New Frontiers: The Rush to Invest in Frontier Markets

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New Frontiers: The Rush to Invest in Frontier Markets

If any event could illustrate the fragility of the BRICS conceit, it is the recent blackout in India, which left as many as 600 million people without power for up to two days. More than anything else, it reveals the sorry state of India’s governance. Yes, there are some extenuating circumstances: an unusually hot and dry monsoon season, which has reduced the available flow in hydroelectric plants while also causing the wealthy to use more power to run their air conditioners, while at the same time farmers are using more power to run pumps bringing up irrigation water from deep wells.

But the real story is under-investment in power generation, in coal production, and in transmission and distribution infrastructure, which in turn are attributable to monopoly pricing, hugely inefficient subsidies, endemic corruption, and political stagnation. The power outage was unique only in its extent and duration. Businesses, households, and public institutions all rely on diesel generators, which to a large extent have gone from a backup to the primary source of electricity, as “load shedding” – the system of rolling blackouts that utilities impose to reduce the strain on an overtaxed network, which often deprive whole areas of a city of power for as much as 14 hours a day. The event, and the global publicity it has attracted, has put a dent in India’s self-image as a nascent superpower. India has nuclear weapons and a space program – it launched a lunar probe in 2008 and has announced plans to send an orbiter to Mars next year – but it can’t keep the lights on.

In Brazil, meanwhile, forecast GDP growth of 2%, sclerotic state enterprises, mounting inflation, a slumping stock market – the iShares MSCI Brazil ETF (EZW) is down 11.3% so far this year – and an overall business environment ranked in the bottom third of countries by the World Bank have taken some of the bloom off that particular rose.

In any other country annual GDP growth of 7.6% would be cause for jubilation, but in China, which has averaged close to 10% growth for more than three decades, it has caused grave concern, not only in China itself, but also in the rest of the world economy, which has developed an unhealthy dependence on China’s ever-growing demand for raw materials. With China’s imports growing only 1.0% over the past year (down from 11.3% the previous year) and export growth down from 6.3% to 4.7%, the world waits nervously to learn its fate. China’s economic juggernaut similarly depends on robust demand in the U.S. and Europe for its manufactured exports, and although U.S. demand has remained fairly strong, European demand has fallen off a cliff.

The near-term prospects for Russia don’t look good, and the long-term ones are even worse. Oil accounts for two-thirds of Russia’s exports and half of its government revenues, and its breakeven oil price (the price at which the budget is in balance) is $117 a barrel. With the current benchmark Brent crude price at $113 a barrel, Russia has no need to panic in the near term, but given its propensity for deficit spending in good times and bad, and the possibility that fracking technology may partially wean Western European countries off their reliance on Russian natural gas, the longer-term outlook looks pretty grim.

Economic growth in South Africa, which was “admitted” to the BRIC (now BRICS) club, has bumped along at about three percent since 1994. This is significantly better than the 1.2 percent it averaged in the latter years of apartheid, when economic sanctions began to bite, and it would be considered a respectable rate of growth for a mature economy, but for a country with nearly 25 percent unemployment and a third of the population living on less than $2 a day, it is sadly deficient.

I wrote in a previous blog post about the absurdity of the new “CIVETS” group of countries, a construct which some HSBC analysts with fevered imaginations and too much time on their hands floated earlier this year, encompassing Cambodia, Indonesia, Vietnam, Egypt, and South Africa. Not to be outdone, Wesley Fogel and Michael Harris, analysts at Bank of America Merrill Lynch have recently produced a report on a hot new group of frontier economies, which they say offer a “fairly significant and still overwhelmingly under-owned long-term investment opportunity.”

The members of this elite group are Saudi Arabia, Qatar, United Arab Emirates, Kazakhstan, and Nigeria, which don’t exactly lend themselves to a catchy acronym. CANSUQ anyone?

