It’s not an easy time to make money in mainstream stock markets. Yet the returns from frontier emerging markets have been positive over the last 6 months, in contrast to the UK stock market. Are UK-based investors missing a trick? Is there an opportunity in frontier markets going forward? And what will drive their returns?
In this first note this month I thought you might enjoy exploring frontier markets. It’s not for everyone but nonetheless fascinating.
I’ll get on to performance and the outlook in a moment. But for now just keep in mind that the top performing frontier stock market was up 50% in the last year (the UK was down).
What are Frontier Markets?
Frontier markets are an eclectic bunch. As potential investment destinations the size of the economy or income per head is not a big issue. Political stability and a sound legal and regulatory system are vital. And financial markets must be sufficiently developed not only can you get in… but you can also get out!
With the latter in mind people like FTSE and MSCI have indices which include acceptable frontier markets, and these are regularly reviewed by them. Depending on which definition you use, there are 23-27 frontier markets, and they range from Argentina and Nigeria to Jamaica and Cyprus.
The frontier markets universe encompasses 5,700 individual stocks – but there are a lot of frogs! So you don’t kiss the frogs, fund managers exclude those which are too small or where there is not enough day to day trading (the liquidity problem). This can reduce the universe to less than 500.
For example, Barings will conduct in-depth research on just 150 of these companies, and invest into 45-55.
What is the point?
In a nutshell the point is huge upside when much of the developed markets are struggling to make investors money.
These are countries both large and small which are under-developed but have key advantages which can underpin superior economic growth in the years and decades to come.
The precise drivers of that economic growth will vary from country to country, but many have common features, such as:
- Young populations. One in three young people will live in Africa by 2050. Young populations are vital for a growing economy as they are relatively bigger spenders – but only if they are working, which is a key point of analysis for fund managers at a country level
- Reform agenda. Growing emphasis on reform (political and/or economic) unlocks the potential. See Argentina below.
- Natural resource reserves. The need for natural resources is perpetual, even if the last 12 months makes it feel otherwise, and frontier markets dominate the reserves. For example, they have 73% of oil reserves, 50% of natural gas, 78% of phosphate, and 55% of potash.
They don’t run with the global herd
In addition to superior growth potential these markets tend to move independently of each other, and independently of the larger global markets.
Their economic growth and stock markets tend to be driven by idiosyncratic domestic issues, which add valuable diversification attractions for investors, where so much of the rest of the world moves up and down as one.
Nonetheless, they are not always immune from global trends. The big hit in the last year has been the fall in oil prices, with many of these economies relying heavily on exports of oil and other commodities e.g. Nigeria and Saudi Arabia.
Did you miss the Jamaica boat? Another along soon…
Jamaica was the top frontier market over the last 12 months, up in excess of 50% (for comparison, the UK stock market was down about 10%).
I’m not sure any manager would have backed Jamaica for that top slot, and it is frankly guesswork which will be top dog over the next 12 months.
But what is clear is that though the Jamaica boat has sailed, there will be another along soon enough. These countries are interesting candidates for longer term outperformance:
Iran is barely on the starting blocks as a frontier market, but lifting of US sanctions will provide a huge boost.
In anticipation of this potential, Oliver Bell of fund managers T.Rowe Price recently visited Tehran to get his bearings. He noted that:
“Iran appeared more like Turkey than Saudi Arabia- Tehran being a very cosmopolitan city with a much more liberal attitude than we expected”.
The country is educated, entrepreneurial and asset rich. They just need the access to capital which the lifting of sanctions can generate.
It is yet another youthful frontier market (60% of the population under age 30), and the highest literacy rate in the Middle East and North African region.
And the market is cheap, with a price earnings ratio of just 6 (the UK is almost 3 times this level).
Argentina might just be at the beginning of a big comeback, long overdue. In 1914 it was one of the ten richest economies in the world, ahead of Germany, France and Italy – but it all went wrong from there. Now it is classified as a frontier market, and is ranked 81st in the world (based on GDP per head), some way below Greece and Greenland.
But now there is a significant catalyst for change. The recently elected the new President, has a mandate to restructure the economy, where business activity has been stifled for years. They already have a decent infrastructure and well educated work force – now they might just be let off the leash.
Again the market is cheap, on a price earnings ratio of 8.5.
Valuation will drive your long term performance
Even if a country has superior long term growth potential, this counts for nought if this potential is already reflected in the price.
The idiosyncratic risks of individual frontier markets certainly dictate that you should pay less for them, and this can be seen via the price earnings (PE) ratio.
For example, as you saw above, Iran and Argentina have PE valuations of 6 and 8.5 respectively, whereas for the developed world is around 20 (according to FTSE). This is a huge differential and makes these markets look cheap
What can go wrong?
You buy frontier markets because of their huge upside potential. Remember that all markets were once in the “frontier” category. The New York stock exchange was formed under a tree 220 years ago – no one could have foreseen then that the US in its infancy would grow to dominate the world.
But countries can regress too. One of the best long term examples is Argentina, which peaked in 1914, as set out above. In now sits below Greece and Greenland in world rankings.
Politics is probably the biggest and most fundamental risk. Oil prices can go up and down in cycles but investor unfriendly politics can persist for a very long time e.g. over 50 years in the case of Cuba, as much as it is otherwise dearly loved.
But politics doesn’t simply mean “are they democratic or not?”. For example, the biggest decisions impacting on developed economies (including the UK!) are now taken by unelected central bankers.
The more intelligent questions revolve around whether the leadership (democratic or not) has a reform focus, is dynamic, is stamping out corruption, and listens.
For example, Middle East investment specialists MENA Capital tell us that King Mohamed VI of Morocco is one of those few absolute rulers who would probably win the top job should an election be held. He is “hard working, dynamic, and smart”, and is a big reason why Morocco is a favoured investment destination of MENA.
There are a limited number of frontier market funds, some are global and others are focussed e.g. Africa or Middle East. A number of the funds are very small, so we have focussed on those with a value in excess of £25 million.
Below are shown the available funds sorted on the 3 year performance number. It hasn’t been an easy 3 years for anyone, but the frontier market index has still provided a small margin over the FTSE 100 index. The problem is that none of the active unit trust funds got close to this performance, but for the Franklin fund focussed on the Middle East.
Partly the latter differential arises from the peculiarities of the index makeup. But it is also a tough and mixed-up environment for active fund managers.
Nonetheless, looking forward a few years, frontier markets as a whole have much more attractive valuations and fundamentals than many developed markets.
In the table we also show the 6 month performance figure too, so you can see where momentum lies right now. Again frontier markets (and emerging markets) are outperforming the UK stock market, but the active funds are trailing a tad.
If we also take into account investment trusts (of which there are two) one stands out, Blackrock Frontiers, which has done better than the frontier market index over both 6 months and 3 years (up 2.47% and 13.64% respectively).
Who should buy?
You certainly have to be realistic about the risks, though a fund does ensure you don’t have all your eggs in one basket.
They can provide an edge in a portfolio dominated by (dull?) main stream stock market funds, not just by virtue of higher growth potential but also their lack of correlation with developed markets.
You could invest up to 10% of your portfolio into this exciting area.
Monthly investors have a particular advantage as they can simply accumulate month after month until this sector explodes upwards – as it will one day
Do let us know if you have a taste for the exotic!
Table 1: Frontier Market Funds vs. Indices
Notes: Pricing spread: bid-bid, Currency: Pounds Sterling, Data as of April 2016