Frontier Markets: Out Of The Shadows

Via FundWeb, a report on frontier markets:

While compelling growth stories abound in the world’s frontier investment markets, uncertainty around rapidly evolving political situations as well as ongoing corporate governance and liquidity problem seem to be keeping some investors on the sidelines.

Often characterised by having some form of political or macroeconomic risk or under-developed capital markets, it appears the frontiers space may be losing out to perceived safer options elsewhere in the world, following a number of periods of volatility over the last 18 months.

Looking back to 2010, frontier markets returned nearly 10 per cent more than developed markets, with some investors reportedly looking to the fledgling markets as an alternative to their popular emerging counterparts.

So far in 2012 (to 17 August), the MSCI Frontier Markets Index has fallen 2.1 per cent, compared with a 9.1 per cent gain for the MSCI World Index and a 6 per cent climb for the MSCI Emerging Markets Index.

According to CITI Investment Research and Analysis, EPFR via Schroders, as at March 2012, investors had $11bn in frontier markets compared with $691bn in emerging markets.

At the same time fund managers say frontier regions are teeming with investment opportunities for those willing to stay the course, as more markets open to foreign investment and demographic trends, a lack of debt and low correlation to developed markets boost company prospects.

“If you look around the world, it has sort of been the ignored space and it, in many ways, is the actual real last frontier in terms of investment opportunities,” says Malcolm Gray, the manager of the Investec Africa Opportunities fund.

While trepidation continues for many investors, some fund managers are heading full-force into frontier markets, with a view that many longer-term positive trends and their resulting effect on domestic companies and multinational subsidiaries cannot be ignored.

New launches in the space since early 2011 included the Templeton Africa fund, run by Mark Mobius, the Schroder ISF Frontier Markets Equity fund and the Russell Emerging Markets Extended Opportunities fund. HSBC also recently launched a GIF Frontier Markets fund.

Part of the reason, explains Mobius, executive chairman of Templeton Emerging Markets Group, is that rising consumption is giving these economies strong purchasing power and the ability to spend their way into growth.

“You can also see frontier market countries have been, and continue to be, positively impacted by the substantial investments made by large emerging market countries such as China, India, Russia and Brazil,” he adds.

For instance, China’s trade with Africa ballooned to $160bn in 2011, from $9bn in 2000, with investment occurring across several sectors, including telecoms and resource extraction, according to the African Development Bank.

More broadly, the International Monetary Fund notes that growth in Sub-Saharan Africa is “expected to remain robust in 2012–13” helped by the region’s relative insulation from external financial shocks.



In contrast with the expected moderation in global growth this year and next, the IMF says growth in the Middle East and North Africa will be stronger, “as key oil exporters continue to boost oil production and domestic demand.”

Andrew Brudenell, the manager of the HSBC GIF Frontier Markets fund says there will be a host of businesses within these countries which will benefit from that growth.

“Whether it is banks benefiting from credit growth or consumer branded companies benefiting from a larger, wealthier middle class and that brand conscious consumer and sort of everything in between,” he says. He adds: “Infrastructure spending will benefit cement and steel companies and real estate businesses.”

The MSCI Frontier Markets Index itself includes 25 countries as well as six under consideration. More than 50 per cent of the index is made up of countries in the Middle East where eight of its top 10 constituents are based.

Sam Vecht, the manager of the BlackRock Frontiers Investment Trust, favours Qatar in particular, with both Qatar Electricity & Water and the Commercial Bank of Qatar in his portfolio’s top 10 holdings. He points to the country’s status as one of the fastest growing economies in the world, having ramped up its oil exports and natural gas production and averaging about 10 per cent GDP growth per year over the last four years.

“There is a range of companies in the financial, industrial sector that have seen 20-25 per cent annual earnings growth and a yield of 6 to 7 per cent,” he says.

For some managers, the number of investable frontier markets extends beyond MSCI’s list, with some considering the frontier universe to be any country not deemed to be a developed or emerging market – a group that can include up to 150 nations.

Indeed, the frontier investment universe has changed dramatically in recent years, with more economies being added to the list of investable countries and the number and quality of companies increasing, says Mobius.

Andy Brown, an emerging markets investment manager at Aberdeen Asset Management says that while the MSCI Frontier Markets Index is heavily concentrated in the Gulf region, Aberdeen’s frontier markets portfolio is heavily skewed away from the area in favour of better opportunities in places like Kenya and Nigeria.

According to the Economist Intelligence Unit, while this will be a challenging year for prospects in Sub-Saharan Africa owing to the unfavourable global economic outlook, the medium-term outlook for the region remains positive.

