Frontier Market Investing: Inefficiency Equals Opportunity

Frontier markets are often thought of as inhospitable investing outposts where corruption abounds and investors face outsized risks. The inherent risks of frontier market investing were recently exemplified by news that Argentina plans to nationalize YPF, its biggest company, which is 57%-owned by the Spanish firm Repsol. Notwithstanding this asset grab by the Argentinian government, the safety and integrity of frontier markets has greatly improved over the past decade, and their growing popularity with professional investors is testament to the fact that the risk-adjusted returns offered by frontier markets are indeed attractive.

For investors looking for growth, frontier markets certainly deliver: Nick Padgett, CFA, recently pointed out to attendees at the 2012 Emerging Markets Conference that 22 of the 25 fastest-growing economies over the next five years (as estimated by the International Monetary Fund) are expected to be in frontier countries.

“Frontier market” is an economic term first used in 1992 by the International Finance Corporation to describe a subset of very small and illiquid emerging stock markets. Twenty years later there is no strict definition of frontier markets, though, by default, they are commonly viewed as those markets which are neither developed nor emerging. Highlighting both their opportunity and their challenge, frontier markets represent one-fifth of the world’s population, yet less than 10% of global GDP, and only about 2% of global market capitalization.

In Frontier Market Equity Investing: Finding the Winners of the Future, a Research Foundation of CFA Institute publication, Larry Speidell, CFA, presents a balanced overview of the opportunities and risks associated with frontier markets. Speidell is chief investment officer at the aptly named Frontier Market Asset Management and is recognized as a trailblazer when it comes to uncovering the stocks of companies overlooked by mainstream investors. As Speidell is quick to point out, properly vetted, these forsaken companies offer attractive valuations and investment returns. And when it comes to risk, their low correlation with other asset classes only adds to the appeal.

Below are some key takeaways from the monograph.

Frontier Markets: Beyond Commodities

Standard & Poor’s, MSCI, and Russell Investments each maintain frontier market indices. At last count they represented, in total, 45 countries (see table below). Surprisingly, these indices are not dominated by commodity producers but by financial firms, which make up approximately 50% of frontier market indices. Many of the big producers of oil and other resources are global multinational companies or government-owned, with smaller firms often listed in London or Toronto. Ironically, Speidell notes, banks in frontier countries may be in better financial condition than their counterparts in developed countries because they are less leveraged and have been more conservatively managed.

Note: Countries are members of the MSCI, S&P, or Russell frontier markets indices.

The Opportunity

• Favorable economics. Speidell cites generally favorable economic fundamentals as a chief reason for optimism for the prospects of frontier markets. A young labor force, low wages, and rising productivity all bode well for future growth. Robust capital formation and rising foreign direct investment, as well as a burgeoning middle class, will help to fuel this expansion. Local politics, of course, can either nurture or hinder economic growth. While noting pockets of corruption and instability, Speidell sees generally improving political climates and points to the efforts made by the World Bank and international communities to support the economic development of these countries. And as measured by the Heritage Foundation Economic Freedom rankings, frontier countries are nearly the equals of emerging countries when it comes to fostering free markets.
• Attractive valuations with low correlations. As the table below demonstrates, despite posting excellent returns relative to the developed markets over the past 10 years, frontier markets still sell at a significant discount to both developed and emerging markets. These attractive valuations come with comparable levels of volatility and low correlations to developed markets.
• Contrarian play. Speidell suggests that frontier stocks should instinctively appeal to contrarian investors — those who are comfortable avoiding the herd and relying on “asymmetric information.” Behavioral biases, Speidell adds, “create abundant opportunities for patient and persistent investors in frontier markets.”

Source: Frontier Market Asset Management.

The Risks

• Bureaucracy and transaction costs. Common regulatory hurdles in frontier markets include ownership limits and trading restrictions. Also, trade execution can be erratic and transaction costs steep — as high as 5%.
• Counterparty risk. The relatively recent development of central depository systems and insurance in many frontier countries has mitigated, but not eliminated, counterparty risk.
• Foreign exchange risk. Volatile currencies, capital controls, pre-funding requirements, and exchange fees all present additional challenges for frontier investors.
• Liquidity constraints. Frontier market stocks are usually thinly traded, and without careful execution, trades can send important signals to local investors at the expense of foreign investors.

The Bottom Line

When it comes to frontier markets, Speidell likes to say that “inefficiency equals opportunity.” Frontier markets offer attractive risk-adjusted returns with low correlation to developed markets. At the same time, the diverse nature of these markets, and their potential pitfalls, mean that experience, strong risk controls, and partnerships with established global custodians and brokers are essential to success.

According to Speidell, the most attractive investment opportunities today exist in Romania and sub-Saharan Africa. He considers Africa’s abundance of natural resources to be part of a “virtuous circle” of trade between emerging and frontier countries that will help to fuel future growth. And Speidell is not alone — in “Africa: The Land of Alpha,” my colleague Michael McMillan, CFA, succinctly outlines the case for investment in Africa recently made by frontier investor Cliff Quisenberry, CFA.

For more from Speidell, listen to “Author Insights: Larry Speidell, CFA, on Frontier Markets,” in which he discusses his monograph and advocates for investing in frontier markets.