Recent years have been full of swings for investors in Nigeria’s stock market, the continent’s third largest by capitalisation (after Johannesburg and Cairo). While investors welcomed what they saw in 2010 as a fleeting recovery in markets, 2011 was more challenging, on the back of sustained volatility in global markets and fallout from the 2008 margin lending crisis. A search for yields has drawn investors towards the fixed income and money markets, allowing the government and corporations to finance domestically, albeit at increasingly high rates. Regulators have seized on the crisis as an opportunity to restructure exchange fundamentals by improving transparency and governance, while a pipeline of new issues and instruments is being built. A significant sanitising of the sector, a clean up of Nigeria’s banks (which accounted for close to a third of market capitalisation in 2011) and low relative valuations have all attracted a number of value investors to Nigerian stocks as they buy to hold, anticipating a market bounce back in coming years.

RISK-ON, RISK-OFF: The equity market continues to be dominated by foreign inflows, but domestic institutional investors have flocked to high-yielding federal government bonds, whose large number – along with high benchmark interest rates – has crowded out corporate bond issues (see analysis). While “riskon, risk-off” sentiment swings by foreign investors seeking to cover their positions in core markets at the expense of frontier markets will continue to create some volatility, 2012 may yet prove a turning point in the recovery and see a gradual return of domestic investors. To attain the goal of growing the nation’s total capital markets to $1trn by 2016 (from $60bn currently), authorities will need to accelerate efforts to attract supply and liquidity.

SUBDUED EQUITIES: The Nigerian Stock Exchange (NSE) hosts a total 186 equities on its main board, 12 on its Alternative Securities Market (ASeM) dedicated to small and medium-sized enterprises (SMEs), and one exchange-traded fund (ETF). Equities reached a market capitalisation of N6.54trn ($41.86bn) at the close of 2011, while trading remains highly concentrated amongst a select few blue-chip stocks. The 20 largest stocks accounted for 83.61% of the equity market’s capitalisation and 53.11% of the total market in 2011, according to the NSE.

DEALING WITH THE PAST: Trading on the NSE is still grappling with the consequences of the drawn-out bust from March 2008, with volumes yet to recover. During the four years prior to 2008, the NSE’s All Share Index (ASI) grew 225.37%, to reach 66,371.20 points, while the market capitalisation of listed equities surged 841.46% to roughly N13trn ($83.2bn). Following banking consolidation in 2004, the value of financial sector stocks grew nine-fold at the peak. Foreign asset managers may have been responsible for part of this, but the strong growth in domestic investment – both retail and institutional, as freshly recapitalised banks played the markets – also played an important role. What began as a predictable correction due to an outflow of foreign funds in March 2008 (as foreign investors withdrew money to cover their positions in core markets) was compounded by Nigeria’s margin lending crisis. Well-capitalised banks post-2004 had shied away from lending to the real economy and instead lent significant sums to brokers, who then bought those banks’ shares and other equities. Many banks were particularly exposed to the financial sector sell-off, as well as losses on loans to the downstream oil and gas sector, some of which were defined as non-performing in 2009.

As the sell-off gathered steam and the NSE shed two-thirds of its value, brokerages were hit and defaulted on their loans, with bank balance sheets deteriorating. The central bank moved to clarify banks’ exposures in 2009, highlighting incidents of irresponsible bank lending and inadequate risk management. However, the drop on the NSE continued, with market capitalisation falling to N4.989trn ($31.93bn) by the close of 2009, while the ASI fell to 20,838.9 points. Equities staged a tentative rally in 2010 as global conditions improved and investors returned to frontier markets. The index rose 18.9% in value during the year, closing at 24,770.52 points, and market capitalisation grew by 58.5% to N7.91trn ($50.62bn). This was driven mainly by the listing of Dangote Cement, which accounted for a quarter of the market’s capitalisation.

RECENT EVENTS: Yet 2011 was marred by volatility and turbulence worldwide as global investors continued to cut their exposure to stocks, particularly in emerging markets. The index dropped 17% to 20,730.63 points by the start of 2012. The oil and gas and banking sectors were the two worst performing sectors, with the average value of bank stocks dropping 32% – seven of the 15 listed banks posted higher than expected losses for the full year.

