MIND THE GAP : MEAN REVERSION IN LISTED AFRICAN EQUITIES

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1 MIND THE GAP : MEAN REVERSION IN LISTED AFRICAN EQUITIES Mean reversion is the mathematical phenomenon whereby an asset s performance tends to become more average (less extreme) over time. If true, it implies that asset classes (including stock markets) that have outperformed historically are likely to underperform in the future (and vice versa). In this newsletter, we compare the historical 10-year performance of African listed equities (excluding South Africa) with the returns of Emerging Markets and South Africa in particular. We warn investors to mind the gap in the relative performance of these markets that has widened materially over the past 3-4 years (since 2009). In order to restore parity under the mean reversion theory, the gap between Africa ex-sa equities and Emerging Market equities would need to narrow by 18% from current levels. Despite its recovery in early 2012, the Africa ex-sa equity market would need to recover by a further 40% against the South African equity market (on a relative basis) to revert to its long-term average. Greg Barker - Head of Investment Research Since the beginning of 2009, South African equities have returned 110% in USD terms and Emerging Markets have returned 95%, whereas the Africa ex-sa equity market has returned only 25%. This explains why African ex- SA markets still have significant headroom to outperform before they restore their historical relationship with their Emerging Market and South African counterparts. The natural conclusion of our analysis is that mean reversion is likely to follow its inevitable course by closing the gap over time, which is likely to provide interesting opportunities to long-term investors and asset allocators. Introduction There is a regression to the mean (or to longer-run past values) for stock prices; what goes up a lot tends to come back down, and what goes down a lot tends to come back up". Robert Shiller (author of Irrational Exuberance ) Mean reversion is the mathematical phenomenon (discovered by Charles Darwin's cousin, Sir Francis Galton) whereby an asset s performance tends to become more average (less extreme) over time. If true, it implies that asset classes (stock markets or specific securities) that have outperformed historically are likely to underperform in the future (and vice versa). The idea of mean reversion over long-term time horizons is strongly supported by empirical research. At Sustainable Capital, we respect the tendency of history to repeat itself, particularly in financial markets, where human nature seldom fails to drive prices through cycles of irrational exuberance and intense pessimism. Mean reversion is a powerful tool, especially in African listed equity markets where imperfect information creates chronic inefficiencies that drive wide deviations between the market prices of assets (driven by sentiment in the short-term) and their fair values (driven by long-term economic fundamentals). In the words of John Bogle (Founder of the Vanguard Group): Reversion to the mean is the iron rule of the financial markets... The evidence is compelling that when decade-long real stock returns are inordinately high by historical standards, returns in subsequent decades are likely to tumble; when past returns are exceptionally low, future returns are apt to rise. In this newsletter, we compare the performance of African listed equities (excluding South Africa) to the returns of Emerging Markets and South Africa in particular. We warn investors to mind the gap in the performance of these markets that has grown materially since mid We review the evidence for mean reversion in the total return profiles of these markets using long-term, historical performance of stock indices. The natural conclusion of our analysis is that mean reversion is likely to follow its inevitable course by closing the gap over time, which is likely to provide interesting opportunities to long-term investors and asset allocators.

2 10-year Performance Comparison: Africa (excluding South Africa) vs Emerging Markets (total returns in USD) The graph below plots the total returns of African ex-sa listed equities (excluding South Africa, represented by the MSCI Africa ex-sa index 1 ) against Emerging Market equities (represented by the MSCI Emerging Markets Index 2 ) over the past 10 years 3. All of the graphs and data presented are based on total returns (capital gains/losses and dividends) in common currency (US dollars). The upper half of the chart below displays the total return index of the Africa ex-sa (lower white line, denoted MXFMEAFZ Index) and the basket of emerging markets (upper orange line, denoted MXEF Index). Observe from the graph that, since the beginning of 2009, total returns in African listed equities have significantly lagged those of Emerging Markets equities. The lower half of the chart displays the ratio between the total returns of Africa ex-sa listed equities (in the numerator) and Emerging Markets (in the denominator). An upward slope signifies that Africa ex-sa is in an outperformance cycle (relative to Emerging Markets). Conversely, a downward slope implies an underperformance cycle. It is evident from the ratio graph that African markets outperformed Emerging Markets sharply in and peaked (on a relative basis) in late 2008 (peak ratio = 1.22), after which Africa ex-sa underperformed against Emerging Market equities for over 3 years, reaching a trough in early 2012 (trough ratio = 0.41). The table and bar chart on the right hand side of the chart provide statistical data supporting the 10 year history of the ratio between the total returns on African ex-sa and Emerging Markets equities. The average ratio over the 10 year period is 0.64 and the ratio is currently close to a full standard deviation below that, at This implies that, in order to restore parity under the mean reversion theory, the gap between Africa ex-sa and emerging markets would need to narrow by 18% in favour of Africa ex-sa equities. MSCI Africa ex-sa Index plotted against MSCI Emerging Markets Index (10 years, total returns, USD common currency)

3 Moving forward to 2009 when the material divergence between the markets really started (refer to the following graph, which displays total returns based to 100 at 1 January 2009), the graph illustrates that since the beginning of 2009, Emerging Market equities have returned 95.2% whereas Africa ex-sa has returned only 23.9% 4, which explains why African markets still have significant headroom to outperform before they restore their historical relationship with emerging markets. MSCI Africa ex-sa Index plotted against MSCI Emerging Markets Index (since 2009, total returns, USD common currency)

