Executive Summary

• Fixed Income: Yields on government securities were on an upward trend during the month indicating a rising rate environment. The Monetary Policy Committee retained the Central Bank Rate (CBR) at 11.5% citing favourable macroeconomic indicators;
• Equities: The equities market was on a downward trend during the month, with NASI, NSE 20 and NSE 25 declining by 6.1%, 6.6% and 6.1%, respectively. EABL released their H1?16 results, recording a 67% increase in profit to Kshs 7.7 bn, driven by one off gains from sale of its subsidiary Central Glass Industries. Excluding one off gains, net profit was up 16%;
• Private Equity: Private equity as an asset class has seen increased deal flows in the month of January and we expect global capital to continue flowing into the region;
• Real Estate: The real estate sector continues to attract investment especially in office, retail and hospitality sectors as residential apartment rents and yields take a dip while prices remain stable.

Company Updates

• This week, we continued with our Middle East road show targeting both institutional investors and Kenyan diaspora. Our Head of Private Equity Real Estate is meeting leading global private equity players in the Middle East and Diaspora team led by Hetal Nathwani hosted a professional dinner event for Diaspora Kenyans in Dubai
• Our Senior Investment Analyst, Duncan Lumwamu discussed the extension of the IMF Credit facility for Kenya and government local borrowing. See link on CNBC Africa: Duncan on CNBC Africa
• We will be launching the Cytonn Real Estate Nairobi Commercial Office Sector Report on Monday morning: Cytonn Real Estate Nairobi Commercial Office Sector Report
• This week we formally re-launch our brand in the market with Sharp is the New Smart campaign
• We continue to beef up the team with other ongoing hires

Fixed Income

Subscriptions on Treasury bills remained high during the month, with overall subscriptions at 138.4% compared to 137.1% in December last year. Yields on T-bills rose, with the 91-day, 182-day, and 364-day paper closing at 11.7%, 14.4%, and 14.5%, up from 10.9%, 12.8%, and 13.3%, respectively at the end of December 2015. The rise in yields can be attributed to the expectations of rates increasing due to increased demand for money by the government to finance the budget.

The government issued a 2-year and a re-opened 10-year bond (that was issued in 2013) for Kshs. 35.0 bn, raising a total of Kshs. 24.2 bn for budgetary support. The yield on the 2-year bond came in at 15.7% while those on the re- opened 10-year came in at 16.1%, with most of the funds (Kshs. 20.2 bn) raised from the 2-year bond. The Government preference to play on short end of the yield curve further confirms the uncertainty in the interest rate environment.

Despite improved liquidity in the money market during the month as a result of (i) significant maturities of Government instruments, (ii) Open market activities operations by the Central Bank and (iii) activities of the Central Bank to redistribute liquidity in the market through reverse Repos of Kshs 30.8 bn during the month, the Kenya Shilling remained steady during the month, closing at Kshs 102.3 to the dollar. These can be attributed to:  

1. Continued strong dollar reserve by the Central Bank of Kenya, standing at 4.5 months of import cover
2. Improved current account deficit to GDP now at 6.9% of the GDP from 10.4% as at the end of 2014
3. The willingness of the IMF to continue supporting the country by giving and extending the facility. Currently the facility stands at USD 688 mn

The monetary policy committee (MPC) retained the CBR and the KBRR at 11.50% and 9.87%, respectively. The decision was as a result of a stable macro-economic environment, with key indicators remaining stable, expect for inflation, which increased largely due to one-off changes in tax and transitory El-Nino effects affecting food prices. The currency has also remained stable despite rate increases in the US. The decision by the MPC to retain the CBR at 11.50% was expected but not for the KBRR. The KBRR is a function of the CBR and the 2-month moving average of the 91-day T-Bill, which would have resulted to 10.8%.  As illustrated in our Cytonn weekly report #3, we believe the CBK retained the KBRR so as to protect the consumers from higher borrowing costs, as banks would have re-priced their loans upwards. Going forward, CBK indicated that they will be re-working the formula for calculating KBRR, and also establishing enforcement mechanisms to ensure the rate is adhered to by commercial banks. Holding KBRR constant, even though it should have changed based on the formula for KBRR, calls into question the credibility of the metric. CBK should not expect markets to price off an arbitrary metric. We think KBRR as a pricing reference is now completely destroyed. In our view, CBK and other policy participants should focus intensely on how to make the banking sector more competitive rather than trying to regulate pricing. 

