Is there an optimal way of investing in Africa?

The Johannesburg Stock Exchange (JSE), the stock market for South Africa, is the most liquid market in Africa. The rest of the other exchanges in the continent are not as liquid and this has certain consequences and implications of how investors can best make their investments when investing in Africa (excluding South Africa).

What is a liquid market?

A liquid market is a market where investors find it easy to buy and sell shares and other assets in that market. This means that if an investor wanted to buy shares of a specific company, say Shoprite, they will be able to buy those shares in a short period of time, at relatively the prices they want to buy them at (current prices) and incur less costs associated with buying those shares. This is because there is too much traffic in that market in the sense that there are many investors who are buying and selling those shares, hence it is easy for any investor to trade in that market. That is liquidity in a market.

The opposite is true, an illiquid market is a one where an investor finds it difficult and costly to buy and sell shares and other investments assets traded on that market. There could be a couple of factors why some stock markets are illiquid. One of the common factor is that most of these markets do not trade popular shares or investment instruments. This results in less activity on such exchanges, that is, less buying and selling of shares. This leads to higher costs of trading in that market.

Why are most African Exchange Markets illiquid?

The common reason why most of the stock markets in Africa are illiquid is because they don’t have popular shares listed on them. This is so because most African countries have not yet witnessed a significant number of multinational companies that get to be listed on their local exchanges. There are always outliers and Dangote Cement is one these outliers. However, outliers are commonly very small proportional to the rest of the statistics and very rare as well.

Is an illiquid market a bad thing for investors?

It depends on what kind of investor you are. Hedge funds that pursue different strategies actually find an illiquid market to be the most profitable market to be in depending on the strategies they follow. This is so because an illiquid market opens up a lot of arbitrage opportunities. This can be combined with some complex derivatives to profit from the illiquid market, for instance, using a Short straddle derivative (This is a derivative that earns profit when the underlying asset’s price does not move significantly.) Because an illiquid market’s activity is low, most of the prices in such a market usually remain the same for a long period of time, hence derivatives such as a Short straddle can be used.

Long term investment managers, on the other hand, might find an illiquid market to be unattractive and not as profitable to trade in. This is so because most of them follow the plain buy-low sell-high strategy, which might not work out so well in an illiquid market. This is because as previously mentioned, in an illiquid market, trading activity is very low and prices usually remain more or less the same over a long period of time. Take for instance Investor A who believes that the current market value of the share XYZ has surpassed its intrinsic value and now believes is the best time to sell the share. Investor A might find it difficult to sell that share at that very moment at that very same price he believes he will make profit and if he is selling a “statistically significant” proportion of such shares, the investor might drive down the price of the share themself.

Is there optimal way of investing in illiquid markets such as those in Africa?

There is a way to invest in Africa without taking “significant risk” or using complex derivatives to profit from the illiquid markets. Most African countries, like the rest of other developing nations such as India, are still lacking behind in terms of development. This means that there is a huge gap that will need to be filled by both governments and entrepreneurs (who will solve problems that governments will not have the capacity to solve.). This essentially means that there could be plenty of start-ups that will launch in these markets in the future that have the potential of growing big and even expanding to other emerging markets that might be facing the same problems as the initial market launch of the start-up(s).

Nigeria is one country that is leading in this space of having start-ups that are growing big in a relatively short period of time due to the size of the population of the nation and the idea of “mass-producing a solution”, that is, solving a problem that is faced by many people. Some of the start-ups in Nigeria and other African countries that have grown significantly include Paga, M-pesa, Sendwave and Paystack. It is worth noting that most of these start-ups are in finance or more precisely fall under the description of “Fintech”. One reason for this is because a huge problem in developing countries is Underbanking (When the majority of a country’s citizens do not have access to mainstream financial services) and these start-ups solve this challenge by making it easier for people and businesses in these developing nations to be included in the “financial pipeline”, so to speak.

Underbanking, however, is just one of the many problems that needs to be solved. There are still many more and pressing issues that need to be addressed in developing countries and where governments will not have the capacity nor the incentive to solve these problems. It will be entrepreneurs that will solve these problems in smart ways and are very likely to even develop new business models in coming up with solutions to these challenges. My point here is that private equity and in particular Venture capital investing could be the most optimal way of investing in Africa because Africa is still setting us its own “Silicon Valley” and is yet to experience a high number of start-ups that will grow significantly.

Section 12J investing in South Africa

The South African government has recognised the need to stimulate economic growth through SMMEs and these led to the introduction of Section 12J investment provision in 2009. This provision allowed investors to invest in start-up companies and other private equity related investments whilst also providing a tax incentive to investors who invest through Venture Capital firms. The result of Section 12J can be seen in the amount of capital Venture Capital firms raised during this period since 2009 and the respective number of investments that were made in some local start-ups. It is worth noting that Section 12J has a sunset clause that ends in June 2021. This was a great initiative to get investors to invest in start-ups and private equity firms although other African countries needed a regulation like this one more than South Africa did.

Conclusion
Investing in start-ups and other private equity firms might seem to come with high risk of investors losing their capital. However, this could be the most optimal way of investing in countries that are still developing and have illiquid exchange markets.

Disclaimer
This article should not be regarded as investment or tax advise and anyone seeking such advise should do so with a person or entity registered with the relevant authorities to give such advice.

The views expressed in this article are that of my own and do not represent the same views of any entities that I am associated with.