A post-election rally fell short of expectations, and the increases recorded in the first half of 2011 were reversed in the second half, wiping out all the gains of 2010. Transaction volumes and values were also down during 2011. Average daily trading fell from N3.23bn ($20.67m) in 2010 to N2.58bn ($16.51m) in 2011. Similarly, during 2010 the total value of transactions on the NSE was equivalent to 2.73% of GDP, a figure that declined to 2.39% in 2011.

REGULATE & REFORM: Starting in 2009, the exchange and industry regulator, the Securities and Exchange Commission (SEC), has initiated several far-reaching market reforms to spur recovery. Just as the central bank used significant governance problems to overhaul the banking sector, authorities are now seeking to turn the post-2008 crisis into a longer-term opportunity. A new administration at the exchange in April 2011 and the constitution of a new board and six constituent committees has begun addressing concerns. “We would never be talking about this kind of reform if we had not had the meltdown,” Oscar Onyema, the CEO of the NSE, told OBG.

The NSE and SEC have moved swiftly to increase penalties for violating disclosure standards and moved to reform and consolidate the brokers’ market (see analysis). While many quoted companies flouted the requirement for the timely filing of results, the exchange now estimates 96.81% of listed companies submitted annual accounts in 2010. All listed companies were required to present forecasts starting in 2011. Some 80% of listed companies (and eight of the 10 largest) share a common year-end date of December 31 according to the central bank. This should rise to 100% once international financial reporting standards (IFRS) are implemented in 2013. Stricter rules on profit warnings and half-year financial reporting are also being implemented, while reporting under IFRS is mandated for all listed companies. In a clear signal of increased enforcement, the NSE moved to penalise 72 companies that did not comply with reporting requirements in April 2012. “There has definitely been more enforcement in the past two years, with the delisting of certain stocks, the speeding up of results announcements and the release, for the first time, of forecasts,” Hajara Adeola, the managing director of Lotus Capital, Nigeria’s first sharia-compliant investment house, told OBG.

PROTECTING CONSUMERS: The regulator has also used the Consumer Protection Council to strengthen investor protections. In July 2012 the NSE was finalising the establishment of an Investor Protection Fund, capitalised with N635m ($4.06m), to compensate investors who suffered pecuniary losses. Meanwhile, new guidelines on share buy-back schemes were approved in 2011. These allowed companies to buy up to 15% of their shares, but required them to abstain from re-issuing those shares for one year.

More fundamentally, the NSE is also moving towards demutalisation. In 2011 the SEC established a working committee to advise the commission on the demutualisation process, which in February 2012 announced its recommendations, including a cap on the percent of the NSE that can be owned by any individual shareholder. Advocates of demutualisation say that it will improve oversight of brokers and dealers and enhance the exchange’s transparency and efficiency. Yet a precondition for this reform will be the development of a clear regulatory framework for demutualisation. Notably, there is at present some uncertainty regarding how many brokers, corporations and individuals are actually members of the exchange, as well as questions regarding the length of their membership. This would need to be clarified before the demutalisation process could proceed.

INTERNATIONAL STANDARDS: Management of the NSE is also preparing to apply for membership in the World Federation of Stock Exchanges in a bid to raise its credibility. “The enhanced corporate governance standards, transparency, ownership diversification and disclosure requirements of the exchange will help drive value and efficiency in the industry,” Onyema told OBG. While the NSE’s governance reforms have been widely applauded by the investment community, significant gaps in governance at the SEC came to light in early 2012 with a parliamentary probe into Nigeria’s capital markets. This led to the suspension of Arunma Oteh, the SEC’s director-general, in June 2012, on allegations of embezzlement.

These revelations were welcomed as a sign of improved governance at the market’s regulator, but it has proved yet another reason for retail investors to remain on the sidelines. The appointment of a new director-general will be likely be a key factor in any recovery of confidence.

Alongside regulatory reforms and technical upgrades, the NSE is planning to boost liquidity in 2012 by extending trading hours to maximise the overlap with US trading. New rules will also relax restrictions on price fluctuations, moving from a 5% to a 10% cap on price swings. Meanwhile the launch of securities lending and short-selling in 2012 will likely entice more foreign liquidity, particularly hedge funds, as well as more sophisticated local trading houses. A first step was taken in April 2012 when 10 market makers were accredited (see analysis).

