What is driving Nigeria's stock exchange's positive performance?

As I followed the Seplat-ExxonMobil debacle, where regulators have gone back and forth on whether to approve the sale of ExxonMobil's shallow water business, I pondered on how this would affect Seplat's share price as a publicly listed company.
 

To be very honest, my concerns were purely selfish.

You see, I have Seplat shares in my portfolio, and unsurprisingly, their value had begun to fall due to uncertainty about the sale.

This makes sense because I buy a company’s shares in anticipation of higher profits that the company would make. These profits would lead to higher cash flows and dividends paid to shareholders like me. Often, higher profits would also lead to share price appreciation as more investors vie for a slice of the pie. In the same way, any perceived threats to the business would trigger investors to sell the company's shares.

The same logic should apply to the stock market as a whole when compared to the state of the economy. Investors would expect lower economic growth, high inflation, unemployment, foreign exchange (fx) issues, and the like to impact company earnings negatively.  

You can imagine my surprise when I discovered that the Nigerian equities market, i.e. the NGX All Share Index (ASI), was up 15% year-to-date as of the start of this week (by yesterday's market close, the NGX ASI was up more than 16%).

How come the Nigerian stock market is thriving when the economy is crashing? 

When you look abroad, increased fears of a global recession have translated to negative stock market performances in major economies such as the United States (US) and the United Kingdom (UK), so why does Nigeria buck this trend? 

As we see from the above chart, the Nigerian equities market has outperformed other stock markets.

Ironically, the resolution to this paradox will reveal just how dysfunctional Nigeria's economy is today. But before we get there, we need to understand the link between the economy and the stock market, and confirm that NGX ASI is really doing as well as it seems.

Let's begin with the basics. What drives the relationship between the stock market and the economy?

Stocks and the economy

The stock market is where company shares (stocks) are bought and sold. Every market has an index representing a group (or entire market) of stocks selected to represent the overall performance of that market.

For example, the Nigerian Exchange Limited (NGX) has the All Share Index (ASI), known as the NGX ASI—a total market index reflecting the behaviour of the common shares quoted on the Nigerian Stock Exchange.

Similarly, the US has the S&P 500, which tracks the performance of the largest 500 companies (by market capitalisation) listed in the US.

Now, because the stock market usually encompasses top companies from different sectors of the economy, the stock market's performance is often seen as an indicator of how an economy will perform.

I will explain.

As we explained earlier, we purchase company shares in anticipation of higher future profits. So a company's share price today is the market's estimation of what those future earnings will be. When share prices rise, investors are implying that they believe the company will perform better in the future, and vice versa. 

And since the stock markets typically have companies operating across different sectors in an economy, a bull run indicates that the economy doing well or will do well in the future.

Of course, this can end up being self-fulfilling. As share prices rise, investors and companies get richer, allowing them to perform better, and the economy thrives, creating a virtual cycle.  

The opposite is true for when share prices are falling or when the economy is doing badly—one should follow the other.  

Hence my surprise that even with an economy plagued by slowing economic growth, high inflation, unemployment, a fiscal crisis, and perpetual currency depreciation, the stock market is doing well.

But, is it really?

A 15% year-to-date return sounds impressive. But investors care about their real return, so in Nigeria, we need to account for the falling value of the naira, especially if we are to make international comparisons.  

The search for real returns

To compare the NGX ASI to other stock markets, we need to account for currency depreciation. Let's look at a quick example to show why.

Take a Nigerian citizen in the diaspora like Deola (a foreign investor), who might consider withdrawing her foreign currency savings, earning 3% on a 2-year US Treasury bill, to invest in her motherland’s equity market, returning 15%.

However, before Deola can make this decision, she must consider Nigeria’s volatile exchange rate.

Say Deola decides to bring in $10,000 to invest in the Nigerian equity market. Due to Central Bank of Nigeria (CBN) regulations, Deola first has to change her dollars to naira through the banks (i.e. via official channels) to purchase these naira-denominated assets.