“Growth will be supported by rising external inflows (capital and investment, particularly from Asian sources) and high commodity prices. Economic reform programmes will continue, boosting the role of the private sector in the economy. By 2013-16 the regional economy is forecast to average growth of around 5 per cent a year,” says the EIU.

“In the end it boils down to the fact that it is a large continent with a billion people, positive demographics with good internal consumption demand and growth, reasonably underleveraged balance sheets, both at the sovereign and at the private level, and there is a lot of pent up demand,” says Gray.

Mobius says over the 10 years to 2010, six of the world’s fastest growing economies were on that continent. In particular, he says, Africa is seeing a revolution in infrastructure investment, and increased spending on mining and oil, with countries beginning to wake up to the reality that they have to undertake a private sector or market-orientated model for economic development.

“There is a rising income and middle class expansion in these countries, which has resulted in increasing demand for consumer products. This in turn has led to a positive outlook in earnings for consumer products companies such as automobiles and retailing, as well as services in finance, banking and telecommunications,” he adds.

Indeed, many managers point to the underpenetration of credit in frontier markets as a theme within which to find well capitalised banks with long-term growth opportunities.

While Gray says there is no reason why an investor would necessarily want to own a Nigerian bank any more than they would want to own a bank anywhere else in the world right now, he says African banks are in a much better position than those in the developed economies.

“Their balance sheets are strong, the markets are growing and they have a huge opportunity for loan growth and penetration of banking services,” says Gray, who counts Access Bank Nigeria, First Bank of Nigeria and Zenith Bank among his fund’s top 10 holdings.

Vecht also points to the strong dividend yield of many Nigerian banks, a trend that is found across many frontier sectors and which managers say sets these markets apart from their emerging cousins.

In Nigeria more generally, Brudenell says the financial crisis has helped enable management teams to think more clearly about the usefulness of having long-term shareholders on their side.

Still, adds Gray, investors are significantly underexposed to Africa directly. “If you looked at it on a GDP or population basis, so Africa’s GDP accounts for about 4 per cent of the world’s GDP, its definitely not 4 per cent of people’s investment portfolios,” he says.

Much of the reason is that, in spite of the moves forward for companies in many frontier regions, these economies are still fraught with risks. After all, says Brown, there is a reason why frontier markets are not yet considered to be emerging.

SooHai Lim, the manager of the Baring ASEAN Frontiers fund, says his concerns include potential expropriation and nationalisation of assets if there is a regime change, as well as poor policy management and execution.

“We would not invest in markets where the risks of nationalisation/capital controls are high as the rewards are unlikely to outweigh them,” he says.

Brown says his team does not have much minerals exposure in frontier markets, with a view to avoiding bureaucracy and government red tape which can be present in the development of mineral wealth.

Liquidity is also an ongoing concern in many markets. Outside of South Africa, says Gray, the liquidity managers deal with in Nigeria or Kenya, for example, is significantly below that of the more liquid emerging markets. While he says South Africa might trade $2bn a day, Nigeria might trade between $15m and $30m.

Access to information is also still a big probelm, say managers. John Cusack, associate director, and head, financial services risk management at global risk advisory organisation Maplecroft, explains that in rapidly-growing frontier economies, it has always been difficult for both corporations and investors to find transparent, reliable financial data on companies, projects and countries.


“The extra-financial data search can be as equally as important as the financial data search, as not having good information about company, project or country environmental, social, governance issues, supply chain issues, or climate change/natural hazards risks (like the floods in Thailand and the Philippines or the tidal wave in Japan), or human rights and corruption issues, can be a major material financial risk as well as a questionable balance sheet or P&L statement,” he adds.

In addition to looking at fiscal pressures, geopolitical reasons why companies might look cheap and whether politicians are focused on particular sectors, one of the only ways to effectively counter frontier market risk, say managers, is to get on the ground, meet company management and maybe even government or central bank representatives.

Over decades of investing in emerging markets, Mobius says he has learnt there is no substitute for local knowledge – a fact that seems to be more prevalent with frontier markets.

“A unique aspect of our investment approach is our on-the-ground presence which allows us to mitigate risk by understanding the local languages, politics and culture, but also getting to know the companies and the market environment directly by meeting with company management teams, understanding the impact of local regulations, and talking with local customers and competitors,” says Mobius.

While a bottom-up, fundamental focus does not change whether you are looking at a developed market, emerging market, or frontier market, explains Brudenell, achieving what you are trying to find out might be slightly different in the frontier market world.

For example, he says, working out what makes a company like Microsoft or IBM tick can probably be achieved by contacting any number of people who can send models and research, coupled with a manager’s own understanding about the company and the country within which it operates.

“What is different in frontier markets of course, is you are always hoping and trying to discover new businesses that people do not know about, that you do not even perhaps know about initially, and that requires just that little bit more hands-on research,” he says.

