Equity prices in emerging markets suffered last year as investors re-priced financial assets to reflect heightened economic shocks including inflation, and the reaction of central banks thereof.
Emerging markets equities fell by 20% in USD terms during the year 2022, considered the worst calendar year since 2008. In the region, the Nairobi All Share Index (NASI) saw a 23% annual decline, touching its 20 years low in June 2022, while the Uganda All Share Index touched its 10 years low in the same month.
Despite a positive return of 9.1% of the Tanzania Share Index (TSI), a combined PE ratio of the eight most traded stocks on the DSE is at five years low in February 2023, as foreign investments into listed equities take a substantial toll since quarter one of 2022.
With the solid banking sector performance, corporate earnings growth for 2022, and economic prospects for Tanzania, we expect PE ratios to be sky rocket to 2015 levels.
In this article I try to connect how global inflation has raised the discount rate and underpriced Tanzanian equities due to perceived risks of emerging markets; global inflation emerged on the advent of the energy crisis in 2022 following Russia’s invasion of Ukraine in March 2022, and some root causes of inflation linked to monetary easing during the height of COVID-19.
Expectedly, central banks reacted by raising interest rates in 2022, to suppress excess purchasing power.
According to Reuters, the U.S Federal Reserve hiked its policy rate by 225bps during the year 2022 and apart from Japan, all other central banks controlling the 10 most traded currencies globally, rose their policy rates by a total of 2,700bps in 54 rate hikes during the year 2022, making this the fastest and biggest scale of monetary policy tightening in the last two decades.
Rising interest rates in developed economies trigger a series of related risks for emerging economies. The first impact of rising interest rates is sluggish economic growth from a rising cost of financing, while consumption of goods and services slows down.
Slower economic growth negatively impacts demand of commodities and minerals, which account for 60% of exports from two thirds of developing countries and 89% of countries from the Sub-Saharan Africa according to UNCTAD.
Rising interest rates also elevate the cost of sovereign borrowings and debt service payments, especially for emerging economies which already have relatively low debt service coverage ratio. Kenyan Eurobonds reached 20% in the third quarter of 2022, while a number of emerging economies have defaulted recently, including Sri Lanka and Zambia. Ghana is currently going through a domestic debt restructuring program after suspending service of most of its external debt, while the country’s Eurobonds yield above 30%.
Elevated economic and default risks mentioned above, prompt a transfer of global investor funds from emerging markets as they settle for safer fixed returns in developed economies. The most common culprit of funds transfer is the stock market.
According to Financial Times, the year 2022 saw the longest foreign outflow streak from emerging stock markets, in history.
Tanzania saw foreign purchase of equities drop to 49% of the total turnover compared to historical average above 85%. Foreign purchase for January 2023 was 14% of the turnover, compared to 78% in January 2022 while foreign sales intensified from 41% to 69% during the same period.
Shift of funds raises another risk on the stability of emerging markets currencies. Foreign outflow during the year 2022 saw the nominal emerging markets U.S Dollar Index rise to two years high, and only second to the height of the pandemic between March and May 2020, since it was formed in 2006.
How does all of this affect the pricing of equities you ask? Everything discussed above is accounted for in the discount rate which is an integral part of equities valuation process.
A discount rate, almost similar to the internal rate of return (IRR), measures the minimum bearable risk adjusted rate of return for a particular investment.
The return is what capital (debt and equity) providers are paid; therefore, the discount rate is the average cost of both, also known as the weighted average cost of capital (WACC).
The weights of equity and debt are determined by the capital structure of that specific company.
The cost of debt is simply the cost of credit facilities available to a specific company dependent on the company’s credit score. The cost of equity is somewhat more complicated and can be calculated through various methods. The most widely used method in computing the cost of equity is the Capital Asset Pricing Model (CAPM).
CAPM includes the risk-free rate, a premium of stock market return above the risk-free rate, and the risk of the particular company being valued. The risk-free rate is the return on a medium-term Treasury bond.
Return on the Treasury bond is the ultimate opportunity cost of any investment in an economy. The rationale is simple; Treasury bonds are considered default risk free. If the expected return on a risky investment is less than the existing return on a Treasury bond, just invest in the risk-free Treasury bond.
The second component of CAPM is the equity risk premium which is calculated by subtracting the risk- free rate from the overall equity market return. Since equities are riskier than Treasury bonds, the potential return from equities should be higher than the return on Treasury bonds. The equity risk premium is then multiplied by a stock’s Beta which measures the risk of that specific stock relative to the overall equity market where the stock is listed. Beta is calculated as a correlation of the price movement of a specific stock and the movement of the respective stock market, with the assumption that the risks of the specific stock and the market are captured in the volatilities of their respective prices.
