What Makes a Good Equity?

Tuesday, November 23,2021 09:15 AM / by Coronation Research/ Header ImageCredit: Scriptbox

In our recent publication 'Equities for a SuperiorReturn' we created a hypothetical portfolio of10 stocks, each with a high Return on Equity and backtested the performance to1 January 2016. Our readers then asked: "What makes a good equity?"

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 CentralBank of Nigeria's (CBN) foreign exchange (FX) reserves declined by 0.31% - itsthird consecutive weekly decline - to US$41.41bn. However, FX turnover in theofficial market has been rising recently, contributing to stability in theI&E Window rate. Now that the CBN has brought more liquidity into theofficial FX markets, we may see continued stability and possibly a furthereasing of pressure on the parallel market rate as well.

Bonds & T-bills

Last week, activity in the Federal Government of Nigeria (FGN) bondsecondary market was bearish as investors focused on the bond Primary MarketAuction (PMA). The average benchmark yield for bonds rose by 7bps to 11.36%. Onbenchmark notes, the yield of the 7-year (+8bps to 11.76%) and 10-year (+24bpsto 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 2050bond 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 2021average of 1.97x. Demand was actually weaker, on average, than prior auctionsthis year. Nonetheless, we maintain our expectation that a future rise in bondyields is unlikely to be sharp as the monetary authorities appear content with recenteconomic and monetary outcomes (e.g. Q3 GDP growth at 4.0% y/y, a high level ofFX 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, theannualised yield on a 328-day T-bill fell by 27bps to 6.57%. On Wednesday thisweek, at the T-bill PMA, the DMO is due to rollover N118.73bn worth ofmaturities, which we believe can be absorbed easily. Elsewhere, the averageyield for OMO bills fell by 14bps to 5.48%, with the yield on a 319-day OMObill falling 45bps to 6.11%.

Oil

Last week, the price of Brent fell by 3.99%, its fourth consecutiveweekly decline, to settle at US$78.89/bbl, its lowest level since 1 October2021. Nevertheless, Brent is up 52.30% year-to-date and has traded at anaverage of US$70.39/bbl, 62.87% higher than the average of US$43.22/bbl in2020. Oil prices fell mainly as surging COVID-19 cases in Europe threatened toslow the economic recovery. Traders also weighed a potential release of crudereserves by major economies, e.g. the US and Japan. We reiterate that the priceof Brent oil is likely to remain well above the US$60.00/bbl mark over the restof the year and on into the early part of next year. This is a comfortable positionfor the public finances of Nigeria, in our view, though this, in turn, dependson levels of domestic production being high.

Equities

The NGX All-Share Index fell by a marginal 0.12% last week to closeat 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 FBNHoldings -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, FlourMills of Nigeria announced plans to acquire a 76.75% equity stake in HoneywellFlour Mills at an enterprise value of N80bn.Included in the 76.75% stake is FBNHoldings' 5.06% holding.

WhatMakes a Good Equity?

Last week we published 'Equities for a Superior Return' whichfocused on the potential of some equities to deliver longterm returns that beatboth inflation and depreciation of the Naira against the US dollar. Using arule to guide us, namely that the best-performing NGX Exchange-listed companieshave a long-term Return on Equity of 20.5% per annum or more, we selected 10stocks. We constructed a hypothetical portfolio, allocating 10% of theportfolio to each stock, and measured their total returns (i.e. with grossdividends reinvested) from 1 January 2016 until 30 September 2021, almost sixyears.

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 CAGRof 9.7% in US dollar-equivalent terms. Neither T-bills, FGN bonds, nor the NGXAllShare Index itself would have matched this.

One question our readers asked was: "What is so special about these10 stocks? What is the common theme?" The 10 stocks are (in no particular order):Dangote Cement; Nestle Nigeria; Zenith Bank; Guaranty Trust Holding; StanbicIBTC; Dangote Sugar; Nascon; Okomu Oil; Presco; and Custodian Investment.

Proshare Nigeria Pvt. Ltd.

Clearly, the 10 stocks, selected purely for RoE that wassustainable 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: anindustrial company; a processed food manufacturer; three banks; two producersof basic foodstuffs; two oil palm producers; and one insurance company.

In our judgement, the common factors are strong management, goodmarket position and alignment of management with the interests of allshareholders (and not just the interests of the dominant shareholder). Thosethree factors add up to an unbeatable combination. High Return on Equity (whichis an internal measure of profitability) is often associated with strong freecash flows, hence the ability to pay dividends. And it is the reinvestment ofdividends that makes the long-term returns superior.

Some of our respondents asked whether our report stands as arecommendation to buy and hold the 10 featured stocks. The answer is thatnothing in business stays the same for long, and a long-term historic RoE of20.5%, or more, is no guarantee that future RoEs will be the same.

One factor we have noticed in companies whose RoE fell during theperiod from 2010 to 2020 was faltering revenue growth. A company that stopsgrowing its top-line sales (and these need to be measured in inflation-adjustedterms, because nominal top-line growth can deceive) is likely to see its RoEdecline. The reason, in all likelihood, is that sales are essentially staticbut the costs - almost inevitably - grow.

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

Model Equity Portfolio

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

Proshare Nigeria Pvt. Ltd.

The positive driver of the Model Equity Portfolio last week was itsnotional position in Airtel Africa which delivered 80bps. There were no othergains. The notional positions in five banks cost 31bps. Noteworthy were smalllosses in two medium-size stocks that have furnished us with outperformanceyear-to-date. There was a 5bps loss from the notional position in Seplat and asmall 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. Thiscomes as a salutary reminder that we cannot rest on our laurels when it comesto selecting medium-size stocks and must hunt for new opportunities.

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

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