In case the similarities are not readily apparent between Nigeria, an African country with 140 million people; Qatar, a Middle Eastern principality with 1.8 million inhabitants only 12 percent of whom are citizens; and Kazakhstan, a Central Asian country with twice the land area of Alaska and 18 million inhabitants, it comes down to this this: all of them are economies based almost entirely on energy exports. They also share a few other characteristics: thinly traded markets, relatively few listed companies, and a market capitalization heavily weighted towards the banking sector (except for Kazakhstan, whose stock exchange lists only three companies, two of them banks, with the national energy company Kazmunaigaz accounting for 85 percent of total market capitalization).

Give or take a few countries, these lists of hot new emerging markets are nothing new. Goldman Sachs, which invented the term “BRIC,” in 2005 came up with the N-11, a group of eleven emerging and frontier markets whose aggregate size, could rival not only the BRIC countries but also the G7. Their selection of Bangladesh, Egypt, Indonesia, Iran, South Korea, Mexico, Nigeria, Pakistan, the Philippines, Turkey, and Vietnam is nothing if not, in Goldman Sachs’s words, “a very diverse grouping.”

Merrill Lynch in 2008 introduced a Frontier Index of 50 stocks from 17 countries in Europe, the Middle East, Africa, and Asia, with Middle East listings accounting for 50% of the index, followed by 22.6% for Asia, 14.1% for Europe, and 13.3% for Africa.  Stocks listed in the Middle East make up 50 percent of the new index, followed by a 22.6 percent share for Asia, 14.1 percent for Europe and 13.3 percent for Africa.

Also in 2008, MSCI came up with its own Frontier Markets Index, covering 31 countries ranging from Argentina to Zimbabwe and including such hotspots as Bosnia-Herzegovina, Jamaica, and Trinidad & Tobago. It then further refined the selection with the Frontier Emerging Markets Apex Index, intended “to serve as a liquid proxy to the broader MSCI Frontier Emerging Markets Index, and cover[ing] all countries from the MSCI Frontier Markets Index and some countries from the lower size spectrum of the MSCI Emerging Markets Index, all of which tend to be less correlated with developed markets.” Gone from the index were Zimbabwe, Nigeria, Botswana, and Ghana – leaving Kenya and Mauritius as the sole sub-Saharan African countries – as well as Vietnam, Bosnia, Jamaica and several others, replaced by Qatar, Colombia, Egypt, the Philippines, Peru, and Morocco.

There is also the S&P Frontier BMI (Broad Market Index), which tracks 36 frontier markets.  The 565 companies in the index have a total market capitalization of around $300 billion.  S&P also has the Extended Frontier Index, which tracks 150 of the larger companies in 27 countries.

There may be other frontier market indices out there, which I have missed. But even if not, there is likely to be a continual tweaking of these existing indices as certain countries graduate from frontier to emerging status and others newly qualify or fall behind.

There are valid reasons for each of these selections. The problem arises when equity analysts and investors start treating them as a group. South Korea, Mexico, and Turkey are members of the OECD club of high-income and select upper-middle-income countries. All three countries have fairly well developed capital markets, and Korea and Mexico have several world-class companies and international brands, including LG, Samsung (SSNLF), Hyundai (HYMTF), POSCO, and Cemex. Korea’s stock exchange has a $1 trillion market capitalization – a third as much as the Tokyo Stock Exchange, substantially more than the Johannesburg Stock Exchange, and roughly the same as the Australian, German, Swiss, and Bombay bourses. But the main exchanges in Nigeria, Pakistan, Bangladesh, and Vietnam all have a market capitalization of less than $50 billion. Several countries on the list limit the convertibility of their currencies. Vietnam limits foreign ownership of companies to a maximum of 49%.

Some of these markets represent potentially interesting investment opportunities today, while in others it may be years before an investment yields a positive return. In many of these markets the universe of listed companies may be heavily weighted in one or two sectors (most typically banking and other financial services) and therefore may not reflect the true mix of industries in the real economy. So buying an ETF that seeks to replicate a market index may give you less exposure than you would like to the growth sectors of the economy. In that case, you would be better off buying shares in an international company undertaking direct investment in factories, farms, mines, hotels, or casinos. In the case of many frontier market funds, that’s exactly what you are doing when you buy in.