FOREIGN CAPITAL: Although the NSE estimates that it caters to some 5m investors, the share of domestic ownership remains low. Nigerian investors accounted for just N1.24trn ($7.94bn) of market capitalisation as of the end of 2011, heavily led by institutionals, which made up N1.13trn ($7.23bn).

The central bank implemented “anti hot money” rules in 2008, requiring foreign managers to hold their naira position for one year, in a bid to curb excessive inflows at the time and calm pressure on the currency. These were lifted in July 2011 to encourage inflows and stabilise the naira.

The NSE estimates net foreign portfolio flows in 2011 amounted to N177.08bn ($1.13bn), a 3.53% increase from the previous year’s N171.04bn ($1.09bn), driven primarily by funds based in the UK, the US, Hong Kong, Luxemburg, South Africa and Germany. Similarly, the foreign share of average daily turnover rose from 49% in 2010 to 81% in 2011.

During the first seven months of 2012, foreign investors have been active on the exchange, accounting for 67% of total market turnover on a weighted buy-sell basis during the month of July, according to the NSE. International investors have been particularly keen to buy, with foreign portfolio investment accounting for more than 80% of purchases (as measured in value) during that same month, Stanbic IBTC Bank has calculated. This has been the case despite the fact that Nigeria was reclassified as a “smaller frontier” and “low liquidity” market by the MSCI Frontier Markets Index in November 2011.

HELP FROM ABROAD: In the face of lacklustre domestic appetite for equities, foreign demand has dominated activity. This has resulted in sustained volatility, as global investors continued to switch between “risk on” and “risk off” modes.

Foreign interest has been cautiously growing on the exchange during the first half of 2012, in part due to generally low returns in more developed markets and improved earnings for listed Nigerian corporations. “Foreign investors have been adopting a buy and hold strategy of late and we expect this to continue for the rest of 2012,” Wale Agbeyangi, the managing director of Cordros Capital, told OBG. “We may not see a major jump in the ASI, but we do expect value investors to continue taking long-term positions because valuations are attractive.”

While the heyday of trading in the four years to 2008 brought an increase in domestic participation, reaching 53% of turnover, local investors have retained memories of the long downturn afterwards. Moreover, new rules for banks ban them from directly investing in stocks, while loans to brokers now require usual loan provisioning. Meanwhile, local pension fund administrators (PFAs) – another potential source of domestic participation – have largely shifted from equities to fixed-income instruments in recent years. Nonetheless, regulators have increasingly focused on the role of PFAs as potentially the largest source of domestic investment, including in the equities market. New guidelines for PFAs will raise the ceiling on equity investment to up to 50% of total assets, and are expected to mandate minimum PFA investments in equities of 10% of assets under management. The new guidelines will also create a multi-fund structure, mandating that each PFA to manage four funds, including a sharia-compliant fund if desired (see analysis).

Pension funds have the potential to be important players in the local capital markets, with assets under management having grown rapidly since reform in 2004, reaching a total of $16bn in early 2012. Given that PFAs are expected to allocate a large portion of assets to domestic investments, they are widely expected to drive the growth of domestic liquidity on the exchange. This is despite remaining on the sidelines – PFAs like Crusader Sterling have cut their exposure to equities by some 80% since 2008.

SPREAD THE WORD: Alongside moves to encourage more institutional liquidity, the NSE and SEC have embarked on aggressive retail investor education seminars and roadshows in partnership with Morgan Stanley and the main brokers on the market in a bid to rebuild the appetite of retail investors, which accounted for N111.6bn ($714.24m) of turnover in 2011, according to the NSE. The NSE has also been pushing for a reduction in transaction costs by prodding the Revenue Department to lower total exchange fees. Total taxes amounting to some 12% of transaction value (7% through value-added tax, or VAT, and 5% in stamp duties). The exchange has called for elimination of VAT on brokerage transactions, maintaining that investment fees should not be categorised as consumer goods purchases. The NSE also wants the stamp duty removed, since investment trading is separate from government-related transactions. While these have yet to pass, they could affect liquidity by reducing transaction costs.

