Frontier Markets: Investing In The Middle Of Nowhere To Get Somewhere

Via The Emerging Frontiers blog, a look at a recent Citi report on frontier markets:

There’s investing for the long term, and then there’s investing as though you won’t need to cash out until the day after forever. A recent report by Citigroup offers ideas for anyone who has a time horizon that’s not quite so long but is nevertheless in no hurry to reap gains. And yes, there are funds for that.

David Marcus, manager of Evermore Global Value Fund, is heavily invested in Spain, Italy and the U.K., but many of the companies in his portfolio conduct business outside of Europe. He talks with MarketWatch’s Jonathan Burton.

The Citi report, “Global Growth Generators: Moving Beyond ‘Emerging Markets’ and ‘BRIC,’” by Willem Buiter and Ebrahim Rahbari, begins with a forecast that might elicit smirks from anyone who has noticed how difficult it is for economists to even guess what tomorrow’s data will bring: “We expect strong growth in the world economy until 2050.”

Smirk-worthy or not, the report projects global growth to average 4.6% annually until 2030 and 3.8% for 20 years after that. Then it names 11 economies whose growth rates the authors foresee to be particularly strong.
Future stock

It’s no surprise that none of the 11 is a developed country; the West has seen better days, and certainly not lately. Five of the 11 — China, Egypt, India, Indonesia and the Philippines — are classified as emerging markets by research firms like MSCI, although many investors may not place Egypt and the Philippines in the same league as the other three.

The remaining six on the list are commonly referred to as frontier markets, if investors refer to them at all: Bangladesh; Iraq; Mongolia; Nigeria; Sri Lanka and Vietnam. Poverty in these countries is widespread due to economic mismanagement, political instability, weak education systems and war, but the future that Buiter and Rahbari glimpse is far brighter. Here’s an abridged history of the next 38 years, as they imagine it:

“Developing Asia and Africa will be the fastest-growing regions, driven by population and income per-capita growth, followed in terms of growth by the Middle East, Latin America, Central and Eastern Europe, the [former Soviet states] and finally the advanced nations of today. . . . For poor countries with large, young populations, growing fast should be easy: Open up, create some form of market economy, invest in human and physical capital, don’t be unlucky and don’t blow it. Catch-up and convergence should do the rest.”

If you want to buy that story, there are several options. A handful of mutual funds play stock markets of frontier economies, including Nile Pan Africa Fund NAFAX -1.45% ; Harding Loevner Frontier Markets Fund HLMOX 0.00% ; T. Rowe Price Africa & Middle East TRAMX -0.55% and Wasatch Frontier Emerging Small Countries WAFMX -0.46% .

There are also exchange-traded frontier country funds: Market Vectors Vietnam VNM +3.04% and Market Vectors Egypt EGPT +2.80% .

Be careful before throwing a lot of money at these funds. The MSCI Frontier Markets Index lost about two-thirds of its value in 2008-09, slightly more than indexes of developed and emerging markets. Those indexes have recovered nearly all of their lost ground, but MSCI Frontier is still at less than half of its 2008 high.

Frontier economies may have nowhere to go but up, as the Citi analysis suggests, but one lesson from the history of emerging markets is that fast economic growth does not readily translate to strong investment returns. Fast-growing economies often have high interest rates that keep a lid on corporate profits, and much of what is earned is reinvested to achieve further expansion.
Seeds of change

For fast growth to become productive growth for investors, there needs to be a catalyst, such as a change in economic or political policy that enhances productivity. What history also teaches, however, is that by the time a catalyst comes along and its importance is recognized, the most vigorous initial stage of a market advance is likely to be over. For instance, the time to invest in Brazil, one of an earlier generation of frontier economies to make good, was before inflation had been brought under control in the 1990s, not after.

It may make more sense, therefore, to be early than late into these markets, but beware: The time spent waiting for a big score can be long and difficult on the nerves. Economic, political and market conditions can be turbulent before share prices catapult higher, and even after.

That’s why any allocation to frontier markets should be well-diversified — the mutual funds seem like better ideas than the ETFs — and should account for only a small fraction of an investor’s risk capital. Then it’s a matter of maintaining extremely low expectations and a lot of patience.

“Growth will not be smooth,” the Citi report warns. “Expect booms and busts. Occasionally, there will be growth disasters, driven by poor policy, conflicts or natural disasters. When it comes to that, don’t believe that ‘this time it’s different.’ ”

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Wildcats & Black Sheep is a personal interest blog dedicated to the identification and evaluation of maverick investment opportunities arising in frontier - and, what some may consider to be, “rogue” or “black sheep” - markets around the world.

Focusing primarily on The New Seven Sisters - the largely state owned petroleum companies from the emerging world that have become key players in the oil & gas industry as identified by Carola Hoyos, Chief Energy Correspondent for The Financial Times - but spanning other nascent opportunities around the globe that may hold potential in the years ahead, Wildcats & Black Sheep is a place for the adventurous to contemplate & evaluate the emerging markets of tomorrow.