The Nairobi bourse in Kenya to add depth and liquidity to markets

The capital markets in Kenya have witnessed many years of sustained and rapid growth. This performance, phrased as one investor as “Africa in fifth gear”, reflects the broader macroeconomic fundamentals of the country’s economy, which is set to strengthen further in 2017 as a result of ongoing government spending on infrastructure and the recovery in tourism. Both the IMF and the National Treasury have projected 6.1% growth in GDP in 2017.

However, short-term hurdles have dampened enthusiasm, such as the global uncertainty resulting from Brexit and the unexpected outcome of the US presidential elections in 2016, and domestic concerns over the national elections in August 2017. Indeed, Richard Mambo, head of Global Financial Institutions (East Africa) at Standard Bank, said that trading volumes are likely to stay low ahead of the election.

Still, while investors at the Nairobi Securities Exchange (NSE) may have been holding back investments to take account of short-term moves, excitement in Kenya’s long-term growth trend has not dimmed, as demonstrated by the ongoing activity in private equity (PE) and mergers and acquisitions (M&A). Strong performance from listed companies suggests a slight undervaluation, while new initial public offerings (IPOs) on both the main and small and medium-sized enterprise (SME) boards point towards an upturn in capital raising. Marcel Mballa-Ekobena, executive head of investment products sales East Africa at CfC Stanbic Bank, told OBG that although there may be “...a lot of clouds on the horizon”, he did not see “...a material catalyst to undo the markets overall.” He also said that, “Kenya still has a safehaven aspect in terms of equities for investors into sub-Saharan Africa. The trajectory is still upwards, even if the gradient is not up to its potential.”

Market Structure

The NSE opened in 1954, although equity trading on the bourse dates back to the 1920s. At that time, the exchange was based in a café at the Stanley Hotel in downtown Nairobi, a more informal setup, where gentlemen’s agreements were made on the spot and physical settlement of trades occurred later. Now, trading is fully electronic, and in June 2013 the bourse ended a 60-year presence in Nairobi’s central business district in favour of a new facility in the Westlands neighbourhood.

The NSE is currently host to 67 equities, up from 61 in 2014, spread out across the main board. It has an alternative investment market segment (AIMS) – which has lower requirements for assets, share capital and reporting requirements – and a growth and enterprise market segment (GEMS) targeting SMEs. The NSE also trades in bonds and has 26 government bonds consisting of three five-year issuances, nine 10-year bonds and 14 bonds – fixed income and infrastructure – of between 10 and 30 years. There were also six commercial bonds as of mid-February 2017. As of early April 2017, total capitalisation on the exchange was KSh1.8trn ($17.6bn).

Funds & Operators

In terms of market operators, there are 26 licensed fund managers. Among the largest institutional investors on the exchange are pension funds, who in spite of their tendency to buy and hold still play a central role, with an estimated KSh1trn ($9.8bn) in assets. Recent reforms to Kenya’s pension fund regulations, announced in mid-2015, may see that increase further. In his budget statement for financial year 2015/16, Henry Rotich, cabinet secretary for the National Treasury, announced that going forwards pension funds would be able to invest up to 10% of their portfolio in PE and venture capital funds licensed by the Capital Markets Authority (CMA). Pension funds, which totalled $8bn in assets at the end of 2015 according to the latest report from the Retirement Benefits Authority (RBA), the sector regulator, were expected to reach $10bn in 2016.

Regulator Reform

One significant change expected in the market is the long-awaited overhaul of the regulatory structure through the merger of the CMA and the Insurance Regulatory Authority (IRA), the RBA and the Sacco Societies Regulatory Authority (SASRA). A presidential taskforce on parastatal reforms first recommended the new body be established in 2013, but it wasn’t until 2016 that Rotich proposed the Financial Services Authority Bill to Parliament in his budget statement.

Development Plan

The Capital Markets Master Plan 2014-23, issued by the CMA, highlights financing as one of Kenya’s core strengths and stresses deeper, more liquid domestic markets as key to achieving the aims of Vision 2030. New products under development include real-estate investment trusts (REITs), derivatives, asset-backed securities, a commodity exchange and an exchange for carbon emissions, as well as a mobile phone channel for retail savers to invest in Treasury bonds (see analysis).

The NSE transformed into a for-profit company following demutualisation in 2014 and is currently seeking new sources of trading liquidity and revenue. Mambo told OBG, “We find that they are aggressively trying to increase the product range and get new products into the market to encourage local corporates to list and diversify their offering.” However, introducing new products can be slow, even when turning the booming real-estate sector into REITs to be issued and traded on the NSE.

Capital markets institutions and regulators are already working closely on EAC integration projects. The NSE was given a further boost after the African Development Bank and the African Securities Exchanges Association announced that they would be working together on an African Exchanges Linkages Project (AELP), confirming NSE as the capital market centre for East Africa. The AELP will link the Nairobi, Casablanca, Nigeria and Johannesburg bourses in order to encourage cross-border capital raising and trading across the African continent.