The World Bank has lowered its 2016 forecast for crude oil prices to USD 37 per barrel in its latest Commodity Markets Outlook report from USD 51 per barrel in its October projections. The lower forecast reflects a number of supply and demand factors;

• The sooner-than-anticipated resumption of oil exports by the Islamic Republic of Iran, pumping more oil into an already oversupplied market;
• Greater resilience in U.S. shale oil production due to cost cuts and efficiency gains;
• A mild winter in the Northern Hemisphere that leads to less demand for oil, and
• Weak growth prospects in major emerging market economies such as China, India, Brazil and Russia, and being one of the largest consumers of oil, the demand is highly outweighed by the supply.

If the low oil prices persist, Kenya being a net oil importer stands to benefit greatly with oil prices currently at USD 34.2 per barrel.

The government is slightly ahead on its domestic borrowing programme, having borrowed Kshs. 129.5 billion for the current fiscal year compared to a target of about Kshs. 127.8 billion, assuming a pro-rated borrowing throughout the financial year of Kshs. 219 billion budgeted for the full financial year. Interest rates have risen during the month. Given (i) the pressure on the Government to refinance its maturing obligations, and (ii) inflation standing at above the 7.5% upper limit (Cytonn?s estimate for the month of January is 8.5%), we hold the view that rates will continue on an upward trend. We thus maintain our view that investors should be biased towards short-term fixed income instruments given the uncertainty in the interest rate environment.

Equities

During the month, the market was on a downward trend with NASI, NSE 20 and NSE 25 loosing 6.1%, 6.6% and 6.1%, respectively, on the back of losses in large caps led by KCB, Barclays, Co-operative Bank and Safaricom which lost 12.6%, 8.8%, 8.1% and 7.1%, respectively. This week, the market registered a marginal increase with the NASI, NSE 20 and NSE 25 gaining 0.2%, 0.7% and 0.7%, respectively. EABL was the top mover and recorded the highest net foreign inflows of USD 2.8 mn. In our market outlook report for 2016, we launched our Cytonn 10 equities portfolio, which recorded a return of (-6.2%) for the month of January, relatively at par with the market as represented by NASI.  We however still believe that despite the negative start to the year, long-term investors should gradually be taking positions in the market due to the attractive valuations

Equities turnover fell by 12.8% during the month to Kshs 13.0 bn from Kshs 14.9 bn in December 2015. Foreign investors were net buyers with net inflows of Kshs 339.9 mn, compared to net outflows of Kshs 216.7 mn witnessed in December 2015. The sustained foreign investors? net outflow can be linked to a shift in global investor portfolio flows based on the recent rate increase in the US that has reduced their risk appetite for securities in emerging and frontier markets and made the US and other developed markets more attractive.

The market is currently trading at a price to earnings ratio of 11.98x, versus a historical average of 13.81x, with a dividend yield of 4.30% versus a historical average of 3.31%. The charts below indicate the historical PE and dividend yields of the market.

This week, EABL released their half year results to December 2015 recording a 67.3% growth in profit after tax to Kshs 7.7 bn, driven by the one-off gains from the sale of Central Glass Industries (CGI) to South Africa?s Consol Glass Proprietary for Kshs 2.2 bn. Total revenue grew by 8.2% driven by a strong performance of EABLs brands in Kenya which posted double digit growth in 5 out of 8 product segments and recovery in Senator Keg brand following the review in Excise duty remission in Kenya. This is despite negative performances in Uganda, Tanzania and South Sudan. Expenses grew by 9.9% while finance costs dropped 29.4% leading to a 14.5% growth in profit before tax. Adjusting for the one off items, profit from the company?s core operations grew by 16% for the period from Kshs 4.7 bn in Dec 2014 to Kshs 5.5 bn in Dec 2015.

ARM Cement is in talks with India-based cement manufacturer UltraTech Cement over Kshs 12.7 bn equity investment after ARM abandoned its plans to raise Kshs 10.7 bn through a 5-year private bond due to volatility in the interest rate environment. UltraTech Cement is the leading cement manufacturer in India and a member of the Aditya Birla Group, and also has operations in United Arab Emirates (UAE), Bahrain, Bangladesh and Sri Lanka. UltraTech?s equity investment in ARM Cement would potentially be in the form of convertible preference shares, and is expected to take a controlling stake in ARM, as the company currently has a market capitalization of Kshs 17.6 bn. In our view, the investment will be positive for ARM, as it will:

1. Be able to pay off its dollar obligations, which have become expensive to service given the 13% depreciation in Kenya shilling over the last 12 months, while all revenue remains in shillings, and
2. Benefit from a strategic investor with a wealth of experience and expertise in the sector. This will increase innovation and productivity, which is crucial given the impending arrival of Dangote Cement from Nigeria into the market, and the already saturated cement industry in Kenya, with 6 players currently operating in the market.

