Feb 7, 2016

Given the weak start in Kenyan equities market in 2016, with NASI, NSE 20 and NSE 25 losing 6.1%, 6.6% and 6.1%, respectively, in January, the purpose of this Focus Note is to try and figure out the probable direction of the Kenya equity markets going forward. We use the Last 7-years market valuation chart below as the basis of our discussion.

Since the February 2015 peak, the stock market valuation, as measured by price to earnings ratio (“PE”), has been on a decline for an entire 12-months – peaking at a 17.0x PE in February 2015 and declining steadily over the last 12-months to the current PE at 12.4x. The question then is, when and where is the valuation likely to trough and reach the bottom?

To try and understand where valuations are likely to trough, we reviewed the last peak to trough cycle, which was the period from August 2010 to January 2012, duration of 17 months. As of August 2010, markets were valued at peak valuation of about 20x PE, then valuations declined over 10 months to touch the historical average PE of 13.8x as of June 2011, and then further declined for another 7-months, from June 2011 to January 2012, to touch a trough valuation of 8.5x in January 2012. By the time the market troughed, valuations had been cut by almost 60% from peak of 20x PE to trough of 8.5x PE.

In the current bear market, valuations peaked at 16.5x PE in February 2015. The market then declined over a 9-month period to touch the historical 13.8x PE average in October 2015. The peak to average time of 9 months in this cycle is almost similar to the peak to average in the last cycle time of 10 months in the last cycle. Since October 2015, valuations have declined over the last 3 months to below historical average to be at a PE of 12.4x currently. Should we then expect a further decline in valuations? How much more decline and over what period?

A casual look at the chart trends would indicate that just like the last cycle, the markets continued to decline even after reaching the historical average valuation of 13.8x; in fact, from historical average to trough, which was between June 2011 and January 2012, the markets declined from 13.8x average to 8.5x average over a period of 7-months. So one may guesstimate that we may be in for another 7-months of market decline. And to reach the trough of 8.5x from the current 12.4x, it means another 30% dip in market valuations.

To try and figure out what may actually happen and hence what investors ought to do, we compare the actual market conditions during the last bear run of July 2010 to January 2012, to the current bear run that began in February 2015.

In order to understand the direction the local equities market might take, we carried out an analysis of the key metrics that determine stock market performance, drawing comparison with what happened in 2011. These metrics include:

1. GDP growth,
2. Interest rates,
3. Trends of inflation rates,
4. Exchange rates,
5. Corporate earnings,
6. Investors sentiments, and
7. Valuation of the market.

We take a detailed look at market conditions for the 6-month period from July 2011, when markets reached the historical average PE of 13.8x, to January 2012 when markets troughed. Our hypothesis is that if we can draw parallels between the current market conditions during this cycle and the market conditions in the last cycle, we can make a judgment call as to whether we may continue on a downward path as we seek a bottom, assuming the market conditions in this cycle are similar to past cycle; or whether a recovery is imminent, assuming current market conditions are better than the last cycle.

In 2011, the GDP growth rate from July 2011 to December 2011 averaged 4.2%, as a result of economic challenges that were witnessed during that period, including a spiraling rate of inflation and high interest rates. In tandem, the local stock market fell by 21.3% during the same period. In the period that followed between January 2012 and December 2012, GDP growth rate came in at 5.6% while the local stock market recorded a return of (1.4%). We observe a positive correlation between GDP growth rate and the performance of the stock market. Going forward, we project a GDP growth rate of between 5.5%-6.0% for 2016, which is above the 2015 projected GDP of 5.3% - 5.7%. Based on past experience, projected higher GDP growth may provide some level of support to the performance of the market, and will provide a stronger underlying base for fundamental growth in earnings.

The year 2011 was characterized by volatile interest rates environment with 91-day T-bill rising from 9.0% in July 2011 to 18.9% in December 2011, later falling back to 10.1% in June 2012. The policy-lending rate was increased by 1,100 basis points to 18.0% in June 2012, from 7.0% previously. This unstable interest rates environment led to poor performance of the stock markets as most corporations that relied on debt financing found it difficult to fund their operation. The poor performance of the stock market was also as a result of investors preferring to invest in near money fixed income instruments. The period that followed from July 2012 to June 2013 was characterized by stable interest rates environment with 91-day T-bill averaging at 9.2% while CBR closed at 9.0% in June 2013 from 16.5% in July 2012. This stable interest rates environment supported the performance of the market during this period. The year 2016 is expected be characterized by slightly unstable interest rates mainly due to Government borrowing to fund their budgetary obligation. We don’t expect 2016 to be as volatile as 2015, and with the Government proposing a cut in domestic borrowing for the 2016/2017 fiscal year, we expect pressures may reduce on high rates. However, the upward pressures and instability in the rates environment is likely to affect the performance of the stock market negatively. The expected stability in interest rates environment will be positive to the performance of the stock market.

