New frontiers at bargain prices?

The relative lack of inflows has left frontier markets looking cheap. The MSCI Frontier Markets index, for instance, now trades on a consensus PE multiple of 9.2 times 2010 earnings per share and 1.4 times book value - the comparable numbers for the MSCI Emerging Markets index are 11.6 times and 1.8 times with the developed world dominated MSCI World index trading at a ripe 12.8 times earnings and 1.6 times book value.

Mark Mobius, one of the leading fund managers in both the emerging and frontier markets space at Templeton, has suggested in an interview with the website hardassets.com that now is the right time to capitalise on this valuation anomaly: "In these markets, we're able to find cheaper stocks that are significantly better valued than those in normal emerging markets. Of course, the reason why these frontier markets tend to be cheaper is because they have not yet been fully discovered by investors. They tend to be under-researched and not so readily available to normal investors."

Rude financial health

Frontier fans also argue that momentum-driven investors chasing sexier Bric economies are missing out on another key positive for frontier markets: these smaller frontier economies are in rude health, with low debt levels and surging economic growth.

"The quality of household, corporate and sovereign balance sheets in frontier (and emerging) markets is generally excellent (with a handful of exceptions, primarily in Eastern Europe). Public sector debt is typically less than 50 per cent of gross domestic product (GDP) in the vast majority of frontier and emerging markets. It's also true that most government debt is held by local investors and is not dependent on foreign financing. The only countries that appear stretched are Hungary, the Philippines, Ukraine and possibly Vietnam and Argentina. Similarly at the household level there is little evidence of excess – typically because access to credit is a fairly new phenomenon in most frontier markets," says Dr Feriani.

Andrzej Blachut, head of emerging market equities at Swiss & Global Asset Management, is also a big frontier markets bull. "In many countries the loan book to deposits ratio is below 70-80 per cent. This means banks are able to provide loans to economies without external financing, which is very expensive today."

That strong financial position is also likely to result in above-average growth prospects for frontier economies in the next few years. "In terms of economic growth frontier markets have excellent prospects," says Dr Feriani. The IMF's GDP projections () suggest that the emerging and frontier regions have grown faster than the G7 nations and are predicted to continue doing so.

Investment bank Goldman Sachs thinks real annual GDP growth in the 'Next 11' countries (which include Bangladesh, Egypt, Indonesia, Iran, Nigeria, Pakistan, the Philippines and Vietnam) could exceed 5 per cent in the decade between 2010 and 2020.

Not just commodities

Those statistics on top-line economic growth also hide a key differentiator in frontier markets. Although some countries in Africa and the Middle East are still heavily reliant on their commodity exports, local stock markets tend to be much more diversified. Those that do have substantial natural resources generally keep them in state hands. Local stock markets are much more exposed to the domestic growth story focusing on banks and other financials, telecoms, construction and consumer-related stocks.

Another interesting feature of frontier markets is their lack of correlation, not just to western markets, but to each other. Dr Feriani points to two concrete examples of frontier markets that have moved in markedly different directions since the global financial crisis: Tunisia and Morocco. "These are prime examples of markets that have shown clear signs of lack of correlation to the rest of the world over the past few years and continue to do so. Indeed, MSCI Tunisia and MSCI Morocco are up 3.6 per cent and 9.7 per cent in US dollar terms in the year to date. This compares with an increase of 2 per cent for MSCI Frontier Markets and a decline of 3 per cent and 5 per cent in MSCI Emerging Markets and MSCI World, respectively."

Playing the story

For Mr Blachut, the key to frontier investing is to find the right niche that can be exploited through the local stock market, for example Nigeria's growing consumer sector or infrastructure-related sectors such as cement producers. "In central Europe," he says, "exporters of products such as furniture and machinery are being supported because their currencies have been hit harder than the euro, enabling them to maintain sales levels, but with higher margins."

Mr Mobius adds that much of this interest in the fast-growing local consumer economies will focus on corporate takeovers. "When you look at disposable consumer goods, the large multinationals are usually the first in. They buy up the large companies that are established brands, and very often these companies don't find their way into the equity markets. In the frontier area, there are more of these available."

He adds that the stock-specific risks are not as great as we may imagine. "Our studies show that the frontier markets do not necessarily have greater risk. That's because in many of these markets, the volatility is not as great as in other markets, including developed markets, since the markets are not so liquid. Thus there tends to be less volatility, and therefore less risk in that sense."

Mr Mobius also says his firm's research shows that a diversified frontier markets portfolio offers much lower risk in a portfolio than one jam-packed full of US or Canadian stocks. For him, as for Dr Feriani at Advance, the key is diversification.