Frontier Markets  

Go local to seek equity rewards

This article is part of
The Guide: Investing in Frontier Markets

Go local to seek equity rewards

Long-term investors who invested in emerging market (EM) equities between December 2000 and December 2016 enjoyed annualised US dollar returns of 8.7 per cent.

Secular development trends, including demographics, infrastructure investment, industrialisation, urbanisation and institution building, drove economic growth and provided a platform for corporate profit growth. 

Today, investors may find similar, long-term investment potential in frontier market equities. Frontier markets can be considered as EMs at an earlier stage of economic development. In fact, considering the level of GDP per capita and corporate profits of EMs in 2000, frontier market countries appear to be at a similar level. 

Frontier markets comprise nearly 11.7 per cent of the world’s population, generate 3.9 per cent of GDP and yet account for only 1.6 per cent of global equity market capitalisation. EMs have more than four times the market cap to GDP compared with frontier markets. This underscores the potential for long-term economic and capital growth. 

Frontier markets present a unique opportunity to invest in local companies benefiting from economic development trends not found in emerging or developed markets. 

Equity investors may be rewarded by ‘going local’ in the following areas:

•    Financials: Banking sectors are largely underdeveloped and credit growth has been constrained;

•    Consumer: Telecoms, retail, pharmaceutical and healthcare services are demanded as employment and disposable income rises;

•    Infrastructure: Energy, electricity generation and transport are basic building blocks of an economy, supporting industrialisation, trade and urbanisation

In some ways, frontier markets can be considered a separate equity asset class. They offer a relatively independent source of equity returns, with a correlation of roughly 0.72 and a beta of 0.58 between frontier markets and EMs.

Volatility has been typically lower than EMs, due to the low correlation across frontier countries. Frontier markets have typically offered a higher dividend yield than EMs, and appear attractively valued when comparing return on equity and price-to-book.

The state and varying pace of economic development suggests each frontier market firm faces a unique set of opportunities and risks. Given the relative lower level of institutional brokerage coverage of frontier market companies, investors with access to proprietary, on-the-ground fundamental research may benefit. 

But risks at the country and universe level should also be understood, and certain active managers may be able to anticipate issues and position portfolios accordingly. Investors might note that many of these risks are not specific to frontier markets.

Frontier markets are typically less liquid, which underscores the importance of fundamental conviction supporting long-term investment. 

Changes in political leadership can be disruptive in terms of economic policies and regulations, but the impact on equity markets can be positive or negative. In addition, perceptions of corruption have been improving, in general, and frontier market ratings are similar to EMs. 

The question is could frontier markets follow a similar long-term trajectory as EMs?

Considering the progress in economic development and growth in corporate profits to date, frontier markets economies and equities appear ready to embark on a similar journey in the coming years.