Sophisticated investors, especially institutional ones, are known to be persistent in their search to maximize risk-adjusted returns. It is little surprise then that the most seasoned of them have taken a lead in exploring frontier markets.
Frontier markets refer to relatively small and illiquid equity markets in countries that are at early stages of economic and political development. The asset class is on the periphery of global equities investing. Frontier countries are so undeveloped that they even fall outside of the emerging markets category.
While they are peripheral from a capital markets perspective, many of these are vibrant economies with thriving private enterprise and a high level of entrepreneurship. Such countries have transformed themselves over the last two decades, with progress on several fronts. These include advancements in literacy, access to credit, communications revolutions, improved public sector accountability and an entrenchment of democracy. These advances have elevated the sustainable growth rate of the region and subsequently reduced risks. Local exchange-listed companies are among the greatest beneficiaries.
Those who have been in the asset management industry long enough may remember that in 1988, the newly-launched Morgan Stanley Capital International (MSCI) Emerging Markets Index1 represented less than 1% of the world’s market capitalization. Today, emerging markets comprise 13%. We believe a similar fate awaits frontier markets, given (under the broadest definition) they comprise over 100 countries accounting for more than 30% of the world’s population and almost 10% of global gross domestic product (GDP).2
Opportunities and risks
There are several arguments supporting investment in frontier markets, including:
1. Expectations for robust economic growth
Frontier market economies are projected to have some of the highest economic growth rates in the world over the next five years, driven by factors such as the low penetration of goods and services, favorable demographics, rapid urbanization, technology transfer and increasing availability of credit to the private sector.
2. Favorable demographics
In contrast to many developed countries, frontier markets have a young, growing population that will contribute to a developing workforce and increased domestic consumption.
3. Improvement in governance and accountability
Encouragingly, governance and accountability have found their way up the agenda in recent years. Political leaders generally understand the need for orthodox economic management to maintain a stable economy and attract inward investment. The electorate tend to be much better informed, which means corruption and accountability are now heated topics during elections. Several of the most populous frontier nations, including Pakistan and Nigeria, have seen an entrenchment of democracy, while others such as Myanmar and Sri Lanka have emerged from decades of obscurity.
4. “Convergence” and diversification benefits
Investing in frontier markets can also offer the potential for valuable diversification benefits. Correlations relative to developed markets have generally been lower than their emerging markets peers, as have intra-country correlations within frontier markets itself because of the highly diverse nature of the asset class. As these markets open up to foreign direct investment (FDI), correlations are likely to increase. But there will be other benefits, including the adoption of global best practices on the part of local corporates, and better access to funding and more advanced technologies from abroad.
5. Greater prevalence of mispricing and other market inefficiencies
For fundamental, research-driven investors, there are opportunities to capitalize on market inefficiencies that occur because of short-term liquidity squeezes, weak intelligence or corporate analysis where there are naturally fewer market participants.
Investing in these markets, as with any other market, is certainly not without risk.
Liquidity varies greatly, with several markets lacking scale and depth in comparison to more mature emerging markets. Democracy is not always entrenched either, with governance and judiciary structures often fragile or untested, making political graft more likely. On the macroeconomic front, most frontier markets suffer from low domestic savings rates and are dependent on foreign capital for investment. Others are overly-exposed to agricultural production or other commodities.
These risks can be minimized through in-depth market knowledge and a disciplined bottom-up investment approach focusing on high-quality businesses with strong governance credentials. This often includes locally-listed multinational subsidiaries and sometimes home-grown corporates with a good reputation and proven management track records.
Within the frontier markets universe, companies in Africa and Frontier Asia are the most attractive right now. For example, there are several promising businesses emerging in Kenya, Vietnam and Pakistan.
Kenya’s economy has been enjoying strong growth of c6% per annum supported by lower energy costs, investment in infrastructure and a robust agricultural sector. Despite the country’s sizeable twin deficits, the International Monetary Fund (IMF) remains supportive of the government’s structural and economic reforms and has extended a $1.5 billion package to the government.
Additionally, a lower oil price has seen the current account deficit narrow substantially, while inflation has stabilized, and the government has committed to further spending cuts, all of which has brought greater stability to the Kenyan Shilling. Kenya’s capital, Nairobi, is one of the most dynamic cities in the African continent and home to several highly entrepreneurial businesses.
Vietnam is set to be one of the fastest-growing markets globally over the next decade with forecasted annual GDP growth of between 6-9%. FDI has boomed as the country continues to open up to free trade such as through the Trans-Pacific Partnership. FDI rose from $2 billion per year in the early 2000s to closer to $10 billion per year in 2015.3 The government has also made great strides in improving access to education and developing much-needed infrastructure relative to other frontier markets. This again bodes well for future growth. Despite the corporate sector still being prone to state interference, we believe there are well-run businesses to invest in across sectors, such as the consumer industry.
Pakistan has long been ignored by foreign investors because of poor security situation, severe energy shortages and a messy political environment. But things are falling into place for this nation of 200 million people. This includes a serious crackdown on militancy and willingness from both the private and public sectors in the country to resolve the energy situation. It also includes a rosier economic outlook driven by better wage competitiveness relative to the rest of the region, falling oil prices and the prospect of significant infrastructure development spurred by Chinese investment.
Frontier markets comprise a sizeable portion of the world’s land mass and population, not to mention many of the world’s fastest-growing nations. Yet their nascent level of development and limited capital market depth result in barely any representation in most equity portfolios. We expect this to change over the coming decades. For those investors that can take a long-term view, the asset class can present a compelling investment opportunity and a valuable diversification tool.
1 Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.
2 Sources: Renaissance Capital, Aberdeen Asset Management, September 30, 2015.
3 Renaissance Capital, December 2015.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
Diversification does not ensure a profit or protect against a loss in a declining market.
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