TRUSTS & FUNDS: The mutual funds industry remains in its infancy and could prove another source of growth over the medium term. Seen as a necessary means of aggregation for retail investors and a useful means of diversification for institutionals, unit trusts and mutual funds are being pushed by the regulator and the exchange as an alternative to direct investment through a brokerage.

Growth has been subdued in recent years, with the net asset value of the unit trust market doubling from N46.18bn ($295.59m) in 2005 to N98.82bn ($632.45m) in 2009, but falling back to N85.3bn ($545.9m) by February 2012. Composed of a variety of schemes from bond and equity funds to sharia-compliant funds, two real estate investment trusts (REITs) and one ETF, this market segment has 43 collective investment schemes listed. However, retail investors have not flocked in significant numbers towards unit trusts, preferring investments in the fixed income market instead.

One of the challenges has been taxation, given that mutual funds are not currently considered “pass-through” vehicles. Only in Lagos are investors able to constitute a limited partnership that provides for this type of vehicle in the same manner as in more developed markets. A planned new regulation by the central bank regarding special-purpose vehicles should help resolve this ambiguity.

NEW TACTICS: ETFs are being marketed as a means to draw reluctant investors back to market, while retail investors are being encouraged to invest through mutual funds. “Mutual funds are another way of aggregating capital, but retail investors must have trust in the fund managers,” Onyema told OBG. “We are working on increasing the transparency of this industry segment, while reducing the cost of transaction. This type of fund should indeed be one of the primary means for individuals to invest.”

The objective is to move small investors away from dealing with brokers directly, transforming brokers into deal executors rather than money managers and advisors. In mid-2012 the NSE estimated only 250,000 investors placed funds in a mutual fund; with some 5m accounts nationwide, there is clear scope for growth. Brokerages like Cordros Capital expect these initiatives to start bearing fruit in 2013.

The country’s sole sharia-compliant fund manager, Lotus Capital, has launched the first sharia-compliant NSE index (NSE Lotus Islamic Index) in July 2012. Including 15 stocks in non-interest bearing companies, such as consumer goods and building materials that have outperformed the general market in the past three years, the index caps specific stocks at 30% of the index and each sector at 40%. Welcomed by investors, the index is likely to attract new liquidity and new instruments. Lotus Capital expects new ETFs to be structured on this index.

NEW SUPPLY: Reform is not only focusing on supervision and enforcement, but also on promotion and development. The breadth of companies represented on the exchange remains unrepresentative of the structure of the Nigerian economy, with companies in important sectors like energy, agriculture and telecoms for the most part unlisted. The SEC intends to revise listing requirements and share buy-back procedures to reduce costs and time for listing. While listing costs were cut in 2009 in the face of the stock market slump, investment banks continue to worry about the expenses involved with listing.

The number of primary issues dropped to nine in 2009, but this figure rebounded somewhat in 2010. The 23 issues in 2010 saw the listing of 12 equities (mainly rights issues by existing listed companies), six corporate bonds and five sub-national bonds. Yet the continued instability in the equity market drove an increasing number of corporations towards fixed income markets (see analysis). The slowdown in 2011 seemed to have scared any new equity issuance away, with no IPO that year and only one unit trust fund (Sim Capital Alliance Value Fund) issuance of N5bn ($32m). “Part of the challenge stems from unrealistic expectations by market participants,” Rotimi Oyekanmi, the group head of Ecobank Capital, told OBG. “Most companies see the 2008 valuations as their natural level, but I think it will take some time before we see such high prices return. Prospective issuers can not stay on the sidelines forever.”

Despite the lack of new issues, the NSE says it granted 34 approvals for new listings valued at N2.03trn ($13bn) in 2011. The exchange and regulator will have to drive new listings in order to reach the market capitalisation target of $1trn by 2016, as well as a total of five product types on the exchange (see analysis). Authorities place high hopes in particular on the telecoms, oil and gas, utilities and agro-industrial sectors, vastly under-represented on the board, for fresh listings. Only one telecoms operator has listed thus far (Starcomms), but it has been making losses since 2006, while telecoms infrastructure provider IHS Nigeria was floated in 2009.

