Feb 12, 2020
“Investing is laying out money now to get more money back in the future”- Warren Buffett
The opening quote, if combined with the image, truly defines the essence of investing: a growing tree. So why invest in Egyptian equities? Is it worth it? Will it cause our money to grow? I will try to make the answer as simple as possible, but to answer the question it is necessary to understand some fundamental questions first. What entices investors to buy equity stocks in any market, whether advanced or emerging? Which investors is the Egyptian market more suitable for? Those who are risk averse or risk seekers?
Investing is all about the optimal risk/return ration. By applying the golden investment rule of thumb "buy low and sell high", investors are attracted to arbitrage and mispriced stocks from its equilibrium, especially stocks that are undervalued. Egyptian equities belong to the undervalued stocks spectrum, evidenced by MSCI-Egypt index performance in 2019. According to the index prospectus, it is designed to measure the performance of the large and mid cap segments of the Egyptian stock market, constituting approximately 85% of Egyptian equity universe traded at EGX30.
In 2019, the MSCI-Egypt index traded at a valuation of 10.18 times earnings which is considered a 33% discount to MSCI-EM. According to the prospectus estimates for 2020, MSCI-Egypt is expected to trade at a valuation of 9.52 times earnings, considered a 25% discount to MSCI-EM. Consequently, Egyptian equities in 2020 represent an arbitrage opportunity for investors with lucrative returns evidenced by MSCI-Egypt index performance of 42.07% if compared to MSCI-EM index performance of 18.88% in 2019. In addition, the devaluation of Egyptian currency that occurred in late 2016 by almost 50%, makes Egyptian equities cheaper in USD$ than compared to other emerging markets.
That being said about Egyptian return and arbitrage, let's move on to the Egyptian equities risk profile and its suitability to investors’ appetite. Standard deviation is the most common statistical measure for any market volatility and risk profile. According to MSCI-Egypt prospectus, MSCI-Egypt is considered riskier than MSCI- EM evidenced by a 10 year annualized standard deviation of 28.83 if compared to MSCI-EM standard deviation of 17.15 for the same period. Hence, Egyptian equities are more suitable to risk seekers than risk averse investors. Nevertheless, this risk appetite might change in the upcoming years to entice risk averse stemmed from some changes occurring in the Egyptian stock market. In December 2019, Egyptian stock market introduced a short selling mechanism for the first time in its history. Short selling, as an investment tool, has its virtues in minimizing any stock exchange volatility. In early January 2020, the Egyptian stock exchange announced its plan to inaugurate its first local derivative market. Such market will incorporate futures and options trading in local currency. This is considered an advantage from a risk averse appetite, since derivatives will provide the required hedging to cater to a risk averse strategy. Hence, it is expected that Egyptian equities will entice both types of investors: risk averse and seekers. This seems the most optimal scenario, but what if the local derivatives market launch did not occur? As the famous saying goes: if you don't have a plan B, you don't have a plan at all.
In my humble opinion, another alternative to entice risk averse investors and to provide the necessary hedging is by applying cross hedging using index futures. Research conducted by the author of this article concluded that Egyptian equities could be hedged indirectly by longing the Singaporean index futures. This investment strategy will provide investors with some advantages. First, international diversification as Egyptian and Singaporean markets are not perfectly correlated, evidenced by a correlation coefficient less than 0.5. Second, adjusting the portfolio beta without having to long or short the stocks itself, hence no re-positioning is required. In addition, there are minimal transaction costs as the futures initial margins will be cheaper, stemming from the Egyptian currency devaluation. Another advantage, the Singaporean index futures tracks a composite of stock index characterized by sector weights similar to the Egyptian stocks index, hence, minimizing the impact of the tracking error. Consequently, the Singaporean futures recorded a hedging effectiveness with Egyptian equities of 24%. Bearing in mind that MSCI-Egypt futures tracking MSCI-Egypt index recorded a hedging effectiveness of 30% and was terminated in 2016.
Finally, I think the Egyptian stock market under current and future circumstances will make investors' funds grow more, as defined by the Warren Buffet quote above. It will take some time for stock prices to revert back to its equilibrium as compared to EM peers. But how long will the arbitrage window exist? Perhaps Artificial Intelligence algorithms could help answer such a question, but that is a thoughtful story for another day...
This article was first published in TalkMarkets on 15/1/2020
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