NSE Chairman's Statement on the Growth of Kenya's Stock Market

By Mr. Jimnah Mbaru

In the recent past, there have been political statements reported in the media questioning the source of the phenomenal growth of the Nairobi Stock Exchange (NSE) in the past three years.

These statements are misleading and do not reflect the economic and other dynamics that underpin the growth of the Nairobi stock market and the rest of the Kenyan economy.

The stock market and its index are the mirror of what is happening in the rest of the economy. In the past three years, Kenya has achieved substantial economic recovery, recording a growth rate of 5.8 percent and the growth rate this year is expected to be much higher. During the same period, share prices have appreciated to the extent that the NSE market index has increased from around 2,000 to over 5,500 points.

The factors driving the economy include renewed business confidence by domestic and regional investors, resulting from improvements in the domestic and regional environment. The international investors have also been attracted by the good rating of Kenya by Standard and Poor’s, the internationally acclaimed rating agency. Standard and Poor’s has rated Kenya’s foreign debt as investment grade B+, and domestic debt as BB-, which means that foreign pension funds can confidently invest in Kenyan equities and bonds.

The funds being invested in the stock market are a product of improved surplus incomes and prospects of economic recovery and rehabilitation of infrastructure such as roads, airports, water and railways to facilitate intra and regional trade.

Specifically, the main sources of funds for investment in shares and stocks include:

1) Increased individual domestic savings arising from increased incomes from the milk sector, sugar, maize and horticulture, among others. We must also bear in mind that many parents are no longer paying school fees for primary school education since the government implemented Free Primary Education, hence, their disposable incomes are higher.

2) Expansion in the size of funds held by pension funds following reforms that have been carried out by the Retirement Benefits Authority (RBA) since 1998. Previously, most pension funds were overweight in property investments and underweight in equities. Many of these pension funds are rebalancing their portfolios in line with RBA’s regulations, hence, their push into equities market. It should be noted that the size of the pension funds in now in excess of KShs 200 billion and continues to grow annually.

3) Increased in investments in securities by the National Social Security Fund (NSSF) as it tries to balance its portfolio as per the RBA guidelines. NSSF holds over KShs 50 billion mostly in real estate and Treasury bonds

4) Increased insurance premiums as the sector has become more aggressive in marketing innovative life assurance products such as funeral policies, travel insurance, education plans and mortgage protection policies among others. Insurance companies have also expanded with the neighbouring countries and continue to tap new premiums.

5) Increased retained earnings by the corporate sector following improved profitability. This is evident from the many companies that have achieved substantial recovery after years of depressed growth including Kenya Airways, Kenya Commercial Bank, Barclays Bank of Kenya, East African Cables and Mumias Sugar Company, just to mention a few.

6) Increased profitability of small and micro enterprises due to improved market conditions including competition and greater transparency in the award of government tenders.

7) Rapid growth in mutual funds and unit trusts, giving small investors an opportunity to invest their small savings in large, profitable firms. Some of these mutual funds include Old Mutual and British American unit trusts. Currently, these unit trusts hold over KShs 10 billion.

8) Substantial remittances by Kenyans in the Diaspora, who are remitting back to Kenya an estimated US$ 750 million – US$ 1 billion (KShs 50-75 billion) annually through Western Union and commercial banks. Most of these funds find their way into the stock market and the real estate, among others.

9) Increased inflows from international investors, including speculators, dedicated emerging market funds and hedge funds. Presently, international investors contribute about 15 percent of the stock market turnover. Most of these funds are remitted to Kenya through commercial banks who act as custodians for these investors. The Central Bank of Kenya keeps track of where these funds are coming from.

10) Availability of low interest rate and unsecured personal loans to individual investors and similar business loans to small and medium enterprises. The impact of this lending was demonstrated during the recent KenGen primary share issue.

11) First time investors in the stock market. The KenGen issue, for example, attracted 240,000 investors, of which majority were first time participants in the equities market. These new investors include the youth and students who are at home with financial assets, as well as trading on the internet.

These sources of funds have not just developed by accident. They have expanded because of the attractiveness of the Kenyan economy due to economic recovery arising from better macro-economic management, which is demonstrated by low fiscal budget deficit, low inflation, low interest rates and a competitive exchange rate. The Kenya Revenue Authority has also increased its tax collections from about KShs 200 billion in 2003 to KShs 375 billion in 2006. This increased tax revenue has contributed to less borrowing by Government from the money market, hence, the low interest rate environment.

