a few reasons why it’s the first place I look for investment bargains.

Investing in African stocks strikes many investors as impractical at best and foolhardy at worst. I disagree. Here are a few reasons why the continent is the first place I look for investment bargains.

1. Africa’s where the growth is.

Strengthening consumer appetites, a resurgent demand for commodities, and reduced debt loads have African economies firing on all cylinders. Economists expect 23 African economies to grow by 5.0% or more in 2011. The US’s economic growth will likely fall short of 3.0%.

2. African stocks are cheap.

Typically, rapid economic growth translates into sky-high stock prices. Not so in most African markets. The P/E ratios of the continent’s blue chip stocks routinely fall into the single digits. Zambia’s Lafarge Cement, Kenyan oil marketer KenolKobil, and Ghana’s FanMilk currently sell for 7.8, 4.8, and 9.9 times their respective earnings. The S&P 500 index’s 20.3 ratio is bloated in comparison.

3. African markets have little to no correlation with Wall Street indexes.

Thanks to their small size and low visibility African markets tend to march to the beat of their own drummers. If global markets “zig,” they might very well “zag.” Thus, a few positions in African stocks help reduce the volatility of a stock portfolio.

4. To help develop Africa’s capital markets

Each dollar invested in an African stock helps to build the liquidity of the exchange on which it trades. Rising liquidity lowers risk. Lower risk attracts additional investment to the exchange. Greater investment on the exchange lowers the cost of capital for listed companies. A lower cost of capital leads to increased growth and job creation.

5. African markets are more accessible than ever before.

Africa remains a relatively difficult place to invest, but it’s becoming less so with each passing year. More and more funds, ADRs, and African ETFs are hitting the market. African exchanges have improved their trading systems and governance while brokers are improving their quality of service.

This list is by no means exhaustive, but it captures the essence of what makes African stock markets such a compelling opportunity.

Do you invest in Africa? If so, tell us why in the comments?