Burgeoning growth draws investors to the frontier

Whenever quantitative easing or asset purchases occur in the US and Europe, low interest rates at home, be it the US, Europe or Japan, lead wealth managers to look towards riskier assets, such as emerging markets. However, while emerging markets show correlations with the developed economies of the West, frontier markets offer investors significant diversification benefits.

Frontier markets provide access to some of the most dynamic and fastest-growing economies in the world, says Daniel Broby, chief investment officer at Silk Invest, an investment firm specialising in early stage emerging markets.

“These markets are supported by strong growth drivers. The investment opportunities are positive as a result of increasing market liberalisation and attractive valuations, compared to the developed and emerging world,” he says.

Silk Invest is upbeat on Kenya in the short-term, which Mr Broby says is “playing catch up from last year”, after the Nairobi Stock Exchange fell 30.6 per cent, triggered by a currency crisis towards the end of the year. However, a a healthy demographic curve, young growing population and petrochemical wealth are making Nigeria the firm’s favoured market.

“The Nigerian government has shown a strong drive to stamp out corruption and has launched banking sector reforms,” he explains. “Moreover, the inflation is under control.”

Last year’s post elections violence made people far too pessimistic, feels Mr Broby. “It is time the market got a re-rating.”

Whilst usually mistaken as low-income countries, frontier markets include a broad range of economies that can include middle-income countries to those of the Gulf, such as Qatar and Kuwait, which have some of the highest per capital incomes in the world, but are classified as frontier, due to their strict capital controls.

The most compelling reason to invest in frontier markets is their long-term growth potential, believes Mark Mobius, executive chairman of the Templeton Emerging Markets Group, who has been christened as a “frontiersman” on his quest for the next big investment opportunity.

“When you compare the growth rates of many developed nations to that of frontier markets, you find a wide discrepancy,” he says, shedding light on the US GDP, which was under 2 per cent last year in comparison to Nigeria’s 6.9 per cent.

Though they may find interesting opportunities in Vietnam, Kazakhstan, Ukraine and UAE, Africa is of particular interest to Franklin Templeton. “Africa is a very fast-growing region. From 2001 to 2010, six of the 10 of the fastest-growing countries in the world have been in Africa,” Mr Mobius says.

Over the next five years, the International Monetary Fund forecasts GDP growth in excess of 5 per cent for sub-Saharan Africa, while individual countries, such as Nigeria, Ghana and Kenya are projected to grow even faster.

Growth on this scale is creating burgeoning middle class populations and dynamic domestic economies that provide opportunities for consumer companies, as well as a degree of insulation from the problems of developed markets.

“We are very excited by the growth prospects in those countries,” says Mr Mobius. “In addition, we may further see African countries developing into the next frontier markets in the coming years, such as Côte d’Ivoire, Botswana, Zambia and even Zimbabwe.”

Many people’s perceptions about Africa are driven by two sets of pictures, says Sven Richter, head of frontier markets at Renaissance Asset Management. One is the picture of droughts and starving people and the other is a picture of wildlife, promoted by tourism agencies. “But the majority of Africans live in cities, wake up in the morning, take their children to school, go to work and come home in the evening,” he says, attempting to drive home the point that these untapped markets offer compelling investment opportunities, especially in the strong macroeconomic environment supported by rising commodity prices.

“Investing in Africa allows access to emerging markets of the future,” Mr Richter says, giving the example of Nigeria’s bond markets, which were reclassified as emerging last month.

Renaissance’s sub-Saharan fund is witnessing a surge in inflows, with net flows in the last two months outstripping outflows in the first half by seven times, according to data provided by the company. The fund provides 48 per cent exposure to Nigeria and 19 per cent to Kenya. It is mainly invested in financials, which includes 41 per cent exposure to consumer stocks, and around 21 per cent and 10 per cent to non-cyclicals and communications respectively.

Mr Richter recalls an incident in Lagos, where he was informed there was no access to phone lines due to a fire. He asked whether the fire had taken place a couple of weeks before, only to be told it had happened five years ago. “The telecom sector is going strong in Africa, where companies like M-Pesa are even transferring money by mobile,” Mr Richter says. The fund is bullish on companies such as MTN and Safaricom in the telecom sector, and First Bank Nigeria in the banking sector, as they expect more Africans to start using credit and debit card facilities.

The asset manager also has a frontier markets fund, which has an exposure of around 29 per cent to Indonesia, 16 per cent to Nigeria and 14 per cent to Thailand.

While Africa is certainly the favoured frontier market, Clemente Cappello, founder of Sturgeon Capital, finds value in Central Asia and the Caucasus. “We are finding opportunities in Kazakhstan, which is strategically located between China, Russia and India — three of the Bric nations. It is under-researched and has got low valuations,” he says. Listed equities in Kazakhstan across the board also offer opportunities.

“These are trading at low multiples and showing healthy growth,” says Mr Cappello. “We are overweight agriculture and natural resources.”

Phillip Blackwood, managing partner at EM Quest Capital, prefers to look across the globe through top-down macro, country and instrument selection. He rates countries looking at their economic and political health, using a range of quantitative and qualitative factors, such as debt-to-GDP ratio. He is currently upbeat on Mongolia, which he believes will benefit through the mining projects it receives from China. “We also like Nigeria and Angola because of high oil prices,” says Mr Blackwood.

THE DOWNSIDE

However, that is not to say that investing in frontier markets does not come without risk. “There is a wide range of risks, in terms of liquidity. Also, many frontier markets have unstable currencies,” Mr Blackwood explains.

As many frontier markets are commodity-dependent, falling commodity prices can have an adverse impact. Also, political instability brings a policy challenge, as investors are left to the whims and fancies of the ruling government.

“Risks to frontier markets include a number of legal and political challenges and these tend to differ country to country,” explains Sturgeon’s Mr Cappello. “Instability in one country does not affect another.”

Thus, it becomes necessary to look at countries individually, rather than as a whole.

“What we learnt with emerging markets over decades of investing is that there is no substitute for local knowledge and this is just, if not, more prevalent with frontier markets,” says Franklin Templeton’s Mr Mobius.

The firm’s investment approach includes on-the-ground presence, which allows the firm to mitigate risk by understanding local languages, politics and culture. It also allows them to know the companies and the market environment directly by meeting the company management teams, understanding the impact of local regulations and talking to local customers and competitors.

“Technology helps in terms of sharing information with colleagues around the world, but it cannot replace first-hand research,” Mr Mobius explains.

“We visit every country and every company we invest in. We examine the fundamentals unique to each country, and for each company we examine a history of profit/loss statements, balance sheets, and other materials to support a five-year forecast. It’s an intensive process.”

Franklin Templeton looks for companies that appear to have solid long-term growth prospects, supported by a youthful population and rising middle class and good corporate governance. “We also favour a culture of dividends,” Mr Mobius says.

Renaissance Asset Management has a three-pronged approach when it comes to their screening process. Firstly, the asset manager looks at companies with sound management, a simple business model, growing or stable margins and returns that beat the cost of capital. “We look for companies that are able to grow both their turnover and profits consistently,” says Mr Richter.

Then they screen companies according to their risk. “These include companies that have low gearing, can afford their interest and debt repayments, maintain their equipment, can source their raw materials easily and can distribute their products with ease,” he says.

Lastly, the selection process comes down to price. “We want to pay less than what we believe a company is worth and in particular have a preference for companies where they are both absolutely cheap and cheap in comparison to their history and their peers,” says Mr Richter.

Mark Mobius, Franklin Templeton