November 23, 2021/Cornation Research

by Coronation Research

In our recent publication ‘Equities for a Superior Return’ we created a hypothetical portfolio of 10 stocks, each with a high Return on Equity and backtested the performance to 1 January 2016. Our readers then asked: “What makes a good equity?” 

FX

Last week, the exchange rate at the Investors and Exporters Window (I&E Window) appreciated by 0.17% to N414.40/US$1. Elsewhere, the Central Bank of Nigeria’s (CBN) foreign exchange (FX) reserves declined by 0.31% – its third consecutive weekly decline – to US$41.41bn. However, FX turnover in the official market has been rising recently, contributing to stability in the I&E Window rate. Now that the CBN has brought more liquidity into the official FX markets, we may see continued stability and possibly a further easing of pressure on the parallel market rate as well. 

Bonds & T-bills

Last week, activity in the Federal Government of Nigeria (FGN) bond secondary market was bearish as investors focused on the bond Primary Market Auction (PMA). The average benchmark yield for bonds rose by 7bps to 11.36%. On benchmark notes, the yield of the 7-year (+8bps to 11.76%) and 10-year (+24bps to 12.16%) bonds expanded, while the yield on the 3-year bond (-3bps to 9.44%) declined. At the PMA the Debt Management Office (DMO) allotted N225.25bn (US$543.56m) worth of bonds. The marginal yields on the January 2026 (11.65%) and April 2037 (12.95%) bonds were unchanged, while the yield on the March 2050 bond rose by 10bps to 13.30%. Demand was stronger than at the previous auction. A total subscription of N267.15bn (versus N250.71bn at the previous auction) was recorded. However, the bid-to-offer ratio of 1.78x was lower than the 2021 average of 1.97x. Demand was actually weaker, on average, than prior auctions this year. Nonetheless, we maintain our expectation that a future rise in bond yields is unlikely to be sharp as the monetary authorities appear content with recent economic and monetary outcomes (e.g. Q3 GDP growth at 4.0% y/y, a high level of FX reserves).

Trading in the Treasury Bill (T-Bill) secondary market was bullish. The average benchmark yield for T-bills fell by 8bps to 5.11%. In addition, the annualised yield on a 328-day T-bill fell by 27bps to 6.57%. On Wednesday this week, at the T-bill PMA, the DMO is due to rollover N118.73bn worth of maturities, which we believe can be absorbed easily. Elsewhere, the average yield for OMO bills fell by 14bps to 5.48%, with the yield on a 319-day OMO bill falling 45bps to 6.11%.

Oil

Last week, the price of Brent fell by 3.99%, its fourth consecutive weekly decline, to settle at US$78.89/bbl, its lowest level since 1 October 2021. Nevertheless, Brent is up 52.30% year-to-date and has traded at an average of US$70.39/bbl, 62.87% higher than the average of US$43.22/bbl in 2020. Oil prices fell mainly as surging COVID-19 cases in Europe threatened to slow the economic recovery. Traders also weighed a potential release of crude reserves by major economies, e.g. the US and Japan. We reiterate that the price of Brent oil is likely to remain well above the US$60.00/bbl mark over the rest of the year and on into the early part of next year. This is a comfortable position for the public finances of Nigeria, in our view, though this, in turn, depends on levels of domestic production being high. 

Equities

The NGX All-Share Index fell by a marginal 0.12% last week to close at 43,199.27 points. Consequently, the year-to-date return fell to +7.27%. Unilever Nigeria -7.53%, Guaranty Trust Holdco -7.47%, Ardova -5.38% and FBN Holdings -3.75% closed negative last week, while Airtel Africa +4.97% and Oando +0.21% closed positive. Sectoral performances were bearish: the NGX Oil & Gas -3.63%, NGX Banking -1.60%, NGX Consumer Goods -1.41%, NGX Insurance -0.47% and NGX Industrial -0.10% indices all declined. Elsewhere, earlier today, Flour Mills of Nigeria announced plans to acquire a 76.75% equity stake in Honeywell Flour Mills at an enterprise value of N80bn.Included in the 76.75% stake is FBN Holdings’ 5.06% holding. 