Below is our equities recommendation table.

 We remain neutral on equities given the low earnings growth prospects for this year. The market is now purely a stock picker?s market, with few pockets of value. See appendix for update on the Cytonn 10.

Private Equity

The year started with heightened activity in the Private Equity space. As highlighted in the Cytonn Annual Market Outlook, Private Equity players have been focusing on different sectors of the economy with keen interest on financial services, healthcare, education and ICT.

Some of the key deals in the financial sector this month include: (i) the acquisition of 75% of Credit Bank by FEP Holdings for Kshs 4 bn, with the transaction now awaitings approval by the Central Bank of Kenya, and (ii) Leapfrog Investments seeking to inject Kshs 35 bn in the Kenyan insurance sector.

Financial services sector continues to attract private equity players driven by the regulatory needs to recapitalize. The increased interest in the insurance sector is hinged on (i) low insurance penetration at 2.9% of the population, (ii) growth of the middle class, and (iii) the increase of minimum capital requirements, which has driven insurance companies to shore up capital levels. Bancassurance, micro-insurance and agricultural insurance are still in their early stages of development presenting further opportunities for growth in the sector.

In the ICT sector, OkHi, a Kenyan tech firm has raised Kshs 77 mn from local and foreign investors led by Garage Capital, a venture capital fund based in Silicon Valley. This shows that the ICT sector and especially in Kenyan is very attractive as evidenced by the entry of global brands into the country attributable to the dynamic young Kenyan population and a supportive economic and regulatory framework.

There have been additional players in the PE industry this year with new entrants coming in and new funds raised by already existing PE firms with a focus on the opportunities in Africa. Carlyle Group, the second largest alternative investment manager has raised USD 698 mn focussed on Africa. The fund will be targeting banking, consumer goods, manufacturing and business processing in Nigeria, Mozambique, Zambia and Kenya. Silvertree Internet Holdings, a South African venture capital firm has set aside USD 10 mn to invest in Kenyan start-ups focussing on the technology sector.

This increased interest by PE firms in Africa is indicative of the increasing attractiveness of the Sub Saharan market due to its high economic growth compared to global markets and improved political and governance structures in the region.

We maintain our outlook that the Sub Saharan Africa market will continue to attract private equity capital driven by the potential for high returns generated in the region, the stable macro-economic environment and political reforms that have improved the ease of doing business, easier exit routes for global institutional investors and better economic growth projections as compared to global markets. We remain bullish on the PE industry and expect more funds to be raised in the Financial Services, Education, ICT, Healthcare and Fast Moving Consumer Goods sectors. 

Real Estate

The beginning of the year saw statistics reveal that some of the biggest earners in 2015 were those who put their money in real estate investments; with total returns of over 28% pa as compared to returns in equities and fixed income of -10.0% and -14.6% respectively . The real estate sector last year saw increased activities such as: (i) increase in building approvals, (ii) legal and institutional reforms by NCA, (iii) launch of major housing projects (iv) growth of the retail by 14% sector, (v) entry of several international developers and investors such as AVIC from China and Africa Land Investments from South Africa and, (vi) the listing of the first REIT

In that respect, we identified key aspects that shall drive real estate in 2016 being: i) the growing middle class ii) huge housing deficit of over 200,000 units per annum iii) continued investment in infrastructure iv) widespread economic growth with SMEs employing up to 85% of the workforce v) the youth bulge and rapid urbanization which have created opportunities for development to cater for their needs vi) devolution and political goodwill with a slowdown in selected markets in 2017 due to the elections. Some of the major activities in real estate sector in January 2016 Included:

• Old Mutual Property investing Kshs. 6.4 bn in Two Rivers Lifestyle Centre (TRLC)
• The English Point Marina launched in Mombasa after experiencing a three-year delay
• National Construction Authority (NCA) and Nairobi City County (NCC) identified 50,000 buildings in risk of demolition due to lack of construction approvals
• East Africa was identified as one of the regions that is set to steer Africa?s growth in 2016 with Kenya recording the highest number of projects followed by Ethiopia    

