A Simple System to Stalk Super African Stocks

The stock market can be a pretty intimidating place for new investors.

With all of its charts, ratios, and jargon, it’s clear why many people choose to either hire a professional to manage their stock portfolios or to ignore stocks altogether.

Does this sound like you?

If so, I’m glad you’re here, because, today, I’m going to show you a magic (and simple) formula for picking great African stocks.

Beating the Market with a Magic Formula

I wish I could take credit for it, but the system was actually developed by a much smarter investor than me.

Joel Greenblatt, a hedge fund investor and professor at Columbia University, first explained it in his excellent book, “The Little Book That Still Beats the Market.” It’s a great, quick read for anyone with even a passing interest in stock investing.

The formula has posted stellar results. According to research conducted by the American Association of Individual Investors, U.S. stocks selected according to the formula have outperformed the S&P 500, by an average of 7.6% per year over the past 15 years. Not too shabby, eh?

So, how does it work?

Essentially, the formula identifies profitable companies that trade at cheap prices. And it does it by using two simple ratios — the price earnings (P/E) ratio and Return on Assets (ROA).

Step 1: Calculate the P/E Ratio

The price earnings ratio (P/E ratio) is arguably the most common ratio in finance. There’s a reason for that. It’s one of the most straightforward methods to identify attractively-priced stocks.

Photo by Yathin

Photo by Yathin

Here’s how you calculate it:

P/E Ratio = Share Price ÷ Earnings Per Share

So, how do we interpret this ratio?

Well, if we are considering buying a stock, we want the share price to be low and the earnings per share to be high, correct? Of course! Because we want the most profit for the cheapest price.

Therefore, we should be on the lookout for stocks with low P/E ratios.

The chart below shows companies that trade on the Botswana Stock Exchange with their current share price and earnings per share. I’ve ordered them according to their P/E ratios (lowest to highest).

Company NameShare Price (Feb. 25, 2013)Earnings per Share (TTM)P/E RatioScore
FSG Limited1.350.206.759
Sefalana Holdings3.750.527.228
RPC Data0.250.037.657
Chobe Holdings2.600.337.866
Furniture Mart1.750.1710.155
Sechaba Breweries15.871.2213.064
Choppies2.40.1220.463
G4S Botswana5.820.2325.752
Wilderness Holdings2.280.0640.071

Therefore, based on the historic P/E ratio, FSG Limited appears to be cheap and Wilderness Holdings is expensive.

Step 2: Rank the Returns On Assets

Now, let’s look at the second part of Greenblatt’s magic formula — the return on assets (ROA).

Return on assets measures profitability. It tells us how much money a company earns per every dollar’s worth of assets that it owns.

Here’s the formula:

Return on Assets = Earnings ÷ ((Assets at beginning of period + Assets at end of period) ÷ 2)

We’re simply dividing earnings by the company’s average assets. Note that we use average assets because this figure can change significantly over the course of 12 months. [You can find all the data needed to complete this calculation in the company’s most recent financial statement.]

The management of a company with a high ROA is typically making better use of the assets entrusted to it than the management of a company with a low ROA.

Moreover, companies with high ROAs will typically re-invest a portion of their profits in similarly profitable assets, creating a virtuous cycle.

Let’s take a look at how the Botswanan companies measure up according to this ratio.

Company NameEarningsAssets (End)Assets (Beginning)ROAScore
Sechaba Brewery161,676250,117224,13268.2%9
FSG Limited33,168174,035145,26320.8%8
G4S Botswana18,087115,27791,75817.5%7
Chobe Holdings29,477170,291177,55117.0%6
Furniture Mart104,481774,948698,46314.2%5
Choppies129,4301,085,111823,84913.6%4
Sefalana Holdings100,491978,989917,37210.6%3
RPC Data2,25027,27217,92310.0%2
Wilderness Holdings21,457883,061809,6132.5%1

It would appear that Sechaba Breweries generates more profit per dollar (or pula) of assets  than any of the other companies here. That suggests that it can reinvest in expansion more quickly and more profitably.

Step 3: Time for Some Magic!

We’ve arrived at the final step of the magic formula. We’ve seen that, all things equal, it’s better to spend less for a dollar of earnings than more. We’ve also seen that, all things equal, its better to invest in a more profitable company than a less profitable one. So, let’s get the best of both worlds by investing in profitable companies that trade at bargain prices. To do this we simply add the P/E score to the ROA score to create a composite score for value and profitability.

Company NameP/E ScoreROA ScoreTotal Score
FSG Limited9817
Sechaba Breweries4913
Chobe Holdings6612
Sefalana Holdings8311
Furniture Mart5510
RPC Data729
G4S279
Choppies347
Wilderness Holdings112

There you have it. The magic formula points us to FSG Limited, Sechaba Breweries, and Chobe Holdings as potentially market-beating stock picks.