What Makes a Good Equity?

Last week we published ‘Equities for a Superior Return’ which focused on the potential of some equities to deliver longterm returns that beat both inflation and depreciation of the Naira against the US dollar. Using a rule to guide us, namely that the best-performing NGX Exchange-listed companies have a long-term Return on Equity of 20.5% per annum or more, we selected 10 stocks. We constructed a hypothetical portfolio, allocating 10% of the portfolio to each stock, and measured their total returns (i.e. with gross dividends reinvested) from 1 January 2016 until 30 September 2021, almost six years. 

The compound annual growth rate (CAGR) of this ‘High RoE Portfolio’ was 24.7%, which translates into an inflationadjusted CAGR of 8.3% and a CAGR of 9.7% in US dollar-equivalent terms. Neither T-bills, FGN bonds, nor the NGX AllShare Index itself would have matched this. 

One question our readers asked was: “What is so special about these 10 stocks? What is the common theme?” The 10 stocks are (in no particular order): Dangote Cement; Nestle Nigeria; Zenith Bank; Guaranty Trust Holding; Stanbic IBTC; Dangote Sugar; Nascon; Okomu Oil; Presco; and Custodian Investment.

Clearly, the 10 stocks, selected purely for RoE that was sustainable over the period from 2010 to 2020 and in particularly 2017-2020, are very diverse. There is no trend in their sectors because we have: an industrial company; a processed food manufacturer; three banks; two producers of basic foodstuffs; two oil palm producers; and one insurance company. 

In our judgement, the common factors are strong management, good market position and alignment of management with the interests of all shareholders (and not just the interests of the dominant shareholder). Those three factors add up to an unbeatable combination. High Return on Equity (which is an internal measure of profitability) is often associated with strong free cash flows, hence the ability to pay dividends. And it is the reinvestment of dividends that makes the long-term returns superior. 

Some of our respondents asked whether our report stands as a recommendation to buy and hold the 10 featured stocks. The answer is that nothing in business stays the same for long, and a long-term historic RoE of 20.5%, or more, is no guarantee that future RoEs will be the same. 

One factor we have noticed in companies whose RoE fell during the period from 2010 to 2020 was faltering revenue growth. A company that stops growing its top-line sales (and these need to be measured in inflation-adjusted terms, because nominal top-line growth can deceive) is likely to see its RoE decline. The reason, in all likelihood, is that sales are essentially static but the costs – almost inevitably – grow. 

So, our report is not the final word but a beginning. We have established that sustainable high RoE is likely to be rewarded with good long-term investment returns. We will continue to research which companies are best suited to provide this over the coming years. 

Model Equity Portfolio

Last week the Model Equity Portfolio rose by 0.31% compared with a fall in the NGX Exchange All-Share Index (NGXASI) of 0.12%, therefore outperforming it by 44 basis points. Year to date it has gained 10.88% against a gain in the NGX-ASI of 7.27%, outperforming it by 361bps.

The positive driver of the Model Equity Portfolio last week was its notional position in Airtel Africa which delivered 80bps. There were no other gains. The notional positions in five banks cost 31bps. Noteworthy were small losses in two medium-size stocks that have furnished us with outperformance year-to-date. There was a 5bps loss from the notional position in Seplat and a small loss from the notional position in Presco (a 0.1bp loss, to be precise) – these have provided a valuable 77bps of performance so far this year. This comes as a salutary reminder that we cannot rest on our laurels when it comes to selecting medium-size stocks and must hunt for new opportunities. 

We continued to make notional purchases in Custodian Investment last week, bringing it up to a 0.4% position. 

This week we will continue to scale back our notional positions in the banks and will take these to an aggregate neutral weight (last week we declared that we would move towards a neutral weight). We will continue to build a notional position in Custodian Investments, liquidity permitting.