Adrian Ciocoi in London -
Capitulation has probably been the best the word to describe the situation in the investment community at the end of October. Those who didn't throw in the towel, are migrating towards companies of high quality, large market caps, strong balance sheets and high trading/liquidity. So why would anyone consider investing in the frontier markets? The former great hockey player Wayne Gretzky put it best: "Skate to where the puck is going, not to where it is."
The above quote sums up the overall belief stated one way or another by most of the 30-plus participants at the recent "Investing in Frontier Markets" conference held in London on November 6 and 7: frontier markets represent a long-term opportunity and may very well be the next major asset class. Currently, of the total assets under management held by the fund managers invested in emerging markets, approximately just 2% is held in frontier markets; that number is expected to increase.
To boldy go
Most of these "frontiers" are actually developing economies but with undeveloped equity markets. Overall, these countries have a population of approximately a billion, an estimated $2.4 trillion of nominal GDP, and a $1.7 trillion market cap. The table below shows the main frontier markets split by continent.
Below are some of the pros and cons of investing in the frontier markets:
• The availability of information is scarce and most companies don't even have a website. Larry Speidell of Frontier Market Asset Management suggested that, "the opportunity is inversely proportional to the availability of information";
• There is a lack of good equity analysts to research the companies in Nigeria; Dr. Ayo Salami with Duet Victoire Africa Index said an analyst based in Lagos could earn as much as a London-based equity analyst. Independent equity research providers are filling the gap with local presence on the ground;
• There's a lack of quality management teams, complained Laurent Demey, CIO of Propaco; Andre DeSimone with Kestrel Capital East Africa argued the companies in Kenya are extremely well managed. One of the conference participants suggested that the current financial crisis might bring some people back to their native countries;
• Some of the frontiers (like Saudi Arabia) have foreign investment restrictions. Nevertheless, a Deutsche Bank or several Gulf Cooperation Council (GCC)-based brokers could allow access to foreign investors through some structured instruments;
• There are high capital gains taxes, yet in some like Kenya there are no capital gains taxes;
• Corruption is still an issue. Laurent Deney, CEO of Propaco, said in order to get access to information, one needs to know those who are connected in the local community because they do business; and avoid those who do business because they are connected;
• Currently, especially in Africa, trading costs are high and settlement is problematic. There are shallow forex markets in the currencies in which the frontiers are dealing with. To address this, some suggested there are many "frontier-based companies" one could access through ADRs or GDRs (see table below). Also indirect plays could be done by investing outright in the stock of global companies like Heineken, Vodafone, Diagio, Barclays, Lafarge, ie. companies that have a strong representation in some of the frontier markets.
Overall, it was agreed that for the medium term, the frontier markets would continue to be decoupled from emerging or developed markets and this low correlation is an appealing feature of such markets.
At the conference, there were several case studies presented on the stock markets in frontier markets. Dr. Ayo Salami, CIO of the Duet Victoria Africa index Fund, a veteran investor in the Sub-Sahara African (SSA) region, said the change in Africa over the past 10 years has been dramatic. "In the past, there were many companies trading in single P/Es but none above $1m per day. Now the situation reversed, and there are larger companies available to invest in but some P/Es are in double digits." Dr. Salami is an advocate for indexing the stocks currently in the SSA rather then actively manage a portfolio, given there are only approximately 40 companies in the "over $1bn market cap" universe (mostly companies located in Nigeria and Kenya, and predominantly banks), which draw most of the attention anyway. "So why pay a higher fee for an active portfolio manager that has approximately the same options to invest in?"
The following table presents the number of companies with market caps above $1bn that operate in the frontier markets in each of the five continents.
Performance of the frontier markets
In the 12 years from January 1996 to August 2008, the frontier markets outperformed both the emerging and developed countries, and exhibited lower volatility. Dan Broby of Danfonds mentioned that since 1995, there has been at least one African-based equity market among the top-10 best performing markets in the world; in 2007, Zambia returned 127% (in dollar equivalent), Malawi 114%, Cote D'Ivore 105% and Nigeria 90%, and in 2006 Malawi returned 129%.
Adrian Ciocoi is Head of Research "Emerging Europe & Beyond" at Riedel Research Group
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