In 2011, inflation averaged at 14.0%, rising from 15.5% in July to peak at 19.7% in November 2011, before closing at 10.1% in June 2012.This affected negatively the performance of the stock market. In 2016, inflation is projected to remain above the CBK upper bound of 7.5% but within the single digit level. This points to relatively stable inflation rates, which may not result into policy tightening by the CBK in order to tame the inflationary pressure. As a result, we expect the stable inflation levels to provide some levels of support to the local stock market performance.

In 2011, the Kenya Shilling reached a low of 105.9 against the dollar in October 2011 from 85 in July 2011.This resulted into sell-offs in the stock market performance leading to poor performance of the stock market. The same trend was also observed in 2015 where the currency depreciated by 13%. We expect the currency to remain under pressure against major currencies in 2016. We note in 2011, the depreciation of the shilling was as a result of speculative position taking, while in the current environment, the weakening of the shilling will be due to structurally issues that affect the strength of the currency, and the recovery of the US economy. Additional dollar obligation in terms of Euro bond, which was not present in 2011, may further add to the pressure that will result into weakening of the Kenya Shilling. This will have a negative effect and add to the downward pressure on the equities market.

Corporate earnings in 2011 were robust especially in the financial services sector, with the banking sector recording earnings growth of 20.5% for the period of July 2011 to June 2012 with only five listed companies issuing profit warnings. In 2015, earnings growth was lower than historically, with banks recording earnings growth of 9.3% in Q3’15. In addition, 17 listed companies issued profit warnings for the full year, compared to just 5 in 2011. We expect earnings growth to remain subdued in 2016 at 10%, trading at a forward PE of 10.9x and this translates to a PEG ratio of 1 indicating that the markets are fairly valued. This is not expected to positively support the performance of the stock market.

The year 2011 was characterized with low global economic growth at 3.8%. This was mainly as a result of Euro zone crisis, which further led to a reduction in foreign investors’ activities at the Nairobi Securities Exchange. We also note that during the same period the US economy was also struggling with the impacts of 2008 credit crunch. For the year 2016, the world economy is faced with the Chinese economic crisis, which has resulted into poor performance of most world’s equities market indices with Shanghai Composite index losing more than 7% in 2 of the first 5 trading sessions this year. We also believe that the impacts of the expected rate hike in the US have also been priced into the market, given the high levels of foreign participation in the market at 67.8%, we are likely to witness no significant foreign outflow from the market.

1. GDP Growth Rates
2. Interest Rates Environment
3. Inflation Rates
4. Exchange Rate
5. Corporate Earnings
6. Investor Sentiment
7. Valuations

In 2011, the stock market was relatively cheap, trading at a PE of 8.4x-11.4x in the period July 2011 to June 2012.Currently, the market is trading at a PE of 12.4x. We project the earnings will grow at a rate of 10%, this gives a forward PE of 10.9x indicating the market is trading at the same level compared to where it was in 2011.

The table below summarises the above factors:

Following the above comparison, we find that out of the seven metrics that we track;

1. Three factors (GDP growth, Inflation and Interest rates) support the positive performance of the stock market,
2. Three factors (investors’ sentiments, Corporate earnings growth and valuations) support a neutral stance, and
3. Only one of the seven factors, exchange rate, points towards poor performance of the market.

Looking at the above, we observe that in the year 2011:

1. Prices were falling despite earnings growth, due to investor sell-off. This later corrected in 2012, and moved in tandem until 2015
2. In 2015, we saw price appreciation outpace earnings growth, with the expectations of investors of higher projected earnings growth, which did not materialize.

However, in the year 2016, we have seen a sustained price decline, which is lower than the earnings growth, owing to investor sell-off as a result of (i) panic in developed markets, which has negatively affected the Kenyan market investors, (ii) a volatile interest rate environment, and (iii) the depreciating shilling.

Despite all the above, earnings growth prospects, and the prospects for the macroeconomic environment for 2016 are more positive, and as such, we do not expect a repeat of 2011, but rather markets to correct based on fundamentals, with prices to grow in tandem with earnings. We then recommend for investors to purchase stocks, which have pockets of value and strong earnings prospects. This is due to:

1. GDP Growth: A growth of 5.5% - 6.0% in 2016 is a positive for the economy. This GDP growth is also being backed by continuous development expenditure in the economy, which will grow our sources of revenue and continue to diversify the market in terms of growth of industry, which are supported by this increased spending and growth. This is a positive for earnings, investor confidence and growth of prices in the stock market,
2. Interest Rates: Despite the levels we witnessed in 2015, the Government is putting in place measures to be more proactive with managing interest rates, and have maintained the CBR at current levels of 11.5%, despite upward pressures and the threat of inflation. This will stabilize the economy, allow the private sector to begin borrowing to fund growth, and grow earnings. The more stable interest rate environment will also improve investor confidence, which will see increased forays into the equities markets, leading to prices rising in tandem with earnings,
3. Investor Sentiment: As global markets struggle with the negative effects of a Chinese slowdown, the Kenyan market has been more resilient due to its diversity of revenue away from hard commodities, and investors have already priced the outflows in the prices. Any further earnings growth will then result to price growth in the market, with PE of 11.6x – 11.9x expected in the market.

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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.