Africa: The Land of Alpha

The famed hockey player Wayne Gretzky once said, “A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be.” In this post, I am going to offer a twist on the same idea, which also summarizes the presentation given by Cliff Quisenberry, CFA, at the Investment Opportunities and Risks in Africa conference last fall. That is: “A good investor invests where the alpha is. A great investor invests where the alpha is going to be.”

According to Quisenberry, chief investment officer of Caravan Capital Management and manager of the Emerging Frontiers Fund, frontier markets — especially those in Africa — are where great investors need to be.

Of course, frontier markets can be found in all geographic regions of the world, not just Africa, and Quisenberry made a compelling case for frontier markets in general, though he highlighted Africa’s economic strength in particular. Prior to the global recession of 2007–2008, real GDP growth in frontier market countries (including those in Africa) was averaging 6% per year, versus 2–4% in developed countries.

Quisenberry used data from the International Monetary Fund’s World Economic Outlook report to show that real GDP growth in frontier and emerging markets was not only less affected by the global recession — real GDP growth declined from 6% in 2007 to 4% in 2009 — it also rebounded more quickly than in developed countries. The IMF forecasts that real GDP growth in African frontier markets will be 6% per year for the next five years, versus 4–5% in other frontier and emerging markets.

Africa is also rich in commodities such as copper, oil, and gold, and is one of the last bastions of arable land. Demographic trends also favor Africa: It has a young and growing labor force, as well as a burgeoning middle class, and consumerism is on the rise (for more on this theme, read “Africa can remind the world of the capitalist way” in the 6 February 2012 edition of the Financial Times).

From an investment perspective, Quisenberry believes that frontier markets are both underdeveloped and undervalued, and he provided the following statistics to support his point:

• Frontier markets comprise 21% of the world’s population and generate 7.1% of the world GDP, yet they only represent 2.8% of the total world market capitalization.
• Sub-Saharan African markets comprise 8.1% of the world’s population, generate 1.3% of the world GDP, and represent 0.9% of the total world market capitalization.
• For comparison purposes, the developed world represents 13.7% of the world’s population, generates 66.3% of the GDP, and represents 64.5% of the total market capitalization.

To emphasize the undervalued nature of frontier markets, Quisenberry highlighted the fact that the median market capitalization-to-GDP ratio — that is, the percentage of stock market value that represents GDP — is 11.2% in frontier markets (15.6% in African frontier markets), versus 64.8% in emerging markets, and 70% in developed markets. (A ratio greater than 100% indicates a market is overvalued, whereas a ratio of 50% or less indicates a market is undervalued.)

From a portfolio perspective, investing in frontier markets has great appeal because of the low correlations to other markets. For example, African frontier markets have a 0.49 correlation to the MSCI World Index, and frontier markets in general have a 0.74 correlation. By contrast, emerging and developed markets have correlations of 0.85 and 0.93, respectively.

Cross-correlations among African frontier markets (0.28) and standard frontier markets (0.33) are also relatively low compared to emerging markets (0.65) and the so-called BRIC nations of Brazil, Russia, India, and China (0.74). The volatility of the average frontier market — that is, the annualized standard deviation of monthly returns over the past five years — is also relatively low: 30% for frontier markets, versus 34% for emerging markets, and 36% for the BRICs.

More importantly, because of the low cross-correlations, broad portfolios can be constructed that have the volatility of about two-thirds that of the major emerging market indices — and even less than the major developed international market indices, such as the MSCI EAFE Index for Europe, Australasia, and the Far East.

Although frontier markets in general, and African frontier markets in particular, have attractive return potential, there are also many perils, including liquidity risk and geopolitical risk, as well as the risk of economic shocks, currency crises, and regulatory/operational risk.

As in other markets, bubbles and inflation shocks are also potential hazards, Quisenberry noted. In addition, he said, trading costs are higher, there is limited brokerage and research coverage, and financial disclosures as well as access to management is limited. However, the biggest challenge for investors in frontier markets is the lack of liquidity. For example, total trading volume in a month in emerging markets averages about $560 billion, versus only $33.7 in frontier markets. Quisenberry expects the lack of liquidity to change as frontier markets attract greater foreign investment funds and pension reforms within these countries encourage local investors to develop more of an equity culture. Continued privatization of state-owned enterprises should also improve liquidity by increasing not only the number of listings but also their size.

Quisenberry contended that investing in frontier markets is similar to investing in private equity. Because of the lack of liquidity in both types of investments, it is important to take a long-term approach — he suggested a three to five year holding period on average — to limit turnover and to build broad portfolios instead of concentrating holdings. In addition, Quisenberry believes that using a country-level (i.e., top-down) approach will generate greater alpha than a company-level approach.

For more information on investing in frontier markets, see the following resources on the CFA Institute website:

• Exploring the Frontier Emerging Equity Markets: In this webcast, Cliff Quisenberry, CFA, defines frontier emerging markets and discusses the risks, rewards, and unique challenges associated with them that investors should consider.
• Author Insights: Larry Speidell, CFA, on Frontier Markets: Author Lawrence S. Speidell, CFA, discusses his recent monograph, Frontier Market Equity Investing: Finding the Winners of the Future, including why these markets are no more risky than those typically considered emerging and why frontier markets’ attractive valuations make the opportunity for future gain greater.
• What’s Emerging in Emerging Markets: The New Frontier: In this webcast, Lawrence S. Speidell, CFA, argues that frontier market countries present significant opportunities, are priced attractively, and have low correlations with other markets.

In addition, CFA Institute will host a conference on emerging and frontier markets, Investing in Emerging Markets, in New York City, on 1–2 March 2012.