Not long ago, emerging markets such as China, India, Russia, and Brazil were considered uncharted territory for most investors. Today, it isn’t unusual to find stocks and bonds from those countries nestled comfortably in investor portfolios.
Tim Drinkall , who manages the Morgan Stanley Frontier Emerging Markets Portfolio, says a similar scenario is starting to unfold among frontier markets such as Nigeria, Pakistan, and Sri Lanka. “Broadly speaking, frontier markets are where mainstream emerging markets were 20 years ago,” he observes.
“They represent an opportunity to get into an asset class that’s being born and created.” On a personal level, Drinkall enjoys the challenge of watching economies evolve and “seeing countries as they’re trying to figure out what they want to be when they grow up.”
Drinkall’s own experience as a frontier market investor reflects the progress that many of those countries have made over the last few years. “When I met with foreign management six years ago they didn’t have any kind of presentation prepared. Some of them thought I was trying to sell them something. Now, they know I’m looking for information as an investor and they come prepared.” Today, the companies in the portfolio have sophisticated, transparent, and well-monitored financial reporting systems.
Still, underdeveloped economies and nascent securities markets make these still exotic investment destinations a work in progress. Political roadblocks often thwart economic reforms that could ratchet growth into higher gear. Conflict continues to erupt with disturbing frequency in areas of the Middle East and North Africa. Securities in these 30 or so countries are often thinly traded, making them more difficult to buy and sell than those of more developed nations.
Like their more mainstream emerging market counterparts, frontier markets have also been subject to boom and bust cycles. In 2007, many of the stocks were selling at over 30 times earnings. But they plummeted in 2008 and 2009, and their recovery took longer to accelerate than mainstream emerging market stocks.
Nonetheless, investors seem to be testing the waters in increasing numbers. Mutual fund giants such as Franklin Templeton, HSBC, and T. Rowe Price all have their own actively managed frontier markets funds, while ETF sponsors such as iShares and Guggenheim are covering the indexing front.
Many investors have been drawn by the strong performance of frontier market stocks relative to their more established emerging market counterparts over the past couple of years. Year-to-date through July, Morgan Stanley Frontier Emerging Markets Class H shares were up 21.2%, compared to a 6.2% loss for the average diversified emerging markets fund in Morningstar’s database. For the year, the fund was up 37.2%, compared to a 5.3% gain for emerging markets funds.
Longer-term investors have different formulas for frontier market allocations, says Drinkall. “Frontier is nearly 3% of the broader MSCI Emerging and Frontier Markets index, so a neutral allocation to frontier would be about 3%. But I’ve seen institutional investors with 10% to 15% of their emerging markets allocations dedicated to frontier markets. And some private clients have as much as a 50/50 emerging to frontier split.”
Making A Case
While disappointing economic growth in China and other emerging markets may be one reason for investors to migrate into less familiar territory, Drinkall cites other inducements.
Adding or increasing frontier markets equities to long-term, strategic allocations, he suggests, may help reduce portfolio volatility. Benchmark volatility for frontier markets is currently only half that of emerging. Also, most frontier markets do not permit short selling, considered by many to be a major contributor to market volatility.
Frontier markets also have low correlations to other markets. Over the last five years frontier markets have had only a 0.77 correlation to developed markets, versus an emerging market to developed market correlation of 0.92. These markets also have a low correlation to each other, providing additional diversification within the asset class.
Despite the recent upsurge Drinkall believes the frontier stocks are still reasonably valued, and even with the jump over the last two years many frontier market indexes are still 50% below their peak levels of early 2008. While many of them are trading at price-earnings ratios that are roughly even with mainstream emerging market stocks, he believes prospects for earnings growth are better among frontier market companies. Dividend yields are around 4%, a percentage point higher than yields for mainstream emerging market indexes.
Hot Spots For Growth
Drinkall believes that active management in this space is crucial. “No two frontier markets are alike,” he says. “To succeed, an investor must understand the local nuances within each market, and the unique interplay of national and global forces in each country.”
To find securities, he first looks at a country’s GDP growth, inflation rate, monetary policies, central bank policy, and other macroeconomic clues. He examines the political environment to determine whether or not those in power are committed to achieving reform and sustaining economic growth.
“The data indicates that once a President or Prime Minister is in power for more than seven years reform start to die down, and most reforms happen during the first term,” he says. “About half of frontier market countries have leaders who have been in power less than three years, and many of them are pushing through meaningful reforms.”
At times, the potential for reform can make a country a more desirable place for business than it might seem to be on the surface. An example of this is Pakistan, whose economic data points place it among the less desirable frontier markets. But according to Drinkall, its Prime Minister has a reform-minded agenda that promises to lift the economy.
Liquidity is another issue. If a country’s stock market has less than $2 million a day in trading volume, the fund skirts that market entirely.
While the fund has some traits in common with the benchmark, the MSCI Frontier Markets Index, there are lots of notable differences. Both have a hefty weighting in the financial sector. Large state-owned companies, including banks, are often the first to list on newer equity markets, and Drinkall sees the banks as a way to tap into growing consumer markets.
While investors often assume frontier market funds are heavily invested in energy companies because of their strong presence in the Middle East, both the benchmark and the fund tread lightly in that sector. Frontier countries in Europe and other regions are actually resource poor, and many of the largest oil producers in the Middle East aren’t even publicly traded.
But Drinkall eschews the index when he feels it’s warranted. Most notably, as of June 30 it had less than 3% of assets in companies based in Kuwait, compared to 24% for the index. Drinkall says the companies based there don’t have the kind of growth potential he is looking for.
As of June 30, the fund had 12% of assets in Saudi Arabia, a country that has no presence in the benchmark index. Drinkall believes it is one of the few countries in the region with strong growth prospects, and its market has better liquidity than some mainstream emerging markets. The country’s 89-year-old King Abdullah, he says, is committed to implementing reforms in health care, education, and programs dedicated to increasing the number of its citizens in the workforce. With more Saudis working, Drinkall sees growing consumption and increased borrowing by consumers. Fund holding Al Rajhi Bank provides an entry point to this trend.
Drinkall sees mixed signals from Nigeria, which, as of June 30, represented the fund’s largest country weighting at 18% of assets. On the one hand, political roadblocks are thwarting efforts to maximize the region’s oil reserves. But the country’s population of over 160 million individuals represents a growing consumer base, GDP growth is a healthy 6%, there are no major debt issues, and more infrastructure projects spearheaded by local companies are getting underway. Companies such as fund holding Dangote Cement stand to benefit from much-needed expansion of electric power facilities and transportation.
During the second quarter of this year the fund initiated small positions in two countries where it had not held positions for several years, Pakistan and Vietnam. In Pakistan, a new government and a possible new International Monetary Fund program could benefit the local market. Holdings there include Oil and Gas Development Company, an oil and gas exploration firm, and cement producer Lucky Cement.
Vietnam’s leading dairy company, Vinamilk, is growing earnings thanks to government policies encouraging milk consumption. The company has virtually no debt and substantial free cash flow.
Sri Lanka’s John Keells Holdings, which owns and operates hotels and port facilities as well as a supermarket chain, is in the forefront of a movement to beef up the country’s nascent tourist industry. “Sri Lanka has enormous natural beauty,” says Drinkall. “Every time I go there the capital city looks better and better.”