February 15, 2022/Coronation Research

“We want a superior return, but we do not want volatility”, is something we hear quite often, though usually in the context of the potential to lose money, i.e., risk. Risk and volatility are very different things. 

FX

Last week, the exchange rate at the Investors and Exporters Window (I&E Window) appreciated by 0.08% to N416.00/US$1. Elsewhere, the foreign exchange (FX) reserves of the Central Bank of Nigeria declined by 0.27% to US$39.87bn – the lowest level since October 2021 – as the CBN continues to intervene in the FX markets. Our view remains that the CBN’s position is strong as the level of FX reserves remains high in the long-term context. Hence, it seems likely that stability will be maintained in the I&E and NAFEX rates in the near term. 

Bonds & T-bills

Last week, trading in the Federal Government of Nigeria (FGN) bond secondary market was mixed with a bullish tilt following a higher-than-anticipated decline in clearing rates at the NTB auction. The average benchmark yield for bonds fell by 3bps to 11.60%. Notably, the yield on the 3-year (-44bps to 8.29%) bond tightened, while the yields on the 7-year (+9bps to 11.88%) and 10-year (+1bps to 11.99%) bonds expanded. At the FGN Bond primary auction this week, the DMO is expected to offer N150bn (US$361m) worth of bonds, reopening the January 2026 and January 2042 instruments. We reiterate our expectation for a rise in bond yields over the medium term owing to an expected increase in domestic borrowing by the FGN to finance the budget deficit and tight domestic monetary policy amidst global monetary policy normalisation this year. 

Activity in the Treasury Bill (T-Bill) secondary market was bullish as the average benchmark yield for T-bills fell by 14bps to 4.23%. However, the yield on the 286-day T-bill closed flat at 5.10%. At the auction, the DMO allotted N214.96bn (US$516.73m) worth of bills across all tenors. Notably, the stop rates remained unchanged on the 91-day (2.48%) and the 182-day (3.30%) bills from the last auction. However, the rate on the 364-day bill declined, falling by 20bps to 5.20% (annualized yield: 5.48%). Notably, demand was strong, as a total subscription of N446.31bn was recorded, implying a bid-to-offer ratio of 4.55x (vs 3.68x at the previous auction). Elsewhere, the average yield for OMO bills expanded by 16bps to 5.64%; the yield on the 235-day OMO bill declined slightly by 1bp to 5.70%. 

Oil

Last week, the price of Brent rose to as high as US$96.16/bbl, the highest level in over seven years, before settling at US$94.44/bbl. The 1.25% w/w gain marked the eighth consecutive weekly gain for the commodity. As a result, Brent is up 21.42% year-to-date and has traded at an average of US$87.36/bbl, 23.24% higher than the average of US$70.89/bbl in 2021. 

Early in the week, oil prices initially moderated as the market began to factor in the implication of progress of discussions with Iran. For context, the removal of sanctions could return more than 1 million barrels per day (bpd) of Iranian oil to the market, boosting global supply by about 1%. However, as the week progressed, oil prices began receiving support on the expectations of further global supply tightening as some members of the Organisation of the Petroleum Exporting Countries and its allies (OPEC+) continue to struggle to ramp up output. In addition, heightened fears of the possibility that Russia might invade Ukraine gave additional support and predictions of a US$100/bbl oil price. Consequently, we maintain our expectation that the price of Brent oil is likely to remain well above the US$60.00/bbl mark over the first half of this year. 

Equities

Last week, the NGX All-Share Index declined by 0.16%, its first weekly decline since 24 December 2021, to settle at 47,202.30. Consequently, its year-to-date return fell to 10.50%. Okomu Oil Palm (-10.00%), PZ Cussons (-7.19%) and Unilever Nigeria (-4.36%) closed negative last week, while Guinness (+24.61%), Flour Mills of Nigeria (+10.62%), Presco (+10.05%) and Ecobank Transnational Inc (+3.31%) closed positive. Performances across the NGX sub-indices were broadly positive, with the NGX Banking (+2.34%) index recording the largest gain, followed by the NGX Insurance (+1.51%), the NGX Consumer Goods (+1.35%), the NGX Pension (+0.46%), the NGX Oil and Gas (+0.29%), the NGX 30 (+0.07%) and the NGX Industrial Goods (+0.06%) indices. 

Risks versus Volatility

Over the past six weeks, we have witnessed significant activity in global markets following a slew of mixed corporate earnings, military tension in Europe, and expectations of interest rate hikes by central banks in efforts to combat inflation. These factors have led to elevated levels of ‘volatility’ in global indices, and this has created uncertainty among market participants as to how best to manage their ‘risks’ in these times of very high volatility. 

However, we are very careful with these terminologies, risk, and volatility, because we understand that there is a tendency for investors to mix up these terms, which can lead to unnecessary worry, and knee-jerk reactions culminating in financial loss. It is therefore vital that investors understand the difference between the two. 

Risk is the chance or probability that an investment will lose value, based on a number of factors. Investments face different kinds of threats, from: credit risk; reinvestment risk; interest rate risk; inflation risk; operational risk, etc., which ultimately may erode value and create losses for investors. 

Volatility, on the other hand, refers to the oscillations in price or how rapidly an investment changes in price over a period of time. In highly volatile periods, investment prices swing sharply up and down while in less volatile periods their performance is smoother and more predictable. 