I’ve greatly simplified Greenblatt’s magic formula here. So, if you have any interest at all in screening for stocks, I highly recommend reading “The Little Book That Still Beats the Market (Little Books. Big Profits).” It’s an easy, entertaining read that distills all you really need to know about value investing.

Let Me Hear It

Do you think FSG, Sechaba, and Chobe will be among the Botswana Stock Exchange’s best performing stocks over the 12 months? Let us know why or why not in the comments!

Related Reading

How to Invest on the Botswana Stock Exchange

10 South African Stocks Poised to Beat the Market

Ranking Kenya’s Most Efficient Banks

Comments

  1. hi ryan thanx for that great research information

  2. Aristide says:

    Hi Ryan,
    First, thanks for the interesting report. Where do you get all the data on African markets (P/E, ROA ..)? There don’t seem to be a lot of sources for African financial markets out there.
    Regards

  3. christian sirikali says:

    Hi Ryan!
    Thanks for the report again. The book is amazing, really, and I never thought that it could be applied to African stocks. Thanks a lot, again.

    A point I would like to add is on the P/E ratio. Sometimes growth in earnings per share can be a smokescreen since most of the companies do keep a portion of their previous year earnings to increase their equity base. If re-invested at a fixed rate of 8-10 % (possible in Africa), it’s no different than putting money in savings and compounding the interest and that the coming earnings. I have to disclose that everything mentioned here is in a book mentioning Warren Buffett’s strategies that I found really rewarding in the long term. I think the same can be applied to African stocks and keep getting the rewards.

    • Thanks, Christian. I agree that earnings figures must be used with caution. Some cash-rich firms do indeed make significant income off their bank balances. One way to evaluate the health of the underlying business is by focusing on operating income or cash flow from operations instead of net income.

      I’d be interested in hearing the title of the book you’re reading. Sounds like it would be worth a look!

      • Hi Ryan,
        Thanks again for the report. Please, what sources can be used to collect data on African markets (P/E, ROA ..)? There don’t seem to be a lot of sources for African financial markets out there.
        Regards

        • Hi Aristide,

          You’re right. There aren’t many good sources of financial data for African stocks out there. That’s why I calculate many of the ratios that appear here myself using this financial statement library.

          You can find PE ratios and dividend yields for most African stocks at http://www.bloomberg.com. Simply type the name of the company that you’d like to research into their search bar.

          Some local brokers also publish good info for their clients.

          Hopefully, more data providers will emerge as these markets develop. As far now, you’ll likely need to dig up your calculator and some annual reports if you want ratios like ROA, ROE, etc.

          Happy investing!
          Ryan

  4. Dear Ryan, thanks I find your regular news updates very good. Regarding this article posted exactly a year ago, how about giving us an update on how these companies have performed against the analysis and rankings as referred to in your article. Regards. Edmund,

    • Thanks, Edmund. That’s a great suggestion.

      Over the past year, the Botswana Stock Exchange’s main index increased 15.4%.

      Here’s how the top three stocks in the ranking fared.

      FSG Limited: +77.9%
      Sechaba Breweries: +29.5%
      Chobe Holdings: +26.9%

      The system worked pretty well in this case!

      All the best,
      Ryan

  5. Hi Ryan, I would like to invest in the Nairobi Stock Exchange and based on this system can you please tell which stocks would be the best performing this year. Would you please also list the best stocks to invest in for long-term purposes like lets say 5years to 10years growth or more. Thanks

  6. Ryan,

    Thank-you for the great insight…

    Would it be to simplistic if I just look for a low price and a good DPS on a solid good company that has good business fundamentals, that is at the moment priced low for one reason or another…

    • Thanks, Maina!

      Dividends are very important, but make sure you factor in growth, too. High-yielding companies are often those with the least potential to expand. Also, keep an eye on payout ratios to make sure the existing dividend is sustainable. Dividend cuts can wreak havoc on share valuations.

  7. Edna Okerosi says:

    Hi Ryan. I just started reading your articles and they are very informative. Could you please this ratio to analyze Kenyan stocks?

  8. Hi Ryan,

    I am a university student who recently started investing and I think this info will come in handy as I build my portfolio. I always try and look for stocks with low valuations and high growth potential (those involved in consumer products in the top emerging African countries) listed on the JSE. Love your blog, keep up the good work.

  9. Just came across one of your articles and I have just been opening one after the other and sharing it with my investment groups, Thank you.

  10. Many thanks for this informative article. Keep ‘em coming.

Speak Your Mind