Look to frontier markets for clients who can stomach risk

Once relatively inaccessible to foreigners, frontier markets are increasingly gaining the attention of investors who are willing to assume greater risks for the opportunity to obtain greater rewards. Countries that are less developed than emerging markets present opportunities because of their rapidly expanding consumer markets.

Frontier markets are widely regarded as the next generation, or a subset, of emerging markets. Typically, although not necessarily always, frontier markets are relatively small and illiquid compared with their traditional emerging counterparts. In many ways, they are similar to what Brazil, India and China were 10 years ago; many will eventually undergo a transition into the universe of emerging markets.

“It is only a matter time before some frontier markets are reclassified as emerging markets,” says Daniel Smaller, a partner with Dubai-based Algebra Capital Ltd., a subadvisor to Franklin Middle East and North Africa Fund, which is sponsored by Toronto-based Franklin Templeton Investments Inc. “It could be as early as next year.”

Although there is no widely accepted definition for frontier markets, they are generally at the lower end of the development spectrum and have the potential to grow at impressive rates, says Mark Mobius, the Singapore-based manager of Templeton Emerging Markets Fund.

As well, frontier markets have low correlation to emerging and developed markets. According to Standard & Poor’s Corp. ’s October 2007 report, entitled Frontier Markets: Investment Rationale, Accessibility and Risks: “The correlation between frontier and developed markets has remained well below 50%, while the correlation between emerging and developed markets has consistently been above 80%.”

So, frontier markets could well benefit from the next wave of investors seeking a “first-mover advantage,” says Mark Grammer, vice president of investments with Mackenzie Financial Corp. in Toronto and lead manager of Mackenzie Universal Global Future Fund.

Adds Smaller: “Investors have the opportunity to double or even triple their money in frontier markets.”

Arguably, investors in frontier markets are searching for the next Brazil, Russia, India or China. Many of those markets that are still considered to be emerging have either achieved — or are close to achieving — developed-country status.

Switzerland-based Credit Suisse Group advances the case for investing in frontier markets in its January 2008 Global Investor Report on the argument that many countries still seen as emerging markets have now achieved an economic profile that is close to developed markets, thus the search is for markets that present the same characteristics as emerging markets before they emerged.

There is consensus on which specific markets are considered frontier, albeit with some variations. Mobius offers a broad definition: markets that are emerging but would typically not be included in an established emerging-markets index. This opportunistic stance facilitates investing in markets that are not yet part of a typical index.

From a structural standpoint, globally accepted benchmark indices — such as the S&P/International Finance Corp. global frontier markets composite index, the Financial Times/London Stock Exchange’s frontier 50 index and the MSCI Barra frontier markets index — use criteria such as liquidity, free-float market capitalization, minimum size and accessibility in selecting companies.

From a country classification standpoint, factors include:

• the existence of a formal and independent stock market authority that actively monitors the market;

• no objection to or significant restrictions or penalties applied on the repatriation of capital and income;

• the availability of in-depth market information, visibility and timely trade reporting processes and international price dissemination;

• a well-developed clearing and settlement process, with rare incidences of failed trades.

The S&P/IFC global and the MSCI Barra indices each list 22 countries, while the FTSE index lists 23, although there are some differences in the countries listed.

To provide a sense of the structure of frontier markets, the 22 countries on the MSCI Barra index had a combined market capitalization of US$100.7 billion and an average market cap of US$559 million as of Dec. 1, 2008. In total, 177 companies are listed on the index, with the smallest stock having a market cap of US$27 million and the largest, US$8.6 billion. The index is heavily weighted in favour of telecommunications, financial services, energy and materials.

MSCI Barra anticipates adding Botswana, Ghana, Jamaica and Trinidad and Tobago to the index in May, subject to due diligence.

Some countries might not be included in an index for structural reasons. For example, Saudi Arabia — one of the largest markets in the Middle East, in terms of capitalization — is included in the MSCI Barra index or the MSCI Barra emerging markets index, but the country is included in the MSCI Barra Gulf Co-operation Council index.

Incidentally, Saudi Arabia does not presently permit portfolio investments from international investors outside the Gulf region. That said, the MSCI Barra Gulf index includes seven other Middle East countries.

There is no doubt that as frontier markets emerge, they will offer investors an abundance of new opportunities. Mobius says that many frontier markets have rapidly expanding consumer markets fuelled by increasing income per capita. He sees opportunities in a wide range of consumer products deriving from increasing demand in cellphone services, consumer banking and credit cards.

As these countries expand, Mobius adds, they will continue to increase investments in infrastructure, offering opportunities in construction, transportation, telecommunications, and banking and finance.

In the Middle Eastern and North African frontier markets, Smaller sees opportunities in roads, power, bridges, desalination plants, fertilizers, consumer durables and countercyclical plays. Many companies in the region, he adds, have distinct catalysts and high earnings and are trading at cheap price/book value and price/cash flow valuations.

Although Chuk Wong, vice president and portfolio manager with Goodman & Co. Investment Counsel Ltd. in Toronto, believes that while frontier markets are attractive, they are prone to external shocks and domestic upheavals. The correction in the prices of hard and soft commodities, he says, will also hurt their economies. Many frontier markets are producers of oil, gas, minerals, metals and agricultural commodities, whose prices have fallen with declining demand.

Looked at another way, Smaller argues, lower oil, food and property prices have contributed to a decrease in inflation, which is no longer a major problem in most frontier markets. He sees the biggest risk as global volatility and instability in the U.S. market. Although there will always be political risk, he adds, it’s becoming less of a factor.

The consensus is that investors have to be first-movers to get the best possible rewards in frontier markets. Typically, these markets can be subjected to wild swings and — even though they’re not highly correlated to developed and emerging markets — they did lose substantial ground in 2008.

For the one-year period ended Dec. 12, 2008, the MSCI Barra frontier markets index was down by 49.4% in U.S. dollars terms vs a loss of 56.6% for the MSCI Barra emerging markets index.

“This is largely due to deleveraging and liquidity constraints,” Grammer contends, “stemming from the global credit crunch.”

Arguably, frontier markets remain poised for relatively strong growth. The United Nations’ 2009 Global Outlook report expects transition economies, which include frontier markets, to grow this year by an average of 2.7% at worst or by 6.1% at best.

Comparatively, developed economies are expected to contract.

Dwarka Lakhan

Dwarka Lakhan is a pioneer in emerging markets journalism in Canada. His first emerging markets article, “Africa Joins Ranks of the Emerging,” appeared in Investment Executive, Canada’s leading newspaper for financial advisors, in September 1994. Since then he has written hundreds of articles on the full spectrum of emerging markets and has conducted more than two thousand interviews with emerging and frontier markets investment professionals.

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