This week, a report released by Hass Consult indicated a drop in average rent for apartments in Nairobi for the first time since 2000. Compared to other properties, apartments recorded the highest fall of 2.3% for the year ending December 2015. This can be attributed to a steady increase in supply of apartments especially in Nairobi County as developers seek to generate higher returns associated with these units. In areas with high land prices, developers are favouring construction of apartments as opposed to stand-alone houses as this makes more efficient use of land. The influx in supply has resulted in a decline in rental yields from 7.1% in 2014 to 6.3% by the end of 2015. In particular, rental prices are not increasing in most suburbs such as Parklands and Ridgeways, as many developers have been concentrating in these areas. 2015 was a difficult year for the Kenyan market, particularly for the Nairobi market given its positioning as regional hub. Consequently, we ascribe the fall in rental prices mainly to heighted insecurity and a volatile macro environment in 2015. We do not see any indication that the rental price depreciation of 2015 is the onset of a trend of softening rental price market ? the secular trends supporting the Nairobi real estate markets, such as positioning as the regional business hub, rapid urbanization and a growing middle class remain structurally sound.

On the other hand, in satellite towns such as Mlolongo, Kiambu and Athi River, annual house prices rose by 11.9%, while rents rose by an average of 9.0%. Developers are therefore likely to capitalize on properties located in the outskirts of Nairobi. Infrastructural development in these areas is a major pull factor as it makes them more suitable for settlement.

The KBA Housing Price Index for the last quarter of 2015 maintains the opinion that apartments continue to be the most preferred residential units by buyers given that they constituted 92.8% of total houses offered in the market.

With the continued development of office space, the research team at Cytonn sought to find out if there is potential over supply of offices in Nairobi. 

Nairobi Commercial Office Sector Report - Research Note

Commercial office sector has grown rapidly in the last five years in both size and returns with completed office space increasing from 1.6 million square feet in 2011 to 5.4 million square feet in 2015, 27.5% annualized growth. Occupancy levels have remained high across all office nodes and classes averaging at between 89- 90%. Grade B offices had the highest average occupancy of 90%. With the CBD having the highest average occupancy percentage of over 95%. In terms of rents, grade A offices have the highest rents averaging at Kshs 118 per square foot. Gigiri has the highest grade A rent at an average of Kshs 140 per square foot, with the lowest being in Mombasa road at Kshs 81 per square foot. Gigiri and Mombasa road yields are 12% and 8.3% respectively. Prices have also been on a rising streak across most markets though in some nodes such as Mombasa road, prices dipped between 2013 and 2015. Grade A offices also have the highest prices. With a square foot of grade A office space selling for Kshs 13,847. While a square foot of grade C office space sells at an average price Kshs 12,167. In terms of yields, grade A offices also had the highest rental yields averaging at 10.4%, with grade B and C offices having yields of 9.4% and 8.4% respectively.

The best performing office nodes are:

• Grade A offices: Upperhill and Gigiri with yields of 11 and 12 % respectively
• Grade B offices: CBD and Kilimani with yields of 10.2 and 9.6 % respectively

We project that 2.5 million square feet of offices will be undersupplied by 2017, assuming occupancy of current stock remains constant as demand for office space by both local businesses and multinationals continue to grow. Generally, the market outlook for commercial office space remains positive.

Find on this link, our comprehensive Nairobi Commercial Office Sector Report: Nairobi Commercial Office Sector Report

Appendix: Cytonn 10 Portfolio

Every end of month, we will show the performance of the 10 best stocks to invest in our coverage universe. We released this selection in the Cytonn Weekly #2 at the beginning of 2016. We will also be comparing, on a monthly basis, the returns for the Cytonn 10 versus the market returns of NASI and NSE 20. Additionally, we will also compare our Cytonn 10 portfolio versus any other published competitor portfolio. So far, the only other published competitor portfolio is the Genghis 13, which we picked from the research published by Genghis Capital on 28^th January 2016.

As seen in the table below, the Cytonn Portfolio has lost 6.2% Year to Date, in line with NASI, which has lost 6.1% YTD. Genghis 13 has fared worse, losing 8.8% year to date. The Cytonn 10 portfolio was negatively impacted by the significant weighting of one-fifth of the portfolio towards KCB, which lost almost 13% for the month of January. We believe that KCB has overcorrected downwards and should stabilize as banks report 2015 full year results.

We encourage engagement from clients, research and investment community on the Cytonn 10 with the goal of picking the very best portfolio for our investors. 

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Disclaimer: The views expressed in this publication, are those of the writers where particulars are not warranted- as the facts may change from time to time. This publication is meant for general information only, and is not a warranty, representation or solicitation for any product that may be on offer. Readers are thereby advised in all circumstances, to seek the advice of an independent financial advisor to advise them of the suitability of any financial product for their investment purposes.