The cost of equity is finally found by adding the risk-free rate to the product of the Beta and the equity risk premium. In nascent equity markets like Tanzania, where more than 60% of domestic capitalization has remained stagnant for more than four years, it is quite common for Treasury bonds to yield higher returns than the overall equity market.
Moreover, due to emerging markets risks discussed above, the domestic risk- free investment in Tanzania is not necessarily a risk-free investment for an investor based in Europe. As a result, it is common market practice to use the U.S Treasury yield as the risk-free rate, and add a country risk premium which caters for the risks associated with emerging markets and some country specific risks. The sum is then added to the product of the equity risk premium and the specific stock’s Beta. This method is preferred by foreign investors.
The risk premiums can be calculated from sovereign debt spreads between developed and developing economies, as well as from sovereign credit ratings. Alternatively, ready computed risk premiums can be obtained from various sources. The most commonly used source for global risk premiums is the Damodaran Online which tracks various valuation metrics for various sectors and countries globally.
Unless one is interested to be a financial assets valuer, they do not unnecessarily need to trouble themselves with the last four paragraphs, let financial analysts deal with the boring jargons of determining the cost of capital and valuation methods. The vital concept to digest out of the above discussion is the impact of interest rates and country risks to the discount rate, and subsequently the valuation of financial assets, specifically equities.
The risks discussed above led to an upward review of country risk and equity risk premiums by the Damodaran Online site. For instance, the published country risk premium for Tanzania was reviewed from 5.44% in January 2022 to 9.49% in November.
The same for the equity risk premium which went up from 9.68% to 15.43% during a similar time frame. The upward review does not identify neither specific risks nor features for Tanzania, but collectively for emerging economies. The review was identical to a number of countries including Kenya, Uganda, Rwanda, Egypt, Gambia, Costa Rica, Cameroon, and many more, despite the risks and economic environment in these countries being far apart.
An upward shift of the discount rate has suppressed the growth of equity prices. Despite a 9.1% growth of the TSI in 2022, a combined Price to Earnings (PE) ratio of the eight most traded counters on the DSE is now half that of 2017 and has been consecutively dropping for the last five years, from 10.14x in February 2019 to 6.04x in February 2023.
PE ratio measures the price of a company relative to its earnings. The eight selected stocks include CRDB, NMB, DSE, Twiga Cement, Swissport, NICOL, TOL Gases and TCCIA Investment Co. Ltd.
This trend does not reflect the development of the business environment and prospects of corporate earnings in Tanzania in the medium term, including the 53% banking sector annual profit growth in
2022.
Banking sector profit has grown almost nine times in the last five years, from 134bn/- in 2018 to 1.16trn/- in 2022, while credit growth to the private sector reached seven years high in quarter three of 2022. Yet, the two largest banks, controlling about 40% of banking assets, are trading at below 5x PE ratio.
The IMF forecasts emerging economies to grow twice the pace of developed economies in the year 2023. The World Bank projects the economy of Tanzania to grow by 5.6% in 2023 and 6.1% in 2024, compared to the world GDP growth of 2.9% and 3.4% for the same years respectively.
The forecast reflects government’s pro-business policies, opening up new business corridors and economic resilience from the fact that Tanzania never went to a full lockdown during the height of the pandemic.
Moreover, Tanzania has well-diversified sources of foreign inflows including minerals, commodities and tourism, which act as a buffer against global headwinds. The Tanzanian Shilling has barely depreciated by an annual average of 0.3% over the last four years.
The country has experienced the lowest inflation in the region and one of the lowest in the world during the year 2022, thanks to favorable climatic conditions for agriculture, and food sufficiency within the country. Value of investments registered by the Tanzania Investment Centre tripled in 2022, while Moody’s upgraded its rating of Tanzania from ‘Stable’ to ‘Positive’.
With these developments, evident in the 2022 growth of corporate earnings, Tanzanian listed equities are low hanging fruits for an investor with a keen eye. Foreign investors are bound to chase higher returns in emerging markets after the global economy settles.
U.S inflation has been falling for seven straight months up to January, while most central banks indicate a slower tightening pace. The return of net foreign inflows shall most likely result to a climb of indices and PE ratios.
The silver lining for local investors is the opportunity to invest now when markets are undervalued, since the discount rate and pricing of equities is highly influenced by emerging markets collective risks rather than specific features of the Tanzanian economy.
The author of this article is the Head of Research and Analytics at Alpha Capital. For feedback, please contact him via email: imani.muhingo@alphacapital.co.tz
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