This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Sam Vecht, manager of the BlackRock Frontiers Investment Trust plc, thinks this is a breakout year for frontier markets.
The final frontier? The holy grail for investors has long been to be among the first to identify a long-term investment trend. Twenty-five years ago, that meant emerging markets, as they liberalised their economies and embraced globalisation, sparking tremendous growth rates and helping living standards improve for millions of citizens. Since then, they have evolved into a mainstream investment destination.
We now believe that frontier markets are poised to benefit from those same processes of development. They comprise a large number of countries that have less developed economies and financial systems than emerging markets but are, nonetheless, ‘investable’. Whether a country is classified as ‘frontier’, ‘emerging’ or ‘developed’ depends on the breadth of the investment opportunities it offers, how liquid its markets are and the degree of access it provides to foreign investors.
As these frontier markets develop, they are periodically upgraded to ‘emerging’ status, with Qatar and the United Arab Emirates the most recent examples.
Both will be elevated to the MSCI emerging markets bracket in May 2014, while Morocco will be classified as a frontier market from November this year. In contrast, Greece has been re-classified as an emerging market – the first developed nation to see its status cut like this.
Natural Advantages
Frontier markets are naturally diverse. They include the thriving equity markets of the Middle East, whose development has been fuelled by the region’s abundant natural resources. For cultural and religious reasons, dividend payments are a key attraction for local investors, which tends to impose higher standards of corporate governance on local companies, often in excess of those found in more mainstream emerging markets. They aren’t the only drivers though – the Qatari state has big ambitions, both locally and globally, and is highly focused on growth. Qatari companies are paying large dividends as they seek to redistribute oil wealth, satisfying both major global shareholders and local retail investors.
The countries of sub-Saharan Africa also enjoy material resource riches, led by Nigeria, Africa’s largest oil producer. The country has been addressing some of the issues that have deterred would-be investors – notably by undertaking a significant restructuring of the banking sector after the crisis of 2009 and 2010. The country is also tackling the challenges of its lack of power capacity, high fuel subsidies and under-investment in energy. Power generation in particular has been a major impediment to growth, with the country still suffering daily blackouts and still only generating enough electricity to power a mid-sized European city.
Meanwhile, Asian frontier markets are likely to benefit from rising wage levels in China. Manufacturing pay in some wealthier Chinese cities is now at the same level as Taiwan, meaning Taiwanese manufacturers are looking to move production to countries such as Vietnam instead. The minimum wage in Hanoi is $95 a month, compared with the China’s cheapest province for manufacturing, Jiangxi, where monthly wages are now around $140.
Home Comforts
It is well known that the emerging world has not seen the same build-up of debt as many Western countries, but frontier markets have even lower levels of debt and faster rates of economic growth. Similarly, whereas an ageing population is likely to limit long-term rates of growth in the West, and the demographic advantage in some emerging markets (like China) is now on the wane, the demographic profile of most frontier countries still provides a strong backdrop for their development.
The majority of market participants are domestic investors – international institutional investors currently have around $20bn of assets under management in frontier markets compared with about $1 trillion of assets in emerging markets. Therefore, in the main, frontier markets are not about ‘hot money’ flows, or investors chasing the ‘risk-on/risk off’ trades that have characterised both developed and emerging markets in recent years. Given that frontier markets are not fully integrated into the world economic system, local issues are far more significant than global challenges. This is especially true in countries which have become more stable politically and have embarked on ambitious programmes of reform.
Taking Stock
The total stock market capitalisation of frontier markets today is about $400bn, approximately where emerging markets were in 1994. Since then, the latter’s total market capitalisation has increased twelvefold to nearly $5 trillion. With developed markets capitalised at more than $28 trillion, the scale of the opportunity for the long-term investor is clear.
However, as well as being aware of their growth potential, investors in frontier markets need to recognise the economic, political and market risks of this asset class. While democratic processes and corporate governance are improving, it can still be from a relatively low base. Investing in these countries inevitably involves exposure to potentially sizeable exchange rate movements that can have a big impact on returns, as well as the risks posed by their relative lack of market liquidity. This will tend to make the value of investments in these markets more volatile although it is a bigger issue in some places than in others – the daily trading volume on the Saudi Arabian equity market, for example, is more than $1bn.
There are about 140 frontier markets, which allows very broad geographical diversification – it often surprises investors to discover that the MSCI Frontier Market Index exhibits lower volatility (of around 7%) than both emerging and developed market indices (at 15% and 12% respectively), which we believe is testament to the diversification benefits that frontier markets offer.
Attractive Valuations
Their valuations, meanwhile, remain attractive both in absolute terms and relative to mainstream emerging markets. Companies that are operating very profitably in Sub-Saharan Africa, Asia and the Middle East offer exposure to some of the world’s fastest-growing economies yet trade on price-to-earnings valuations of less than nine times, supported by dividend yields of 7% and more. The value of SingTel, the Singaporean telecoms company, is greater than the capitalisation of the entire Vietnamese stock market, which we believe highlights the opportunities that current valuations in these markets present.
So What Do I Do with my Money?
More than two billion people live in frontier markets but historically these countries have attracted little attention from investors in the developed world. But with some of the fastest-growing economies in the world, attractive valuations and high-dividend yields, we believe they should. This combination of countries with the best demographic profile, the lowest government debt and a substantial commodity endowment provides an unrivalled investment opportunity. Factor in their relatively low correlation to developed and emerging markets and we believe their worth as portfolio diversifiers is also apparent. It is increasingly likely that 2013 will prove to be the breakout year for frontier markets and we believe they offer a very attractive opportunity for those prepared to take a genuinely long-term view.
But for all their benefits, that long-term view is essential, especially given these markets can at times be relatively illiquid. That’s where an investment trust (IT) comes in. An IT’s closed-ended nature protects investors from the impact of ‘hot money’ flows, and it’s this capital stability that enables us to concentrate on identifying the best stocks and capturing long-term opportunities, rather than making provisions for sudden outflows.
