NSE Investors Appear to be Ignoring Valuations with the Recent Rally

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The Nigerian Stock Exchange is experiencing a dramatic change in investors’ sentiments as evidenced by the significant surge in trading volume and the break above all pertinent cumulative moving averages; thereby reversing the bearish trend.  For the week ended November 12, 2010, the average daily trading volume was 530 million shares. The last time this type of average daily trading volume was experienced was in the week of May 3, 2010 as highlighted in the graph below:

Improvement in moving averages

At the close of trading on November 12, 2010, the NSE all share index at 25,367.83 is above its 20 day, 50 day, and 200 day moving averages of 25,056.93, 24164, and 24962 respectively. The NSE all share index broke above its 20 day moving average on October 4, 2010, and broke above its 50 days moving average on October 12, 2010. The index broke above its 200 day moving average on October 15, 2010 confirming a bullish trend, but on November 2, 2010, the all share index slipped back below the 200 day moving average indicating a trend reversal.  However, on November 9, 2010, the index broke above the 200 day moving average again on very heavy volume.

Motivation of Current Volume Surge:

I attribute the surge in prices and volume to the AMCON chief executive Mustafa Chike-Obi’s pronouncement on November 9, 2010 stating that AMCON will take over the loans given by the central bank to the nine bailed out banks by converting them into some form of equity ( Common or preferred).  It was also noted that the assets acquired from these bailed out banks will be held for at least two (2) years. The effects of Mr. Chike Obi’s comments amazingly resulted in the ignition of some enthusiasm into the market. This enthusiasm appears to have increased money flow into the banking sector especially on some of the bailed out banks that have reflected increases in price and volume as shown in the graphs:

However, it appears that these investors who are rushing to buy the shares of these bailed out banks have not analyzed the implications of Mr. Chike Obi’s comments and the effects of the potential conversion of the CBN funds into equity ( i.e., common or preferred).

Implications of Conversion of funds to equity position

The conversion of the CBN funds into equity will be the worst case scenario for current shareholders. This will basically make the shares of the current shareholders of the nine (9) banks worthless as it will result in a significant dilution in the share position of the current shareholders.  Since I am not preview of exactly how AMCON will perform valuation for the equity conversion. For illustrative purposes, converting the injected funds to equity position based on the closing share prices and CBN capital infusion on a one to one ratio as of November 12, 2010 for the five bailed out banks highlighted in the schedule below, shows that the Federal Government will own an average of approximately 63% of the bailed out banks.

Basically, if the above scenario is actualized, the shares of all current shareholders will be almost worthless since the Federal Government will become the majority shareholder of these banks. If the Federal Government becomes the largest shareholder, how will the issue of the annual dividends distribution be handled?  Will these banks' require authorization from AMCON before any dividends are declared? As investors will recall, in 2009 bonus payment that was declared by one of the bailed out banks was nullified by the CBN.

Therefore, with this scenario in mind, why are investors piling into the shares of these rescued banks?  As a technical trader, “the trend is supposed to be your friend” and as long as the trend favors the trader, stay put and do not buck the trend. Nevertheless, at the current prices, most of these bank stocks are over-valued and trading at “nose bleed” levels. Therefore, investors must realize that they are buying these stocks because of the potentials of generating short term profits, because fundamentally, the stocks of most of these recued banks are worthless for now.

Conversion of the Bailed out funds to Preferred Stock.

Preferred stocks are special equity security that have properties of both an equity and a debt instrument, and are generally considered hybrid instruments. Preferred stocks take precedence over common stocks, but are subordinate to bonds.

Preferred stocks have some other benefits that might be of concern to common stockholders such as:

• Preferred stocks receive a fixed dividend that has been predetermined through the agreement with the preferred shareholders. This fixed dividend is not usually binding but has preference over the common stock.
• The common stockholders can only receive dividend after the preferred shareholders have been paid. Also, most contracts include a provision that mandates the company to pay any arrears to the preferred shareholders before the common shareholders' right to dividend can be activated
• In a bankruptcy, preferred stockholders are paid off first prior to common stockholders.
• The common shareholders have a residual claim on the profits, while the preferred shareholders have a fixed claim on profits after the interest on debt securities have been paid.

With all these aforementioned benefits of preferred stocks which might be of concern to common stockholders, I still believe the conversion of the CBN bail-out funds to preferred stock will be more beneficial to the shareholders of the bailed out banks, because from the point of view of the existing shareholders preferred stocks prevent further dilution of ownership of the company, and preferred stock owners do not interfere with the operations of the company since they do not normally have a right to vote like common stockholders.

 Conclusion

There is nothing wrong with trading the stocks of these bailed out banks with obvious signs of price resurgence for profit making purposes.  However, investors buying these stocks should understand that they are only short term trading vehicles, because as noted by the Chief Executive Mustafa Chike-Obi “ most of these bailed banks will require further funds to get them to minimum capital adequacy levels even after AMCON absorbs the non-performing loans and returns shareholders' funds to zero. Investors who are buying these stocks and believing that they are a sure avenue to future riches may be setting themselves up for a rude awakening, since they refuse to understand valuation or that the fair value of a stock should not be ignored. Finally, these investors who purchased the shares of these banks post the CBN cash infusion have a big decision ahead of them. Do they go along for the ride and cash out before these banks are acquired, or stay in and take their chances regardless of what the post acquisition strategy of the new management team might be (i.e., reduction of the number of share owned to reflect purchase price, share reconstruction, etc), because upon the acquisition of these bailed out banks, the number of shares owned by current shareholders will be adjusted to reflect the purchase price (i.e., which might be based on cash or stock transaction) and the holdings of the new majority owners. Lets watch as events unfold.