Indicators

It is easy to see why Kenya retains its appeal for investors in spite of the headwinds. According to advisory firm I&M Burbidge Capital, in the five years to June 2016 average return on investment was 10% for equities, 12.3% for 10-year Treasury Bonds and 9.6% for 91-day average bills. Total equity trading on the secondary market was KSh73.4bn ($716.2m) in the first half of 2016, some 31% down on the KSh106.5bn ($1bn) recorded in the first half of 2015. The NSE All Share Index (NASI) started 2016 at 145.70 but dropped by 6.14% by the end of the year to reach 136.74, never approaching its February 2015 peak of 176. The Index continued its downwards trend in 2017, posting 130.51 at the beginning of April.

The stocks with the largest market capitalisation continued to dominate activity but with mixed progress in the first half of 2016. Safaricom, British American Tobacco and East African Breweries (EAB) saw significant gains, although some of the country’s larger financial institutions saw drops in price.

Volatility increased in the third quarter of that year, in part because foreign buyers comprise about 65% of market activity. Following Brexit, for example, investors moved funds out of Kenya and other emerging markets to the safety of US dollar holdings and remained sensitive to minor changes in the market. Interest resurged in mid-July, as foreign buyers pushed in a total of $36.7m of net inflows in August, but at the end of August the passage of the Banking (Amendment) Act 2016 led to a number of exits. This was reversed shortly after, and the NASI crept up to 138 in the first week of October.

Eva Murigu, Africa strategist, (global research), at Standard Chartered, forecasts that the market will move sideways in terms of demand, as most investors will hold back in light of the upcoming national elections and global uncertainties about US dollar interest-rate changes and the effect of Brexit on Kenya’s key export markets.

Regardless, listed equities are deriving benefits from the strong financial performance of several important sectors, which have led to suggestions of undervaluations. Listed banks’ core earnings per share (EPS) grew by 15.8% in the first half of 2016 while Safaricom, which holds two-thirds of the mobile telecoms market, reported a gain of 18.8% . By the start of October 2016 the market was trading at a price-to-earnings ratio (P/E ratio) of 12x – a decline from 12.8x in January and a historic average of 13.7x, according to Cytonn Investments. Dividend yield was 6.4% compared to a historic average of 3.5%.

Key Sectors

Perhaps the biggest driver on the NSE is the banking sector, which has performed strongly and comprises a large number of the biggest blue chips by capitalisation. Most of the 11 listed banks released good results for the first six months of 2016. Only Barclays Kenya and National Bank showed declines, while NIC Bank grew by less than 10%. EPS of banking giants Co-operative, Equity, KCB and Diamond Trust all grew by more than 10%, while corporate-focused Standard Chartered, HF Group, I&M and CfC Stanbic pushed earnings growth over 20%. Tighter regulation meant that loan-loss provision rose but costs were contained, with average cost to income at 45.7%, down from 48% in 2015 (see Banking chapter).

Banking Act

The market did see an impact from the passage of the Kenya Banking (Amendment) Act 2016, effective September 14, which sets a compulsory cap on lending rates at four percentage points above the central bank rate (CBR) and rates paid to investors on deposits at least 70% of the CBR. However, inflows had largely returned by the end of the following month. Eric Musau, senior research analyst at Standard Investment Bank, told OBG there has been a “flight to quality”, which has favoured the larger banks. Cytonn Investments says valuations of 0.9x price-to-book and 5.2x P/E ratios should be attractive to long-term investors. However, the interest rate controls and increased regulation is expected to prompt more consolidation and innovation.

In spite of sectoral headwinds, the insurance industry has also increased its attractiveness, with the sector valuation of 1.1x book value down from 1.5x at the start of the year and a 1.7x historic average. There is ample potential for further growth in the industry, particularly in non-life lines (see Insurance chapter).

The sector has nonetheless been impacted by an increase in operating expenses in the first half of 2016, which reached a five-year high of 57.2%, while solvency has also softened, averaging 28.7% by the end of the third quarter, down from 29.1%. Along with core EPS, which declined by 4.7% in 2015 followed by 7.4% in the first half of 2016, and new regulatory reforms, there is an increased likelihood of consolidation. According to Musau, this will result in bigger and more robust insurers. “There is a lot of potential if inefficiencies are addressed, such as trying to eliminate fraudulent claims.” A number of other key segments put in a steady performance in 2016, including industry, as cement companies benefitted from increased infrastructure spending, and breweries, such as EAB, saw a rise in sales (see Industry chapter). Agricultural companies benefited from high prices on commodity exports, including tea, coffee and horticultural products (see Agriculture chapter).

Capital Raising Activity

A number of IPOs and share offers, both crucial indicators for activity in emerging and frontier market stock exchanges, arrived on the NSE in 2016. Deacons Kenya became the NSE’s first listed fashion retailer when it joined the AIMS in August 2016. It was a listing by introduction after shares had been trading on the over-the-counter market for six years. Muchiri Wahome, CEO of Deacons, said that the company aimed to use funds to tap into smaller urban areas and look at expanding its operations in Uganda and Rwanda. Deacons listed 123.6m shares at an opening price of KSh15 ($0.15) each, valuing the company at KSh1.9bn ($18.5m). By early October the price was KSh8.55 ($0.08).