Volatility is not the same thing as risk because the oscillations in price do not give an accurate picture of how sturdy an investment’s value is. The price of an investment is what is paid, while its value is what is gained or lost over a period of time. An investment’s price could fluctuate wildly, largely driven by the market’s perception of what the value is over a short period of time. We say short period of time because, more often than not, factors like significant company news i.e.. quarterly earning reports, potential merger and acquisitions as well external factors like government policy, industry landscape changes, change in credit rating – not to mention investor sentiment – can bring about these sudden fluctuations in prices, even though the underlying value remains steady overthe long term. 

Stocks generally are considered risk assets especially when compared with risk-free investments like government securities. Hence, this misjudgment is most likely when investors pay close attention to short-term price movements. Such monitoring of price movements can be gut-wrenching – understandably so – when prices oscillate wildly. While they do not mean the same thing, volatility and risk are also not mutually exclusive in that, an investment could be risky and experience either high or low volatility. It could also be characterised by low risk but simultaneously experience high or low volatility. 

The chart below illustrates a scenario where Company A is an engineering company, Company B is a consumer goods company and Company C is a photography technology company. During a recession, the earnings of company A declined significantly, following a sharp decline in the demand for its products as customers cut back on capital goods. The earnings of company B were unaffected by the recession due to more-or-less constant demand for its products. On the other hand, Company C is grappling with the distress of the recession alongside a drastic technological advancement that has shaken the photography industry, whereby it is unable to compete effectively thus impeding its earning potential and its going concern status. The differences in their respective demand curves would allow for differences in the volatility of their share prices with Company A experiencing more volatility than company B and Company C experiencing more volatility than Company B but less than Company A. 

However, it would be completely inaccurate to say that company A is riskiest of the three companies. Further findings show that Company A has a record of over two decades of consecutive annual dividend growth, longer than that of Company B, and it has been able to get through no fewer than three recessions while still maintaining dividend payments to shareholders. This proves that risk of permanent loss of capital is low in Company A. However, Company C is at risk of permanent capital loss as it is in a declining industry in the wake of new technology. Hence, Company A’s ability to generate cashflow growth over the long term has been maintained despite having volatile earnings. 

It is clear that volatility does not mean that an investment loses value over a long period of time, although short-term investors may make losses especially when they exit positions during periods of share price loss. It is pertinent to remember that over the long term, share prices tend to bounce back. For example, stock markets in the US and Europe hit record highs in March and April 2021, just a year after the pandemic’s record lows in 2020. 

Where market participants adversely and collectively react to volatility, traders and investors can create a contagion effect which ultimately increases the risk, which appears to be the problem currently affecting the Chinese property sector. 

Risk can be managed by paying close attention to valuation and long-term business prospects, with the aim of building up positions in sustainable business. Best of all is to buy them on the cheap. These are companies whose stocks are priced below their fair values after applying a valuation technique i.e., discounted cash flow analysis or spot multiple analysis. In addition, portfolio diversification is another way risk can be managed to balance investor’s exposures to different sectors or industries whose economic lifecycles do not correlate. 

It is therefore important that investors invest objectively and rationally, remaining calm and maintaining a long-term horizon to reduce the chances of making costly mistakes.

Model Equity Portfolio

Last week the Model Equity Portfolio fell by 0.17% compared with a fall in the NGX Exchange All-Share Index (NGX-ASI) of 0.16%, therefore underperforming by 1 basis point. So far this year it has gained 8.84% against a 10.50% gain in the NGX-ASI, underperforming it by 166bps

Last week, the single largest problem for the Model Equity Portfolio was the fall in our notional position in Okomu Oil, whose price was negatively affected by news of an attack on its facilities and the burning of 90 hectares of its plantation. Given the small area affected relative to the total area under cultivation, the correction in the share prices appears overdone to us, assuming there is no long-term damage to the business. We will take the opportunity to make notional purchases, though liquidity in this stock is low (except on the day when it was sold down heavily in what looked like a knee-jerk reaction). 

The next problem was the fall in the price of MTN Nigeria, a large index weight which fell by 1.1% last week. We thought that the price was susceptible to a correction, as we described on these pages last week, given that the shares of last December’s public share offer are due to settle by 18 February. We slightly lightened our notional position in this stock last week, but not by much, as it is a stock in which we intend to have an overweight soon after 18 February (i.e. after the end of this week). 

We also made notional sales in Stanbic IBTC last week, in pursuit of our declared tactic of bringing down the portfolio’s overall exposure to banks. We will continue to lighten the overall notional position in banks this week. Last week, there was a rally in banks with the NGX Banking Index rising 2.34% against the 0.16% fall in the NGX All-Share Index. Much of this rise came from what we consider to be second-tier banks, for example Ecobank Transnational (+3.31%), Fidelity Bank (+2.81%) and Union Bank of Africa (+2.54%), another indication that the market is chasing mid-cap stocks. We do not, as a rule, chase mid-cap stocks in this market. However, we will build a small position in Fidelity Bank going forward. 

Last week, we also made a small notional sale in Dangote Cement, as earlier advised, to bring in line with its index weight. We made notional purchases of Guinness Nigeria and of Flour Mills of Nigeria, as advised in this publication a week ago. This week, we will endeavor to makes these into index-neutral positions by making notional sales. As ever, we intend to increase our position in Custodian Investment if there is sufficient liquidity.