However, on hearing news about the foreign airlines being unable to repatriate their funds and dollar scarcity forcing banks to ration the $4,000 Personal Travel Allowance (PTA) to Nigerians, she fears being stuck in this “official exchange rate market”. She then decides to take the route many are forced to go: the parallel market.

But this year alone, the naira has depreciated to ₦680 in the parallel market (a 14% decline). In the official market, the depreciation is 4% to ₦430.

So, if Deola brought in her $10,000 (₦5.85 million @ ₦585/$1) at the beginning of the year and made a 15% gain, it should amount to $11,500 (₦6.73 million @ ₦585/$1). But the 14% naira depreciation means that when she is ready to book her profit and take her dollars home, she will have $9,893 (at ₦680/$1), effectively losing money. This is Deola's real return, i.e. the returns left after accounting for changes in the value of the naira.

After considering this, Deola may be forced to step back and think to herself, “Is the juice worth the squeeze?"

For this reason, we consider the impact of currency devaluation (against the dollar) on stock exchange returns in different economies. 

We also stretch the definition of “returns” a step further to “total returns”.

As I mentioned, when I bought Seplat shares, I paid for the money I hoped to receive later. Essentially, I invested in the company’s stock because I expected it to make more money in the future and pay higher dividends. And hopefully, the stock price of the company also goes up.

Before now, we have simply referred to returns as share price increases. But the dividend received is also a part of the benefits (total returns) we enjoy from investing in stocks, so we must consider it for this exercise to see the impact of currency depreciation on stock market total returns.

To do this, we assume that the dividends received are reinvested in the stock market, increasing the value of our portfolio holdings. 

The chart below shows the real returns an investor would get from investing in various stock markets. This real return depends on two variables: the total returns from investment (dividends plus share price increase) and the currency depreciation/appreciation. The US stock markets have no currency depreciation because all other stock markets have been dollarised (so US markets are the base).

NGX ASI: African Giant
 

From the chart above, we see that once we discount total returns by currency depreciation, i.e. total returns minus percentage depreciation, we arrive at real returns.

Therefore, Deola will be better off investing her $10,000 in the NGX ASI as she is less exposed to eroding purchasing power and can claim at least 7% in real returns, juxtaposed against investing in the S&P 500 and losing 12%.

If she considers investing in the equity markets of countries like Egypt, she will experience capital depreciation (minus 12% total returns). She will also suffer an erosion of her purchasing power due to exchange rate devaluation (minus 18%), bringing her total loss to 30%.

In short, even after accounting for currency depreciation, the NGX ASI is still performing better than most stock markets. 

What is driving this?
 

Defying the odds

To be fair, the NGX ASI’s stellar performance didn’t just start. In 2020, even as the Nigerian economy shrank by 1.93%, the Nigerian equity market emerged as the best-performing market in the world, returning 50% (capital appreciation alone) to investors.

This was mainly due to lower interest rates in Nigeria as the CBN tried to cushion the impact of the COVID-19 pandemic.

Interest rates and stock markets have an inverse relationship. Lower interest rates make it cheaper for companies to borrow and expand, enabling them to make higher profits. Meanwhile, lower interest rates mean lower returns on fixed-income investments (the natural substitute for purchasing shares), making company shares even more attractive.

In 2021, with the economy recovering slightly but interest rates starting to rise, the NGX ASI returned 6% (capital appreciation alone) to investors.

Going into 2022, as energy and commodity prices rose due to the Russia-Ukraine war, the Nigerian stock market began defying odds, revealing its disconnect from global stock markets.

Increased fears of a global recession shook global markets—brought about by the war, higher inflation, and higher interest rates (remember, higher interest rates should be bad for the stock market).

However, due to Nigeria’s dependence on oil for government revenues and fx earnings, the Nigerian stock market (a sentiment indicator) has a positive relationship with oil prices, i.e., as oil prices edge higher, so does the stock market.