Take for example the Market Vectors Vietnam ETF (VNM). The fund prospectus states: “The Index provides exposure to publicly traded companies that, predominantly, are domiciled and primarily listed in Vietnam and which generate at least 50% of their revenues from Vietnam.” That turns out to be easier said than done. There are so few attractive listed equities, the fund has had to invest in shares of foreign companies that operate in Vietnam. Of the fund’s top 10 holdings, four are international companies listed on the New York, London, Bombay, and Bangkok exchanges. It is certain that none of these four companies generates 50% or more of their revenues from its operations in Vietnam. Of the remaining six, only one – Vingroup, a property developer – is not a bank or insurance company. More than 47% of the fund’s holdings are in financials, and more than 20% in oil and gas. If you think, as I do, that given Vietnam’s young and growing population of nearly 90 million, productive low-cost labor, a rapidly growing economy, and an improving investment environment, energy and banks may not be the main draw for investors.

There is no longer any shortage of frontier market funds to invest in. T. Rowe Price Africa & Middle East (TRAMX), started in September of 2007, may have been the first of these, though it bills itself as an emerging markets rather than a frontier markets fund, and more than 30% of its portfolio is in developed economies. As these funds go, it is fairly diversified by sector, with less than 30% in financials and less than 9% in energy. On the flip side, seven of its ten top holdings are listed on South Africa’s JSE (Johannesburg Stock Exchange), which I would hesitate to call a frontier market, and of its top 25 holdings only two – a Nigerian bank and Nestlé’s Nigerian subsidiary – are from what I would consider a true frontier market.

Templeton launched its Frontier Markets Fund (TFMAX) in October 2008. It does have significant direct exposure to frontier markets, with a portfolio that includes shares in Nigerian banks, Pakistani fertilizer companies, Egyptian pharmaceuticals, and Zimbabwean telecoms; however 40% of the fund is invested in shares of developed market companies that have a significant exposure to frontier economies.

You could question whether the Morgan Stanley Frontier Emerging Markets Fund (FFD), established in August of 2008, is truly a frontier or emerging markets fund, since over 65% of its portfolio is in developed market equities. It is, however, the only fund I have come across which includes a Mongolian company, Mongolian Mining Corporation (MMC), though its shares are listed on the Hong Kong Stock Exchange..

Schroder’s International Selection Fund-Frontier Markets Equity (SISFMEC:LX), an open-ended fund benchmarked against the MSCI Frontier Market Index, has not done terribly well, chalking up a return of -12.1.% since it was launched in December of 2010, though it has substantially outperformed the benchmark, which turned in a -18.0% return over the same period, and it now shows a year-to-date 8.85% gain. Though benchmarked against the MSCI index, it does not seek to replicate it: it is much more heavily weighted than the index in favor of the Middle East, which accounts for 62.5% of its holdings. Like the index, it is heavy on financials, which make up 54% of its portfolio.

Also launched in December of 2010, the Harding Loevner Frontier Emerging Markets mutual fund (HLMOX) has invested in places like Serbia, Kazakhstan, Bangladesh, Ghana, Nigeria, Kenya, and Ukraine. Frontier markets, as opposed to emerging markets – also included in the portfolio – make up around 55% of the fund’s holdings. It is no surprise that financials dominate, with a weighting of more than 40%, but the remainder is fairly diversified, with substantial allocations for energy, industrials, consumer goods, telecoms, health care, and basic materials.

There are plenty of other funds, and new ones launching almost every day, including Guggenheim Frontier Markets ETF (FRN) and iShares MSCI Emerging Markets Index Fund (EEM). Waiting in the wings are the iShares MSCI Frontier 100 Index Fund (FM) and the Global X Next 11 ETF (NXTE), which are expected to close any day.