4 10-yr Performance Comparison: Africa (excluding SA) vs South Africa (total returns, USD) The following graph plots the total returns of African ex-sa listed equities (represented by the MSCI Africa ex-sa index) against South African equities (represented by the JSE all-share index) over the past 10 years. The upper half of the chart displays the total return index of Africa ex-sa (lower white line, denoted MXFMEAFZ Index) and South Africa (upper orange line, denoted JALSH index). The graph indicates that investors in the South African market have enjoyed a total return of 564% over the past 10 years (a handsome compound annual growth rate (CAGR) of 20.8% in USD terms). In contrast, the Africa ex-sa market has returned 385% over the same period (CAGR = 17.1%). Nearly all of the South African market s outperformance relative to Africa ex-sa has been accumulated over the past 4 years (since late 2008), as illustrated by the lower half of the following chart, which displays the ratio between the total returns of Africa ex-sa equities (in the numerator) and South Africa (in the denominator). South Africa s outperformance cycle (relative to the rest of Africa) peaked in late 2008 at 0.33 and troughed in early 2012 at 0.09 (a relative underperformance for Africa ex-sa of 73% over a period of nearly 4 years). The average ratio between Africa ex-sa equities and South Africa s total returns over the 10 years is The current level is 0.12, which is more than a full standard deviation below the 10-year average. Therefore, despite its recovery in early 2012, the Africa ex-sa equity market would need to recover a further 39.7% against the South African equity market (on a relative basis) to revert to its long-term average. MSCI Africa ex-sa Index plotted against JSE all-share Index (10 years, total returns, USD common currency)

5 Reviewing the more recent history since 2009 (refer to the following graph, total returns indexed to 100 at 1 January 2009), the chart below shows that since the beginning of 2009, South African equities have returned 110.2% (in USD terms) whereas Africa ex-sa equities have returned only 25.1%, which highlights why investors that are overweight in South African equities have an even greater gap to mind than their emerging market investor counterparts, when considered relative to Africa ex-sa equities. MSCI Africa ex-sa Index plotted against JSE all-share Index (since 2009, total returns, USD common currency)

6 Conclusions Its clear that mean reversion analysis is no substitute for detailed fundamental company research. Even so, like gravity, mean reversion is a powerful phenomenon that is strongly supported by empirical research and continues to be driven by investor psychology, which by its nature tends to repeat itself through bull and bear market cycles across different markets. At Sustainable Capital, we prefer not to bet against history unless our research uncovers very sound reasons why a company or industry has changed structurally (and may therefore perform out of synch with its historical track record). Our analysis of the total returns in listed equity markets over the past 10 years reveals that Africa ex-sa listed equities have underperformed materially relative to other emerging markets. The underperformance is even more stretched when measured against the South African market. Since the beginning of 2009, South African equities have returned 110% in USD terms and Emerging Markets have returned 95%, whereas the Africa ex-sa equity market has returned only 25%. This explains why African markets still have significant headroom to outperform before they restore their historical relationship with these markets. We advise investors and asset allocators to mind the gap, as a reversion to long-term averages implies a material rerating of Africa ex-sa listed equities relative to both Emerging Markets and South African equities. In order to restore parity under the mean reversion theory, the gap between Africa ex-sa and Emerging Markets would need to narrow by 18% from current levels. Despite its recovery in early 2012, the Africa ex-sa market would need to recover by a further 40% against the South African market (on a relative basis) to revert to its long-term average. The natural conclusion of our analysis is that mean reversion is likely to follow its inevitable course by closing the gap over time, which is likely to provide interesting opportunities to long-term investors and asset allocators. 1 We selected the MSCI index as a proxy for Africa ex-sa returns because it is the only African index with a sufficiently long-term data history for this analysis. Note that the MSCI is the best-performing African index over shorter-term time periods, so the use of alternative African indices in this analysis would have widened the performance divergence relative to the JSE all-share index. 2 The MSCI Emerging Markets Index is a free-float market capitalisation weighted index of 21 emerging markets with the following country weights (as of 31 August 2012): China 17.3%, South Korea 15.4%, Brazil 13.2%, Taiwan 11.0%, South Africa 8.0%, Others 35.2%. 3 Choice of time horizon: 10 Years is close to the maximum data history available for Africa ex-sa. The MSCI Africa ex-sa index, which has the longest history of any African ex-sa equity index, only dates back to 31 May All graphs are plotted to end dates as per the latest available market data at the time of writing, which is 21 September 2012 for the Emerging Markets analysis and 24 September 2012 for the South Africa analysis. Greg Barker CFA, MBA, MPhil (Sustainability), BTech(Eng) Director, Head of Investment Research, Sustainable Capital Greg heads up Sustainable Capital s investment team. Sustainable Capital is an independent, owner-managed, responsible investment asset manager that specialises in the research and management of listed African equity securities. Sustainable Capital currently manages the Africa Sustainability Fund, the Africa Alpha Fund and the Sustainable Capital Nigeria Fund. The firm s investment philosophy is that the sustainability performance of countries and companies is fundamentally linked to long-term investment returns, yet inefficiently priced by African financial markets. Greg has extensive experience in sustainable investment research in Africa and developed a strong track record of investment decision-making in his previous role as a fundamental investment analyst at a leading responsible investment management firm in South Africa. Since co-founding Sustainable Capital 4 years ago, Greg has been travelling into African countries to conduct fundamental research on companies. Greg is a CFA Charterholder with over 13 years of industry experience. He is a graduate of the University of Cape Town, having completed a Masters Degree in Sustainability and subsequently an MBA from the Graduate School of Business.