This is evidenced in the correlation coefficient of 0.92, i.e. the degree of the relationship between two variables—the closer it is to “1”, the stronger the relationship. 

With brent prices (the global crude oil benchmark) more than 25% higher this year to $100 per barrel (bbl), the Nigerian equity market has appreciated by about 15%.

So, on the surface, higher oil prices may explain the performance of the NGX ASI.

But this story is not as it seems. The NGX ASI is a representation of the broad market, meaning that if an investor held shares of all 156 companies listed on the exchange, the investors’ funds would have returned 15% right now.

But realistically, because events/occurrences affect sectors in the economy differently, investors tend to move towards more positively impacted sectors.

For example, while higher oil prices are good for the general economy, they will directly benefit upstream oil and gas companies. Stears energy analyst, Noelle, argues this compellingly as she explains why investors are bullish on Nigeria’s largest indigenous oil and gas firm, Seplat.

Similarly, higher interest rates will be more beneficial to the banking sector as interest rates on loans increase. However, it would be negative for capital-intensive sectors like manufacturing, which require a lot of debt, as higher interest payments eat into profitability.

Therefore, it would make sense to look at the sectoral performance of stocks listed under the NGX to pinpoint the main actors.

Sectoral breakdown
 

A glance at sectoral performances reveals something interesting. The bullish run in the stock market is concentrated in the oil and gas sector as opposed to the entire market.

This is even more pronounced when looking at the top-performing companies in 2022.

To see which companies have been instrumental to the market’s rise, we need to look at two numbers: how much each company’s share price has risen and how much that company contributes to the NGX market capitalisation. We do that in the table below.  

Notice that two companies (Seplat and Airtel) in the top 10 gainers list account for about 30% of the entire market.

We must consider the weightings of these stocks on the NGX because the heavier (higher weightings) a stock is, the more influential the stock will be in directing the movement of the entire market.

Think of one end of a rope tied to an oil tanker and the other tied to a Volkswagen Beetle, and the drivers are ordered to drive in opposite directions. No matter the effort of the Beetle’s driver, the oil tanker will always end up pulling the beetle in its direction.

The weighting on the index is simply calculated by taking a percentage of individual stock’s market capitalisation (price multiplied by shares outstanding) against the total market capitalisation.

In simpler terms, market capitalisation refers to the total value of all a company's shares of stock. So the NGX ASI’s market capitalisation is simply a sum of the entire market.

Also, it's important to note that Airtel is represented under the NGX ASI and NGX 30 (as the largest stock by market capitalisation), but it is not represented under the sector breakdown, as there are only two listed telecommunication companies (MTN Nigeria and Airtel Africa) which do not have a sector index as of today.

Putting all this together, it is clear that just two companies—Seplat and Airtel—are responsible for most of the year-to-date gains we have seen on the NGX ASI.

Why these two companies? 

With every dark cloud, there’s a silver lining

According to Fisayo Adetayo, a stockbroker at CardinalStone Financial Services, “In early 2022, impressive first-quarter earnings results by companies listed, coupled with higher oil prices spurred improved investor sentiments in the Nigerian equities market.” All very vanilla so far.

“However, the steep rise witnessed in the year's second quarter is attributable to two main stocks—Airtel Africa and Seplat Energy. Foreign investors looking to take out their funds due to heightened global recessionary pressures and higher global interest rates took advantage of the dual listings of these stocks to repatriate their funds,” he adds.

There we have it.

It's no longer news that Nigeria is facing a currency crisis. Just last week, Emirates Airlines announced the suspension of all flights in and out of Nigeria due to its inability to repatriate its profits back to the United Arab Emirates. The foreign exchange shortage has led to the CBN withholding about $464 million earned by Emirates and other foreign airlines from operations in the country.