Investors have also been attracted by the substantial profit growth of the companies listed on the Stock Exchange, which have benefited from the improved economic environment, expansion of regional markets and better business prospects in new markets such Rwanda, Eastern DR Congo and Southern Sudan. Indeed, the substantial price rise of shares of firms such as Kenya Airways, East African Breweries, Kenya Commercial Bank, East African Cables, Mumias Sugar Company and Bamburi Cement Company, among others, has been as a result of increased domestic and regional business growth.

The growth of the stock market has also benefited from a considerable shift in the business strategy of individual and institutional investors. There is a shift from less liquid assets like plots and land to more liquid investments such as equities, Treasury bills and bonds, both Treasury and Corporate.

The NSE has made its contribution in increasing investor confidence by modernizing its infrastructure. In 2004, it launched the Central Depository and Settlement Corporation (CDSC), which has significantly improved the settlement cycle. In 2006, the NSE installed the Automated Trading System (ATS), which was recently launched by H.E. President Mwai Kibaki. The ATS has eliminated inefficiencies in allocation of shares and delays in transfer of shares, hence, better price discovery on the stock market.

The dynamics being experienced by the NSE are not unique to the Kenyan economy. Other sectors of the economy including tourism, housing, agriculture and exports have experienced higher growth and future prospects remain high. Assets in these sectors have seen tremendous increase in prices and values.

As the economy continues to expand, and as the Government continues to privatize its parastatals through the NSE, the new investors both from Kenya and the Diaspora continue to patronize our market. This will lead to a deeper capital market which will enable profitable companies and Government to raise funds cheaply. Investors will also have a good opportunity to diversify their portfolios.

The NSE will continue to play its role to assist Kenya achieve its Vision 2030. I call upon all well wishers to join us and be partners on this journey to greater prosperity.





JIMNAH MBARU
CHAIRMAN
NAIROBI STOCK EXCHANGE
21st November, 2006

Food For Thought

Can Individual Investors Beat the Market?

That's a good question -- and the title of a now-famous academic paper. For most investors, the answer is an emphatic "No." At least not by any meaningful degree, but more on that later.

Fortunately, you have options. You can buy an index fund, something we recommend for a good chunk of your portfolio. That way, you essentially bet with the house. But indexing has its downsides, not the least of which is lost opportunity.

Let's take an example. Imagine that, on top of your core index holdings, you earmark an additional $50,000 as market-beating ammo. If that $50,000 earns 10% yearly -- something you might hope for from the Standard & Poor's 500 -- you'll have $336,375 after 20 years.

Sounds good, but wait.

How about an extra half-million?
If you can muster 15% instead of 10% with the more aggressive portion of your portfolio, you'll walk out of the gates with $818,327! That extra 5% per year gets you an additional $481,952. I don't know about you. ... OK, yes I do: We'd all love to grab half a million dollars extra.

Of course, that extra 5% doesn't do you much good if you don't get it. Sadly, most individual investors don't, for many reasons. Here are just two.

Never letting go. In The Courage of Misguided Convictions: The Trading Behavior of Individual Investors, Barber and Odean find that we are 50% more likely to sell a winner than a loser. Our tendency to avoid pain -- in this case, refusing to take a loss that already exists -- is just one psychological weakness that leads us to poor investing decisions.

That irrational exuberance. Another is a sort of self-perpetuating prophecy: We pursue exciting opportunities to the point where they are no longer such good investments. AMD ( NYSE: AMD) may have merit as a company, but was it worth a triple-digit P/Eback in 2005? Probably not. And that's one of the reasons the stock has dropped even as the company has grown earnings.

OK, it's smoky in here ...
But given the choice, where will you sit? At the table of visor-clad sharks or the one with the Hawaiian-shirted tourists? Sounds simple, but odds are you've been sitting down with the sharks in the stock market, playing a tougher game than you have to.

Lakonishok, Shleifer, and Vishny -- three professors I'll call "LSV" for short -- suspected as much. In 1994, the trio set out to investigate why certain types of stocks consistently tend to outperform. They started by dividing stocks, using a variety of factors, into two groups: Unloved, low-expectation nobodies -- value stocks. High-priced, high-expectation glamour stocks.

Picture shoelace makers and semi-regional banks versus, say, Infosys Technologies ( Nasdaq: INFY), CNET Networks ( Nasdaq: CNET), or Wind River Systems ( Nasdaq: WIND). Tell me, where do you think the sharks are playing?

