When Azeez, an engineer based in Lagos, contacted his stockbroker to buy shares in Nestle Nigeria PLC to augment his investment portfolio, he was told to fund his account and wait. With patience and some luck, a transaction may happen in a few days. This is at odds with the usual image of a bustling trading floor with shares exchanging hands at a frenzied pace in a single day.
In reality, the pace of stock markets like Nigeria's is a lot more measured, with investors taking positions and sticking to them for comparatively long periods. The result is low market turnover and liquidity. In this series, we explore the nature of Nigeria's stock market and examine recent developments to improve liquidity in the Nigerian Stock Exchange (NSE).
Stock Markets 101
Stock markets have a long and varied history. They have evolved as a primary means for companies to raise capital by selling shares of themselves. When you buy a share in Zenith Bank, you become a part-owner, and this status bequeaths you a claim on the bank's future profits. You also carry the risk of losing your investment if the company crashes.
Transactions in the stock market can be split into the primary market and the secondary market. At the primary market, companies sell their shares via public offerings or an initial public offering (IPO). At the secondary market, shares are traded between owners without recourse to the original company that sold them.
Over time, secondary trades form the bulk of the activity in stock markets with the process of trading – the interaction between buyers and sellers – aiding price discovery (the proper valuing of each stock exchanged). Consider that for a trade to occur, there must be both a willing buyer and a willing seller. Both are acting on the interpretation of information available to them. Trading then ensures that information available about a company's health and prospects are reflected in its share price. This ensures allocative efficiency of capital in the economy.
In the market, we have traders, and we have investors. Warren Buffet famously said, "I buy on the assumption that they could close the market the next day and not open it for five years." This is classic investor behaviour – he is in it for the long haul. In contrast, traders are more interested in exploiting changes in share prices over time e.g. buying at a low price and selling at a high price. Though both market players are important, trading activity is usually driven by this arbitrage-seeking behaviour of traders which ensures market liquidity i.e. people are able to quickly buy and sell shares at the going market rate.
Number of Listed Companies in Selected Countries (Source: World Bank, Stears News)
The Economist recently summarised the major problem with Africa's stock exchanges as “too few listings, too little liquidity.” The former refers to the number of companies listed on the stock exchange while the latter speaks to liquidity, already mentioned above. Chart 1 compares Nigeria to the United States and other peer countries. Listings in Nigeria are about half of its peer group average, which in turn are collectively much less than in the U.S. No surprise here though; the U.S. has a significantly larger economy. Chart 1 also includes the GDP of the comparison countries.
Stock Market Turnover Ratios in Selected Countries (Source: World Bank, Stears News)
Stock market liquidity is harder to measure. But let's consider market turnover, a measure of the volume of shares traded in a given period, versus the total value of shares outstanding i.e. available for trading. This provides an indication of the velocity of stock trading in the market. As Chart 2 reveals, Nigeria lags some distance behind on this metric.
Price volatility also offers some perspective. In a liquid market, even a desperate seller would be able to offload his share(s) close to the market price so significant short-term fluctuations in prices could be a sign of illiquidity.
The Nigerian market is dominated by investors – mutual funds, pension funds, etc., and this partly explains the low market turnover. Investors buy shares and "sit on them" whereas traders would be more likely to wheel-and-deal, thus offering others regular opportunities to enter and exit their stock positions.
Finally, information is essential. Traders and investors would prefer to evaluate the attractiveness of a company by assessing information related to it e.g. company results, corporate governance reports, etc. The NSE has made significant strides in ensuring publicly available information, but companies still delay the release of their financial reports. One well-known bank has not released its financial statements for more than a year. Trading activity on stocks like this is likely to be little as market players do not have enough information to make sound decisions.
The NSE seeks to address some of these issues. In April 2017, it stepped up promotion of securities lending and short selling to improve liquidity in the Nigerian market. Securities lending involves lending a stock to another party for a specified period in exchange for collateral. At the end of the period, the stock is returned to the original owner.
In this guise, stocks that would have otherwise remained tied up become available for trading. Short selling works off this principle by permitting the sale of a stock that the seller does not own with the expectation of being able to buy it back later at a lower price. While these provisions have been extant in the NSE for some years, they have not been actively utilised. Concluding this series, we provide an in-depth look at these concepts and how their effective execution could help evolve the Nigerian stock market.