Frontier-focused managers also stress the importance of a diversified portfolio across stock exchanges, as individual companies or markets might be volatile, but the correlation between them is often much less than that of a portfolio of developed market stocks.

“The correlation for example between the Kuwaiti stock exchange and the Nigerian stock exchange, both large components of the frontier universe, are both oil exporters, you might expect them to have some correlation – that correlation is minute,” says Brudenell.

Lim also notes that because frontier markets tend to be relatively immature economies, their economic cycles are less correlated with the developed or emerging markets, providing an element of risk diversification.

Within the parameters of a strong local research network, many managers feel they are able to mitigate and even capitalise on frontier market risk.

For those willing to do the work and get in front of company management, there are a number of opportunities to invest in well-managed and attractively valued businesses in smaller markets like Pakistan, Kazakhstan, Romania and Lebanon, says Brown.

Also, he says, stock prices in frontier markets have been known to collapse for macroeconomic reasons rather than because a company is fundamentally in trouble.

“One of the more attractive things about frontiers for us is that we can pick up stocks more cheaply when there are worries about the foreign currency or there are worries about political change and so on. And then a really good example of that last year, ironically, was in Egypt,” he says.

Although Egypt is classed as an emerging market, Brown says his team holds it in its frontier markets fund, noting the country has every characteristic of being a frontier market. During the selloff in Egyptian stocks in the first half of 2011, Brown says his team was able to top up a position twice, as a result of political worries.

In addition to the reasonably well-established markets in countries like Nigeria, managers report that several frontier markets seem to be increasingly allowing foreign investment, whether opening up equity markets, offering more assets for locals and foreigners to buy or tightening up regulation.

Brudenell notes that Myanmar has begun to open its doors to the Western world in general, with a new foreign investment law making its way through parliament.

Myanmar, and particularly its oil and gas, mining and consumer sectors, is on Mobius’ radar. Supported by credit growth and improved business confidence, growth in the country should be driven by commodity exports and greater investment, he explains.

“Myanmar appears to be on the cusp of political and economic change. I expect modernisation should clear many of the obstacles to the country’s growth, deepening the investment climate and liberalising trade, foreign direct investment and the financial sector,” he says.

Still, he cautions that while there is a lot of excitement about possibilities in the country, investors should try to avoid getting emotionally caught up.

“One should be cautious about potential over-speculation, which tends to run high in the early stages of development. Investors often try to rush in early and can potentially push the price of stocks too high, which can in turn make valuations expensive,” he says.

Brudenell is also finding it easier to get meetings with senior management in Saudi Arabia. While it only became possible for foreign investors get indirect access to the Saudi equity markets in 2008, he adds the country is talking about fully opening up the Tadawul exchange, which he says would be a positive development.

In 2005, Goldman Sachs identified the Next 11 – a list of countries which, after the Bric economies, could “greatly impact the global economy.” These include Bangladesh, Egypt, Indonesia, Iran, Korea, Mexico, Nigeria, Pakistan, Philippines, Turkey and Vietnam.

While the jury is still out on whether any of the frontier economies included in this list will eventually graduate into emerging markets, the list of countries that could soon join the ranks of the frontier markets is growing.

“We may see further African countries developing into the next frontier markets in the coming years, such as Ivory Coast, Botswana, Zambia and even Zimbabwe,” says Mobius.

Gray points to Ghana as likely being a significant market in years to come. At the moment, however, he says the country is still relatively small and from a listed investment perspective, still very illiquid.

“There are some interesting opportunities there as well, given that oil’s been discovered, they’re starting to pump oil, that economy is responsibly run, so it’s certainly got a lot of opportunity over the next 15 to 20 years,” he says. Similarly, Brown says Aberdeen recently added Ghanaian dairy producer, Fan Milk, to its holdings, a stock which he says has a great opportunity to move higher on the back of Ghana’s economic growth.

In spite of this, Maplecroft’s Cusack says there is always a danger of investors over-whelming these markets, with too much cash chasing too few good projects.

“It will take a while for a number of these countries to obtain the critical mass of economic activity to graduate from the frontier markets category to the emerging markets category,” he says, noting that structural risks like lack of infrastructure can hinder both emerging nations and frontier markets.

In the meantime, frontier-focused managers continue to position themselves for the long haul, waiting for some of the last untapped investment opportunities to come to fruition.

“This is something you really have to approach with a long-term sort of five or 10 year investment horizon because there will be ups and downs for a number of these countries,” says Brown.

This entry was posted on Saturday, September 8th, 2012 at 12:10 pm and is filed under Uncategorized.  You can follow any responses to this entry through the RSS 2.0 feed.  Both comments and pings are currently closed. 

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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.

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