Could you profit from new frontiers?

9 February 2009

Countries such as Vietnam, Nigeria and Kazakhstan are often associated with images of political unrest and corruption – few of us imagine that they could offer a sound investment opportunity. Yet these countries belong to a relatively unknown sector called ‘frontier markets’, which has performed very well in recent years. Although highly volatile, this sector may hold hidden treasures for those investors willing to take the risk.

Frontier markets are, in essence, very small emerging markets. Just 15 years ago, the BRIC markets (Brazil, Russia, India and China) were classed as frontier markets, but they now form a part of many investors’ portfolios. Today’s frontier markets, however, are virgin territory for most of us. They can be found across the globe, from Bulgaria to Bangladesh and from Kazahkstan to Kenya.

According to Morgan Stanley Capital International, which launched the MSCI Frontier Market Index in November 2007, there are about 20 frontier market countries vying to become tomorrow’s emerging markets.

“Frontier market economies are generally much smaller and less developed than emerging markets, but investors understand their potential to grow and become tomorrow’s success stories,” says Mark Mobius, executive chairman of Templeton Asset Management and manager of its range of emerging market funds.

So, if you dare to step into the unknown, you could find that high returns are there for the taking.

Growth story

According to the International Monetary Fund, frontier markets are growing at a phenomenal rate. Qatar, the United Arab Emirates, Kazakhstan, Nigeria and Vietnam all experienced annual growth rates of more than 11% over the 15 years to 1 January 2008. By contrast, developed markets such as the UK and the US only grew by 6% over the same period.

“Some frontier markets have certainly defied the gloom engulfing Western economies,” says Alan Smith, managing director of Capital Asset Management.

In 2008, for example, the IMF estimated that the Vietnamese economy grew by 9%, and it expects the country to expand by 8% in 2009. Although Vietnam is a Communist country, in 2000 it opened up to foreign investment, and the Ho Chi Minh stock exchange increased by 23% in 2007 alone.

Perhaps surprisingly, the investment opportunities in such countries do not lie in natural resources; many frontier markets are in fact consumer-driven.

Mark Mobius explains: “Many of these countries have rapidly expanding consumer markets with an increasing demand for mobile phones, credit cards and a whole range of consumer products.”

And, because many frontier markets are leading producers of oil, gas and precious metals, Mobius also believes they are well positioned to benefit from future high global demand for these resources.

“As the economies of frontier market countries expand, they will continue to increase their investment in infrastructure, offering valuable opportunities in the construction, transportation, banking and finance, and telecommunications industries,” he adds.

This is a view that Amr Seif, manager of Investec Asset Management’s Middle East and North Africa fund, shares: “Because frontier market consumers are virtually debt-free they offer local banks and consumer-orientated businesses enormous growth potential.”

Appetite for risk

However, those investors convinced by the potential of frontier markets certainly need strong stomachs – the risks associated with investing in them are enormous. Many frontier countries are politically unstable, and while this may mean they trade at a discount, it could also mean one too many sleepless nights. Other risks include war, disease, corruption, currency devaluation and soaring inflation.

For example, Uzbekistan, with inflation at 20%, suffers occasional skirmishes with neighbouring nations, political instability, a lack of infrastructure and tight state control of the economy.

Investors could also find it incredibly difficult to trade frontier market stocks. Strict limits on foreign investment can apply and price information is hard to come by, while smaller exchanges with relatively few companies mean a real lack of liquidity. For long periods of time there may be no market for a stock in a frontier market company – and this can make it hard to exit your position when times get tough, thereby increasing volatility and accentuating market declines.

“Any market corrections are worrying for investors in frontier markets, because price movements are often sharp, and if panic takes hold a tide of sellers can push prices to the floor,” says Alan Smith. Because of this, only a handful of funds exist that invest solely in the frontiers.

If you are interested in dipping your toe in the frontier markets, the best way to do so is to pick a fund with only some frontier exposure in order to spread the risk.

“Frontier markets are certainly not for the faint-hearted,” says Ben Yearsley, investment manager at Hargreaves Lansdown. “The best way for investors believing in the frontier market growth story is to pick an emerging market fund that has small exposure to the frontiers – around 5%, for example.”

Of course, there’s no doubt that emerging and frontier stockmarkets have gone off the boil over the past 12 months as investors have lost faith in the emerging market growth story.

“The declining appetite for goods in the West has had a severe impact on Asian manufacturers,” says Gavin Haynes, managing director of Whitechuch Securities. “China is home to many of the world’s manufacturing businesses, and they are really feeling the pinch.”

The secondary impact of the credit crunch, adds Haynes, has also been felt by commodity-producing states such as Brazil. “The need for basic raw materials has also dried up, at least for the short term, and this will lead to a lack of investment in projects across emerging and frontier markets.” As a consequence, the MSCI’s Emerging Market Index has plummeted a painful 54.42% in the year to 13 January.

However, frontier stockmarkets suffered a heavier blow. Over the same period, the MSCI Frontier Market Index, which tracks the 50 largest companies across 22 frontier market countries, dropped by 59.51%.

Still, Mobius believes frontier markets can weather the global credit crunch. “As emerging economies mature and wages and production costs rise, frontier markets are a cheaper substitute for businesses in the area,” he says.

“This process is already in full swing. Bangladesh is taking on manufacturing businesses from India, while manufacturing plants are relocating from China to Vietnam, due to the lower labour costs there.”

However, Gavin Haynes urges caution: “In the short term, emerging market funds will continue to struggle as investors are so risk-averse.” But, he adds, “over the longer term, emerging and frontier markets both represent an exciting growth story.”

Global downturn

Another reason investors might be keen to dip their toes into the frontier markets is the hope that emerging and frontier markets could ‘decouple’ from the West and escape the global economic slowdown.

But is that possible? Mick Gilligan, director of fund research at Killik Asset Management, thinks it is. “Frontier markets are less developed than emerging markets and therefore are not as integrated into the global economy. And they have not seen the same sort of global institutional capital flowing into them,” he says.

Gilligan also points out that frontier market stocks are not owned by foreign investors to the same extent as emerging market stocks. “Unlike emerging markets, frontier stockmarkets have strict foreign investment limits in place – most of the shares are either owned by government-owned entities or local investors – making it hard for overseas investors to get exposure,” he says.

However, while frontier markets are shielded from the credit crunch to a large extent because they don’t hold a significant level of debt, they are certainly not immune. For example, market uncertainty across the globe forced New Star to suspend dealing in its flagship Heart of Africa fund – a frontier markets fund – in December, as investors rushed to pull out their cash for the safety of less volatile funds.

But while investing in the frontiers might only be suitable for the aggressive investor, the fact that many developing countries have now entered the investment arena suggests that they will play a bigger part in the future of the global economy.


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