My pick for the coolest of the lot is Frontier Market Select Fund, especially if you are attracted to frontier markets by their sheer novelty. This fund has invested in Bralirwa, which brews the excellent Primus beer in Rwanda, as well as a soft drink bottler in Iraq and a telephone company in the Palestinian territory, all of them more interesting and potentially more lucrative investments than a Qatari bank or a reinsurance company in Abu Dhabi.

In some of the more esoteric markets you will have to wait until there is a stock exchange, unless you have sufficient means and the opportunity to invest in a private equity fund that focuses on these markets. Leopard Capital, for example, manages the Leopard Cambodia Fund, which has so far invested in 10 Cambodian companies, including a water utility, two electric power companies, a bank, and a brewery. Leopard is also raising a Haiti private equity fund, and has plans to set up private equity funds in Laos, Myanmar, Vietnam, and Bhutan.

It is easy to understand the current enthusiasm for investing in frontier markets. A major cause is the much lower correlation of frontier market index returns with those in developed markets; the MSCI Frontier Markets Index exhibits a 32% correlation with the S&P 500, versus 73% for emerging markets and 96% for other developed markets.

Also, In spite of the strong recent performance of U.S. equity markets – the S & P 500 is up 10% so far this year – there is not much in the rest of the investment landscape in the developed and even the emerging markets to excite interest, especially with Europe sinking back into recession, and, possibly, on the verge of a collapse of the Euro. People who may have 10 or 15 years remaining until they retire and have realized that what they have in their IRAs and 401(k)s is never going to grow enough to support a reasonable retirement lifestyle – and no certainty with respect to Social Security and Medicare – may be tempted to seek higher returns in frontier markets, even if they know nothing about them apart from whatever information they can glean from Morningstar or Yahoo Finance. But the lure of markets with fast-growing populations, rising incomes, and cheap valuations may prove irresistible to many.

The table below, from Ryan Hoover’s Investing in Africa blog shows the average price to earnings ratio of a number of African stock markets. With the exception of South Africa’s JSE, operating in a country with highly developed capital markets, they all have a p/e ratio significantly lower than the S &P 500.

Exchange Price/Earnings Ratio (Average of the 10 Largest Stocks)
Namibian Stock Exchange 8.30
Botswana Stock Exchange 9.95
Nairobi Securities Exchange 10.11
Uganda Securities Exchange 10.49
Ghana Stock Exchange 11.04
BRVM (Côte d’Ivoire Stocks Only) 12.04
Lusaka Stock Exchange 12.37
Stock Exchange of Mauritius 13.23
Nigerian Stock Exchange 13.94
Johannesburg Stock Exchange 15.51
S&P 500 16.09

This phenomenon is not restricted to Africa. Vietnam’s Ho Chi Minh City Stock Exchange has an average p/e of 10.

Based on the supposition that the Namibian and Botswana bourses may have such a low p/e because their economies are not growing as fast as the others, Ryan takes the analysis one step further and shows the ratio of p/e to projected GDP growth, as shown in the table below.



Price/Earnings/Growth Ratio

Ghana Stock Exchange


Lusaka Stock Exchange


BRVM (Côte d’Ivoire Stocks Only)


Nairobi Securities Exchange


Uganda Securities Exchange


Namibian Stock Exchange


Nigerian Stock Exchange


Botswana Stock Exchange


Stock Exchange of Mauritius


Johannesburg Stock Exchange


S&P 500



Using this metric, the Ho Chi Minh City Stock Exchange would have a p/e to growth ratio of 1.41.

Armed with this kind of information, it is possible, but not easy, to produce good returns from frontier markets. But an investment in one or more of the funds profiled above may not be the best way. If you are keen on one or two markets or sectors, it may be hard to find a fund that gives you the exposure you want without exposing you to countries or industries in which you have no interest.

There are some ways to get around this. In Vietnam you could invest in one of three closed-end funds managed by Vina Capital, which are listed on the AIM market on the London Stock Exchange and traded in the OTC market in the U.S. Vina’s Vietnam Opportunity Fund (VCVOF) invests in “private equity, undervalued/distressed assets, privatization of state-owned enterprises, real estate, and private placements into listed and OTC-traded companies,” listed shares and private equity, with at least 70% of its portfolio invested in Vietnam or companies in other countries that have substantial assets, revenues, or income derived from Vietnam. Its portfolio includes food companies, banks, basic industries (including steel, fertilizer, oil refining, and chemicals), industrial parks, agriculture and aquaculture, tourism, property development, building materials.