On June 21, Nairobi Business Ventures, a shoe and leather accessories retailer that operates the brand KS hoe, became the fifth listing on the NSE GEMS. The listing marked the end of a two-year drought for GEMS, although that is hardly unusual for SME boards in sub-Saharan Africa. It was listed through introduction with 23.6m shares at KSh5 ($0.05) each, for a valuation of KSh118m ($1.2m).

In April 2016 Longhorn Publishers raised some KSh533m ($5.2m) by issuing 126.2m shares at KSh4.20 ($0.04) each for an offer of KSh530m ($5.2m) on 0.86 shares for every ordinary share held. It will use the money to fund a rollout of digital school products and textbooks, expand into regional markets and retire debt. The company listed in May.

Power generator Kengen followed in May of that year with the Nairobi bourse’s biggest share offer, raising KSh26.4bn ($257.6m) with a rights issue, including a massive uptake by the government, which is a 70% shareholder. Subscription was 92% of the KSh28.7bn ($280m) offer of 4.4bn new shares at KSh6.55 ($0.06) each, on the basis of two new shares for every ordinary share held. The new shares listed in July.

As with many African bourses, there has been a push by the government to encourage new listings. Previously, there was a corporate tax reduction of five percentage points from 30% to 25% for companies that listed through an IPO. From January 1, 2016 that benefit was extended to companies that list by introduction, which should encourage more listings on the GEMS market. In March CMA announced that its listing fees would be capped at KSh30m ($292.7m) compared to 0.15% of the offer value.

Mergers & Acquisitions

Foreign direct investment (FDI) was KSh200bn ($2bn) in 2015, according to the professional services firm EY, which was reflective of substantial growth in extractive and infrastructure activity. In 2016, however, overall levels of FDI are much lower, with only KSh8.6bn ($83.9m) reported in the first eight months. Much of that has gone into M&A, with a handful of large deals undertaken.

Among some of the larger deals is the pending 50:50 joint venture between Kenya’s listed Car & General (C&G) and Netherlands-based manufacturer Cummins. Previously, C&G had been selling Cummins engines and generators independently under licence, but the deal will see the two firms strengthen their collaboration. Financial services group Britam sold its 25% stake in property developer Acorn Group, which is part-owned by London-based private equity firm Helios Investment to an undisclosed buyer for KSh299.6m ($2.9m).

Several other firms have seen changes in ownership. An investor consortium led by Swiss company Pamoja Capital bought 100% of investment banking firm Genghis Capital from Chase Bank through a special-purpose vehicle, while reinsurance company Zep-Re has seen a push by two existing shareholders to increase their stakes; in June 2016 Kenya Re paid KSh1.25bn ($12.2m) for a 4.4% stake, bringing its total holding to 19.9%, while in July DEG paid $14.6m for a 5.4% stake to bring its holding to 14.9%.

Debt Performance

Debt markets have been performing in a volatile fashion in 2015-16. The 91-day Treasury bill (T-bill) rate saw some ups and downs, climbing from 8.6% in January 2015 to 21.6% in the following October. As the market stabilised, T-bill rates declined fast, to 10.4% in December 2015, 7.1% in June 2016 and 6.2% by July 2016, before climbing modestly to 7.9% by September. Secondary bond trading picked up by 41% in the first half of 2016 to reach a total of KSh267.2bn ($2.6bn) compared to KSh188.9bn ($1.8bn) in the same period the previous year, according to the Central Bank of Kenya. In the third quarter it fell by 46% to KSh81.2bn ($792.3m). Trading in government bonds dominates, while corporate bonds account for only a tiny fraction.

Retail Participation

The government is also hoping to increase retail investor participation in debt trading, a field where institutional investors currently dominate. For example, roughly one-third of pension fund holdings are government securities.

One of the key means through which the government hopes to accomplish this is the M-Akiba tax-free, five-year infrastructure bond. The bond has a target of KSh5bn ($48.8m) and aims to tap into the 23m Kenyans who use mobile money and could use mobile phones to register, trade and settle. The minimum investment is KSh3000 ($29.27) compared to KSh50,000 ($488) on other Treasury bonds. Individual savers will be able to bid for the bond. The current limit is KSh140,000 ($1366) a day for any mobile-money transfers. The bonds will also be available for secondary trading on the NSE. The platform officially launched at the end of March 2017.

Outlook

Kenya is ahead of most sub-Saharan African markets in terms of collective investment schemes and its well-developed pension and insurance sectors. However, despite the market’s relative sophistication, new initiatives are likely to require years of support by NSE and other market participants before they achieve a meaningful level of liquidity, particularly when spot equities and bonds are slowing down.