You see, theft and vandalism continue to limit the production of the country’s major source of FX—oil (down 10% in 2022 to 1.18 million barrels per day in July). Consequently, foreign exchange reserves have fallen 4% to $38.9 billion in 2022, despite the 27% rise in the Brent oil price to $100/bbl.

Like foreign airlines, foreign investors find themselves trapped in the Nigerian equity market when they try to repatriate their profits.

But as they say, where there’s a will, there’s a way. And they found a way.

Airtel Africa and Seplat Nigeria Plc are listed on both the Nigerian and London stock exchanges, so investors can convert their Nigerian shares to their London counterparts.

Basically, foreign investors sold their shares in other companies and pumped their funds into these two stocks (Seplat and Airtel) to take advantage of the “naira for pounds” exchange (known as arbitrage) opportunity that exists courtesy of the dual listings of these stocks.

Again, I will explain.

A company can be listed on more than one stock exchange as it seeks to raise funds for growth from more than one economy. Listing on more than one exchange provides access to a wider array of investors that could provide the needed capital.

Apart from the fact that these stocks tend to pay dividends in foreign currencies (which eliminates exchange rate risk for investors), they also provide investors access to more than one stock market, i.e. a holder of Nigerian Seplat shares (like me) can easily contact a broker to convert my current holdings (valued in naira) to their London counterpart (valued in pounds sterling).

As the FX crisis deepened and the flames of a global recession were fanned, foreign investors looking to repatriate funds back to their home countries sold off other stocks and swept up these arbitrage-friendly stocks to access foreign currency.

This is evidenced when we consider the total volume and value of stocks traded on the NGX in 2022 (83 billion units and ₦925 billion, respectively). Airtel Africa and Seplat Energy collectively make up 0.6% of volumes and 6.4% of value traded.

Emmanuel Adeleye, a stockbroker with Investment One Financial Services, shared a similar view. According to him, “Market sentiment is currently weak. We barely see daily value traded above ₦3 billion compared to the ₦6-₦7 billion we saw at the beginning of the year.”

He added, “Foreign investors have been exiting our market since 2020 due to FX scarcity. However, heightened inflation and recessionary pressures in global economies in 2022 exacerbated the rate these foreign investors fled from the Nigerian capital market. With declining oil production and fx reserves, the CBN could not provide the fx needed for profit repatriation. So these investors took advantage of the dual listings to Airtel and Seplat as an exit route, which led to rapid price increases.”

NGX reveals that foreign investor participation in the Nigerian equities market has dwindled sharply from  51% in 2018 to 34% in 2020 and about 15% in July 2022. Domestic investors have been the major players in the local bourse (equity market), contributing 85% (₦1.5 trillion) of all inflows into the exchange. Of that sum, domestic institutional investors (like the PFAs) were responsible for 68% (₦1 trillion).

For those wondering why this is happening now and why investors were not doing this before, it is because the opportunity just arose. Before the listing of Airtel Africa on the exchange in July 2019, Seplat Energy was the only dual-listed stock on the NGX. However, low oil prices and weak macroeconomic conditions negatively impacted Seplat's share price of these stocks, making it less attractive as an exit route before 2022.

Basically, it is only in 2022 that this exit route became viable.

In conclusion, market sentiment is weak, and the positive performance recorded is largely due to price increases in Airtel Africa Plc.

Higher oil prices and impressive corporate earnings that initially spurred domestic investor participation in Q1 2022 have also waned, as economic realities have revealed themselves through less impressive Q2 2022 earnings.

Similarly, recent monetary policy rate (MPR) hikes to tame rising inflation by the CBN in May, and July 2022 (to 14%) have translated into higher interest rates on “risk-free” fixed income instruments issued by the government.

This development has, in turn, led to the NGX ASI shedding off about 5% in total returns from its high of 26% in H1 2022.

Nonetheless, with roughly 20% total returns on investment, Nigeria remains one of the top-performing stock markets in the world, with prospects for further growth if fx liquidity improves, restoring investor confidence.