So, how about that extra 5%?
Breaking stocks into a 10-group spectrum ranked by earnings yield (earnings divided by price, or E/P -- academics prefer to rearrange familiar measures to maintain an air of sophistication), the trio shows that the high-E/P value end of the spectrum bested the glamour end by about four percentage points per year.

That's not pocket change. And it wasn't news to many of history's greatest investors. The likes of Dodd, Graham, Buffett, and many others have espoused buying stocks with low P/Es. It's great to see confirmation of the low P/E ideology from both academia and investors past -- but there's work to be done.

You don't have to be Warren Buffett to notice that E/P, however powerful, is a simple, imprecise measure. LSV knew this -- in fact, the study aimed in part to expound upon a study (by Fama and French) that harped on the book-to-market ratio (B/M), a variable described by LSV as "not 'clean'" for its oversimplicity and inability to capture other forces -- namely, growth.

Investors gone wild
Indeed, growth is sorely missing from measures like B/M (again, an academic inverse of the familiar price/book value ratio) measure. So LSV gave growth special attention.

The trio again broke the universe into deciles, this time using a formula based on historical sales growth. Amazingly, value stocks -- the low-expectation, low-growth nobodies -- again walloped glamour, this time by 7.3 percentage points per year.

It's important to understand why. The gang explicitly rejected the knee-jerk academic explanation that if value stocks do better, they must somehow be riskier. Instead, they identified -- and politely termed "suboptimal" -- inferior behavior on the part of investors as the culprit.

Investors overpursue today's hot performers to the point that returns are no longer lucrative. And, to be more specific, LSV's glamour stocks are high-sales-growth stocks that don't have much in the way of assets or cash flows. In other words, stocks like Apollo Group ( Nasdaq: APOL), CA ( NYSE: CA), or (arguably) even eBay ( Nasdaq: EBAY), which have experienced strong sales growth in the past, wouldn't fit the "glamour" moniker. Moreover -- and I'm probably butchering once-eloquent thoughts -- investors don't adequately understand mean reversion, a concept best explained by analogy.

Odds are that a car going 100 mph on the freeway will be traveling closer to the speed of traffic five minutes later. Similarly, a driver clocked at 35 may be going slowly only temporarily (unless he's driving in front of me) and will, the odds dictate, also be traveling closer to the speed of traffic five minutes hence.

It's not impossible to make money in glamour stocks. In fact, some people make a killing in them. But it's a mistake to assume that current trends will continue indefinitely -- and clearly, the glamour table is a tougher game.

Now I'll drop the bomb
The real secret of the LSV study was the magic of combining factors. A portfolio favoring high (cheap) E/Ps and low growth outperforms its glamour opposite by 11% per year. Now that's astounding. Wouldn't you be eager to sit down at a card table knowing you had an 11% advantage?

And remember the study about individual investors failing to beat the market? There's more to the story, both good and bad. A precious handful -- the top decile -- of investors do beat the market, and nicely, earning "excess returns" of 0.12% to 0.15% per day. But that's largely offset by the bottom decile's 0.11% to 0.12% loss. In other words, for every couch potato investor doing well, one does poorly -- ironically, so poorly that we'd do well to sell short his favorite picks and profit from their declines.

Bottom line for you
If you're just jumping into the game, odds are you won't win. Your odds of consistently beating the market are about the same as those of consistently letting the market beat you. Of course, we'd all like to think we're in that special 10%, but with your retirement at stake, isn't a little honesty in order?

One option is to find someone in that 10% -- a proven top-deciler -- and keep him or her on a short leash. If you either (a) don't have the time, effort, skill, or inclination to beat the market, or (b) don't know anyone who does, I highly recommend you take a look at Tom Gardner.

Cheating off Tom makes all kinds of sense for the "bottom 90%" of us. Since he launched his Motley Fool Hidden Gems newsletter service in July 2003, Tom's picks have returned 47% -- a mind-blowing 26 percentage points above the S&P 500. If you like those odds, Tom is offering a no-obligation, 30-day free trial to Hidden Gems, full privileges included -- simply click right here to learn more.

This commentary was originally published on Jan. 14, 2005. It has been updated.

James Early owns none of the stocks mentioned in this article. CNET is a Rule Breakers pick. eBay is a Stock Advisor recommendation. The Motley Fool has a disclosure policy.