Sophisticated institutional investors are known to be persistent in their search to maximise risk-adjusted returns and provide diversification for client portfolios. It is little surprise then that the most seasoned of them have taken a lead in the frontier markets equity asset class.
“Frontier markets” is a broad term referring to relatively small and illiquid equity markets in countries that are at an early stage of economic and political development. This is an asset class on the periphery of global equities investing, falling outside of even the emerging markets category.
Many of these countries have transformed themselves over the last two decades
But while they are peripheral from a capital markets perspective, these are vibrant economies with thriving private enterprise and a high level of entrepreneurship. Many of these countries have transformed themselves over the last two decades, with progress on several fronts: literacy, access to credit, a communications revolution, improved public sector accountability, and an entrenchment of democracy. These advances have elevated the sustainable growth rate of the region, but also reduced risks in the system. Local exchange-listed companies are among the greatest beneficiaries.
Those who have been in the asset management industry long enough may remember that in 1988, the newly launched Morgan Stanley Capital International (MSCI) Emerging Markets Index represented less than 1% of the world’s market capitalisation; yet today emerging markets comprise 13%. We believe a similar fate awaits frontier markets, given that (under the broadest definition) they comprise over 100 countries accounting for over 30% of the world’s population and almost 10% of global GDP.
Opportunities and risks
There are several arguments supporting investment in frontier markets, including:
1. Expectations for robust economic growth
Frontier market economies are projected to have some of the highest economic growth rates in the world over the next five years, driven by factors such as the low penetration of goods and services, favourable demographics, rapid urbanisation, technology transfer, and increasing availability of credit to the private sector.
2. Favourable demographics
In contrast to many developed countries, frontier markets have a young, growing population that will contribute to a developing workforce and increased domestic consumption.
3. Improvement in governance and accountability
Encouragingly, governance and accountability have found their way up the agenda in recent years. Political leaders generally understand the need for orthodox economic management to maintain a stable economy and attract inward investment. The electorate tend to be much better informed, which means corruption and accountability are now heated topics during elections. Several of the most populous frontier nations, including Pakistan and Nigeria, have seen a genuine entrenchment of democracy, while others such as Myanmar and Sri Lanka have emerged from decades of obscurity.
4.“Convergence” and diversification benefits
Investing in frontier markets offers the potential for valuable diversification benefits
Investing in frontier markets also offers the potential for valuable diversification benefits. Correlations relative to developed markets have generally been lower than their emerging markets peers, as have intra-country correlations within frontier markets itself given the highly diverse nature of the asset class. As these markets open up to foreign direct investment (FDI), correlations are likely to increase. But there will be other benefits, including the adoption of global best practices on the part of local corporates and better access to funding and more advanced technologies from abroad.
5. Greater prevalence of mispricing and other market inefficiencies
For fundamental, research-driven investors like Aberdeen, there are opportunities to capitalise on market inefficiencies that occur because of short-term liquidity squeezes, weak intelligence or corporate analysis, and naturally fewer market participants.
Investing in these markets is certainly not without risk, however.
Liquidity in particular varies greatly, with several markets lacking scale and depth in comparison to more mature emerging markets. Democracy is not always entrenched either, with governance and judiciary structures often fragile or untested, making political graft more likely. On the macroeconomic front, most frontier markets suffer from low domestic savings rates and are therefore dependent on foreign capital for investment, while others are overly exposed to agricultural production or other commodities.
Nevertheless, these risks can be minimised through in-depth market knowledge, and a disciplined bottom-up investment approach focusing on high-quality businesses with strong governance credentials. This often means locally-listed multinational subsidiaries but also home-grown corporates with a good reputation and proven management track-record. Of paramount importance to us is making sure we uncover these opportunities ourselves, which is why we place little reliance on third-party research and do our own due diligence ourselves.
Risks can be minimised through in-depth market knowledge, and a disciplined bottom-up investment approach focusing on high-quality businesses with strong governance credentials
Currently, within the frontier markets universe, we are drawn to companies in Africa and Frontier Asia, with several promising businesses emerging in Kenya, Vietnam and Pakistan in particular.
Kenya’s economy has been enjoying strong growth of c6% p.a. supported by lower energy costs, investment in infrastructure and a robust agricultural sector. Despite the country’s sizeable twin deficits, the International Monetary Fund (IMF) remains supportive of the government’s structural and economic reforms, and has extended a US$1.5 billion package to the government. Additionally, a lower oil price has seen the current account deficit narrow substantially, while inflation has stabilised and the government has committed to further spending cuts; all of which has brought greater stability to the Shilling.
Kenya’s capital, Nairobi, is one of the most dynamic cities in the African continent, home to several highly entrepreneurial businesses. Amongst many, we like Safaricom, an innovative mobile operator that has revolutionised financial inclusion through its mobile money platform, M-PESA, now used by over half of the country’s population and a benchmark for telecommunications companies anywhere in the world.
Vietnam is set to be one of the fastest-growing markets globally over the next decade with forecast annual GDP growth of 6-9%. FDI has boomed as the country continues to open up to free trade such as via the Trans-Pacific Partnership, with FDI rising from $2bn/year in the early 2000’s to closer to $10bn/year in 2015. The government has also made great strides in improving access to education and developing much-needed infrastructure relative to other frontier markets, which again bodes well for future growth.
Despite the corporate sector still being prone to state interference, there are well-run businesses to invest in, such as Vietnam Dairy Products, a dominant player in the local dairy industry that is well-placed to benefit from continued growth in domestic consumption.
Pakistan has long been ignored by foreign investors due to a poor security situation, severe energy shortages and a messy political environment. But things are falling into place for this nation of 200 million people. This includes a serious crackdown on militancy, willingness from both the private and public sectors in the country to resolve the energy situation and a rosier economic outlook driven by better wage competitiveness relative to the rest of the region, falling oil prices, and the prospect of significant infrastructure development driven by Chinese investment.
Our key holding in the country is Habib Bank, one of the leading financial institutions enjoying a strong deposit-gathering franchise and a professional management team that will drive increasing credit penetration as the economy grows and demand for borrowing increases.
Frontier markets comprise a sizeable portion of the world’s land mass and population, not to mention many of the world’s fastest-growing nations. Yet their nascent level of development and limited capital market depth result in barely any representation in most equity portfolios. We expect this to change over the coming decades, so for those that can take a long-term view, the asset class presents a compelling investment opportunity and a valuable diversification tool.
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