Significant unlisted concerns exist in oil and gas, with the only listed firms operating downstream, in contrast to nearby Ghana, whose recent discovery of oil has led to double listings from foreign firms, such as Tullow Oil. The NSE also expects a number of microfinance banks (MFBs) to list in the coming year as the central bank moves to restructure the sector through higher capital requirements.

“There may be some primary market activity as some banks seek to restructure under the holding company bank model and dispose of certain subsidiaries,” Onyema told OBG. “We may see more listings by microfinance banks seeking to recapitalise.”

SMALL BUT STRONG: The ASeM is the NSE’s board for SMEs and comprises 12 companies in sectors ranging from consumer goods to financial services. With a market capitalisation of N4.07bn ($26.05m) in 2011, the alternative board saw 284.73m shares worth some N154.67m ($989.89m) trade hands in 2011. Only one company (Smart Products Nigeria) paid dividends, which is typical of a platform meant to fund smaller companies aiming for expansion. While the minimal capital requirement for listing on ASeM is N500m ($3.2m), new supply of stock offerings has lagged in recent years. The NSE reduced fees for listing on ASeM to N300,000 ($1920) in April 2012, far lower than the cost of N4.2m ($26,880) for listing on the main board.

ACT LOCALLY: While there have long been calls to require multinational companies (MNCs) active in Nigeria to list their local subsidiary on the exchange, 2012 has witnessed a number of actions which could indicate more pressure. The Chartered Institute of Stockbrokers has called on companies such as MTN, whose most profitable operation worldwide is in Nigeria, to list. The House of Representatives committee on capital markets sponsored a bill in March 2012 making it mandatory for oil and gas majors to list locally, although progress in the bill’s reading has been slow to date. The Nigerian Communications Commission is also contemplating a requirement for mobile operators to list, spurred by demands from Nigeria’s stockbroker community.

“Many of the telecommunications firms will have to renew their licences soon, we have an opportunity at that point,” Ariyo Olushekun, the president of the Chartered Institute of Stockbrokers, told an institute meeting in July 2012. “Even if it is a small percent of their shares, they should be listed.” Yet both initiatives have raised concerns that this would dampen foreign direct investment due to the more challenging funding landscape in Nigeria.

The NSE has also established a sales team to promote new listings. The exchange is not only targeting private firms, but is also lobbying the Ministry of Finance, and the Bureau for Public Enterprise in particular, to list a portion of the planned state-owned entities to be privatised (roughly 20%) as a means of improving governance and transparency. To generate alternative revenue streams over the longer term, the NSE has also started offering services like investor relations, analyst coverage and corporate governance to firms that are interested in listing.

Further reforms of listing requirements and procedures are expected in 2012, with the NSE benchmarking itself on more flexible markets like London, New York, Johannesburg and Singapore. “The requirement that companies must have a five-year financial and operating track record has been cited as a hindrance, particularly for exploration and production companies that are not in a position to provide these,” according to the NSE’s 2012 outlook.

Stakeholders ranging from the NSE, SEC, stockbrokers and investment banks are in talks with the Federal Ministry of Finance’s revenue department regarding tax incentives for listing. “These tax incentives should be graduated at different levels according to the size of the float,” Kyari Bukar, the CEO of Central Securities Clearing System, told OBG.

While the minimum float of companies on the main board being set at 20% of share capital in April 2012 (and 10% for dual listings) may have an impact on the amount of stock listed on the exchange, incentives for larger listings could encourage bigger issues. In an economy like Nigeria, with a small tax base and near-systematic tax avoidance by unlisted companies, this could prove crucial to encouraging listing.

SIMPLIFY, SIMPLIFY: The NSE and SEC are also looking at revising and simplifying the rules for cross-border listings. While these reforms are also meant to facilitate the dual listing of firms like Dangote Cement, which in 2012 aims to follow in the steps of oil exploration and production company Afren by listing 20% of its stock on the London Stock Exchange, they will also improve access to the Nigerian markets for neighbouring countries. Investment banks doubt the potential demand for cross-border listing into Nigeria however, given that liquidity on the market is currently largely dominated by several foreign funds.

