Frontier MarketsFeb 13 2020

Frontier markets hold a lot of promise

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Frontier markets hold a lot of promise

The equity bull market of the past decade has been led by the largest market – the US.

Over the past year, the bull run was led by the very largest corporations and has become even more concentrated.

Put simply, ‘bigger is better’ has been the way to outperform of late.

One area we believe has attractive characteristics is frontier markets

However, this mantra may be reaching its sell-by date.

These segments of the market now look increasingly expensive relative to other areas and the time may be ripe for cheaper and much more neglected parts of the market to outperform.

One area we believe has attractive characteristics is frontier markets.

There are 195 countries in the world. Of these, 51 are classified by the major equity index providers as ‘developed’ or ‘emerging’ markets.

The remaining 144 countries make up the so-called frontier markets, and include a wide range of countries at varying stages of political, economic and financial market development.

The total market capitalisation of the MSCI Frontier Markets index amounts to only $118bn (£91bn), compared to $6.2tn for emerging markets and $44.7tn for developed markets, and includes only 92 stocks.

Showing potential

The obvious question is why bother with this tiny corner of the equity universe at all?

The reason is that frontier markets have a variety of unique features warranting their inclusion in a global equity portfolio.

These markets are, by definition, still in the relatively early stages of development – both in terms of their economy and financial markets.

Their ability to catch up, combined with their fast-growing and young populations, provides the potential for strong, long-term growth.

If this potential is to be reached, however, it needs to be combined with structural reform – political, economic and financial – and this varies enormously across frontier markets.

Africa, for example, would superficially seem to be well-placed, given its very favourable demographics.

The reality is that poor power supply due to the lack of appropriate reforms is a major constraint on growth across the continent.

By contrast, Vietnam and various countries in the Middle East such as the UAE and Kuwait have embraced reform and are much more fertile areas for investment.

The need to be highly selective when investing in frontier markets is due not only to the big divergence in economic prospects, but also to the widely differing levels of corporate governance and management skills across companies.

The gap between the good and the bad is particularly wide in frontier markets, and strong management with a good track record of business execution is essential.

Even if a company is enjoying strong earnings growth, a key consideration is whether the benefits will actually accrue to minority investors.

These opportunities, along with the paucity of research available on frontier market companies, mean that there are large inefficiencies in stock market pricing, which can potentially be exploited by extensive, on-the-ground research.

Where opportunity lies

Most foreign investment in these markets is typically concentrated in the few biggest stocks, which trade at high valuations similar to their peers in developed markets.

The opportunities lie not in these companies but in the smaller, under-researched companies where foreign ownership is still low but has scope to increase significantly.

Frontier markets are a classic area where investing via an active manager with the necessary expertise and resources makes much more sense than via a passive exchange-traded fund.

The latter will track an index that is inevitably backward-looking, which is a disadvantage in fast-growing economies and capital markets.

The index will also comprise only the largest, most liquid companies, which in frontier markets are often not where the best opportunities lie.

Finally, the distinction between the smallest countries in the emerging market indices and those classified as frontier markets is somewhat arbitrary for the purposes of an investor.

The same type of opportunities can exist in both, and an active fund that is benchmark agnostic and has a remit to invest in both areas, has distinct advantages.

The Magna New Frontiers fund run by Fiera Capita is one example.

The manager has a long track record of investing in the region, focusing on undervalued, under-researched companies with strong growth potential.

A major attraction of frontier markets therefore is the potential to find stocks at cheap valuations with good long-term earnings growth prospects.

Diversification

Frontier markets are also a good way of diversifying one’s equity exposure.

Their correlation to both emerging and developed market equities in recent years has been relatively low at around 0.55 and 0.50, respectively.

This reflects the fact that the investor base for these stocks is primarily the domestic investor who is generally motivated by factors quite different to those driving investors in mainstream equity markets.

Despite their clear, long-term attraction, the fact is that following a strong run in 2016 and 2017, frontier markets have underperformed developed and emerging markets in the past couple of years. This, however, in the main just echoes the underperformance of value stocks across the investment universe.

Frontier market valuations are now down to a 10-year low and rising foreign ownership levels could well provide a catalyst for a re-rating over the coming year or two.

Frontier markets may well once again have their day in the sun.

Rupert Thompson is chief investment officer at Kingswood