Vina Capital also manages two other Vietnam-focused funds: the Vina Vietnam Land Fund (VCVNL), which invests in residential, office, retail, hospitality and township projects; and Vietnam Infrastructure Limited (VCVIL), which invests in energy, transport, telecommunications, industrial parks and water/environmental utilities. These funds are not as tiny as some frontier markets funds, many of which have much less than $100 to invest: VCVOF has a net asset value of $760 million, VCVNL $560 million, and VCVIL $290 million.

I am sure that if you dig around you will find similar funds in a number of other frontier markets. Another way to go would be to invest in a company that may not be based in a frontier market country or region, but which operates principally or entirely in such markets. Some energy or mining companies fit the bill. Tullow Oil plc (TLW), a London-based firm listed on the LSE (it is one of the stocks in the FTSE 100 U.K market index) and with cross listings on the Irish and Ghanaian stock exchanges, has exploration and/or production operations in 15 African and three South American countries, and has been the leader in exploration and development of Uganda’s and Ghana’s oil reserves.

There is also Lonrho (LONR), also listed on the LSE, which operates exclusively in Africa, though it is headquartered in London. Lonrho is operator and majority owner of the Luba Freeport in Equatorial Guinea. It also owns a manufacturer and supplier of pre-fabricated building in South Africa; hotels in South Africa, Mozambique, Botswana, Gabon, Democratic Republic of Congo, and Zimbabwe; IT services in Mozambique, South Africa and Zambia; and design, construction, logistics, and support services for remote installations such as mining camps, throughout the continent. Lonrho also owns a majority stake in Fly540, an East African regional airline.

In Cambodia you could look into Nagacorp, a Malaysian-owned, Hong Kong listed company that owns, operates, and manages an integrated hotel casino complex in Phnom Penh.

The usual caveats apply. As they used to say on TV, “Don’t try this at home.” Many of the things that make many frontier markets attractive – such as cheap valuations, high growth, rising consumer purchasing power, low correlation, long-term rises in commodity prices  – can make them equally dangerous. High growth typically goes hand in hand with greater volatility, especially when it occurs in a thinly traded market. Daily trading volume on the Ho Chi Minh City Stock Exchange averages around $35 million, so a couple of large transactions can move the market. Small economies can be much more susceptible to external shocks. During the 2008 worldwide spike in food prices, countries from Bangladesh to Haiti to Senegal experienced food riots and other civil unrest. In frontier markets, the ratio of market capitalization to GDP tends to be very low, so the stock market may not be an accurate representation of the wider economy (this is almost certain to be true in countries where as much as half the population may be engaged in agriculture, and it also applies to the over-weighting of financial services in most frontier stock exchanges). Vietnam’s stock market capitalization is only 23% of GDP. Contrast that with Canada’s Toronto Stock Exchange (TSX), with a market capitalization more than six times GDP.

Just as I have previously counseled in this space with respect to the BRICS and the CIVETS countries, I do the same now with respect to the next 11 or 31 or whichever number of frontier markets tracked by one index or another: don’t confuse a handy construct with a real, observable phenomenon or entity. Even Europe, which has a much greater claim to being a real entity than a collection of countries big and small, rich and poor, scattered about the globe, has yet to work out what exactly it means to be European. Investing in “Europe” is not the same as investing in the United States. The United States is a single economy. Europe, it has been revealed is a long way from being a single economy and it may never get there. Yes, there is an MSCI European Index, and there are funds that track it. But if you look into their portfolios, U.K. and Swiss companies are predominant. European unity is all well and good, but if you want to invest in Sweden you certainly don’t want it to come bundled with Greek and Portuguese shares. Investing in frontier markets is no different.

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