While this encouragement should have combined with high interest rates to drive more companies to list, 2012 has seen only timid activity to date. Austin Laz & Co., a manufacturing and building materials company, raised N2.16bn ($13.82m) in late February 2012 with an issue of 1.08bn shares. The second MFB to list on the NSE, Fortis MFB, came to market in late June 2012 with the issue of 2.3bn shares.

KEEPING CAUTIOUS: But despite these hopeful signs, many firms remain cautious due to the prolonged downturn in equities. A notable exception came in July 2012 when fruit juice manufacturer Chivita announced that it was its intention to list on the exchange by the end of 2012.

In 2012 fertiliser producer Notore also announced plans to list, although this will likely come in 2013. A number of listed companies such as Flour Mills of Nigeria and Vono Products are planning secondary rights issues in 2012, although timing will be determined by market conditions.

Meanwhile the ministries of finance, agriculture and trade and investments, along with the central bank, are steering plans to resuscitate the Abuja Securities and Commodity Exchange through its privatisation. The aim is to provide a new means of funding for the country’s agricultural transformation agenda, although specific plans are pending a report by the World Bank in the third quarter of 2012.

A vibrant commodities exchange could open new opportunities for investing in Nigeria’s agricultural growth, while also providing for an important means of hedging for agricultural firms.

OUTLOOK: While a mentality characterised by skittishness has continued to dominate trading, the sum of the various reforms and the clean-up of the banking sector could translate to significant opportunities for value investors. Bank stocks looked particularly undervalued in early 2012, trading at below 1.5 times book value, compared to close to 10 times book value at the height of the bubble in 2008.

With the Asset Management Corporation of Nigeria, the quasi-government agency set up in 2010 to purchase non-performing assets from banks estimating fair value at close to between two and three times book value, valuations had indicated several significant potential upsides for the endeavour.

Having suffered higher-than-expected provisioning for bad loans in 2011, the seven lenders in difficulty that year swung back to profitability in the first quarter of 2012, including big name stocks such as FCMB, UBA and Diamond Bank.

Brokerages such as Vetiva Capital and Renaissance Capital expect a rebound in equities in 2012, largely driven by newly sanitised bank stocks. Vetiva forecasts a 2012 year-end close of 23,200 for the NSE’s ASI, up from a 2012 opening at 20,672, while the NSE forecasts growth of about 7.5%.

In the first half of 2012 the stock market was buoyed by higher foreign interest in strong corporate earnings, particularly for banks in the first two quarters. While sell-offs greeted the start of the year and the fuel-subsidy protests, foreign interest recovered from March to June 2012.

While the consequences of European troubles and a drop in global oil prices affected trading in June 2012, the market recovered in July 2012 as consumer goods companies, banks and cement companies drove growth in valuations. However a possible devaluation of the naira could dampen equity market activity in the latter part of the year, depending on fluctuations in global oil prices.

Although 2012 started with low price to equity ratios, averaging 14.32 times, and a mere 5.2 times for banks, confidence in reported numbers continues to be fairly low among those interested in getting involved with investments. The unification of year-ends, implementation of IFRS reporting requirements by 2013 and stiffer penalties for rule infringements should address this gap in perceptions.

With the main index edging forward in mid-2012, authorities expect a sustained gradual upward trend for the rest of the year. By the start of August 2012, the ASI had gained approximately 12% since year-end 2011. “We don’t expect trading patterns to change fundamentally in 2012,” Onyema told OBG. “The insurance and oil and gas subsectors will continue to struggle, while trading in industrial and banking stocks will continue to drive returns on the exchange.”

Meanwhile, with real GDP growth still above 6% and with market participants expecting interest rates to have peaked, higher corporate earnings should help drive trading on the exchange during the rest of 2012. Better performance, particularly by banking and construction materials firms, should also encourage more dividend payments in 2012, with only 75 of the 186 companies listed paying dividends in 2011.

While recent years have brought much soul-searching on the part of stakeholders on the equities market, significant structural improvements should start to have an impact on trading in 2012 as global investors re-enter frontier markets.

A diversification of instruments available on the exchange, combined with a consolidated brokers’ market, will prove a clear signal to investors. In the meantime, demand for fixed income instruments seems set to continue at a fairly consistent pace.