Frontier markets offer high growth and low valuations

Frontier markets include countries such as Kenya, Nigeria and Vietnam, and are described by some investors as “emerging emerging markets”. They offer exposure to a number of countries that are experiencing higher economic growth than emerging markets and their developed counterparts. And as frontier markets are smaller and less efficient, companies based there can be under-researched and as a result mispriced. This creates investment opportunities for savvy investors who are willing to do their research, and have a strong grasp of the dynamics affecting these markets and their underlying economies.

Although developed markets shrugged off negative investor sentiment in the first quarter of 2018, and performed well in the second and third quarters, emerging markets came under pressure in 2018 as a result of dollar strength, concerns about higher interest rates in the US, and trade tensions between the US and China. Emerging and frontier markets trended downwards between June and October, and sold off sharply in line with developed markets in October. They then staged a recovery between November and mid-December, only to get hit once again by the sell-off in developed markets.

But since the start of 2019 things have improved. MSCI Emerging Markets index is up 3.4 per cent, MSCI Frontier Markets index is up 1 per cent and FTSE All World is up 2.8 per cent. And after a difficult year in 2018, emerging and frontier markets appear to be on attractive valuations.

“Emerging and frontier markets have had a torrid time recently, but now look quite interesting from a valuation perspective,” says Peter Lowman, chief investment officer at wealth manager Investment Quorum.

Ross Teverson, manager of Jupiter Emerging & Frontier Income Trust (JEFI) believes investors are currently overlooking opportunities in frontier markets. “Emerging market valuations look attractive both relative to developed markets and their own history," he adds. "However, the companies we hold in frontier markets are trading on even more compelling valuations."

He cites KCB Group (KCBK:NAI) as a prime example. This bank trades on a single-digit price/earnings ratio – a measure of share price relative to per-share earnings – even though it generates a 20 per cent-plus return on equity. Mr Teverson believes the bank’s growth will be supported by technological development and growing demand for basic financial products and services in sub-Saharan Africa.

“Current valuations are unwarranted, so if the market can take a longer-term perspective we believe there is a bright outlook for companies that are currently being overlooked by the market,” he adds.

Mr Teverson is particularly positive on Kenya and Nigeria as he believes they are supported by strong demographics, and rapid technological and financial innovation.

Sam Vecht, manager of BlackRock Frontiers Investment Trust (BRFI), says that in aggregate the wide subset of frontier markets available to invest in continues to exhibit strong gross domestic product (GDP) growth and benefits from low government debt levels. And a number of companies listed on these markets are supported by strong cash flows and high dividend yields, and trade on what he describes as “some of the lowest valuations in the world”.

Mr Vecht and the trust's co-manager, Emily Fletcher, invest in companies where they believe the risk-reward is skewed in their favour. They added to Indonesia, their biggest country exposure, following the sell-off last year. Argentina is another favoured market as Mr Vecht believes the country has finally turned a corner. 

“By remaining exposed to this country the risk-reward tilts in our favour," he explains. "This is because of current yields, the extent of the currency devaluation and the International Monetary Fund (IMF) backstop.”

Chinese slowdown

Emerging markets have got off to a positive start in 2019 largely due to improved trade discussions between China and the US, and the positive sentiment this has generated has filtered through to frontier markets. This is no surprise because China has developed strong ties with numerous emerging and frontier markets, for example, it is a big importer of commodities from Africa and Latin America. However, investors remain concerned that China’s economy, the second largest in the world, is slowing and could pose a threat to frontier markets.

“If China slows, are frontier markets strong enough to withstand that slowdown?" asks Nathan Sweeney, senior investment manager at asset manager Architas. "Are they in a position to grow without China?”

The data coming out of China has so far been less than positive. GDP figures for 2018 totalled 6.6 per cent, the slowest pace of growth recorded since 1990, so if frontier markets are on your radar it is important to consider this potential correlation.

The performance of frontier markets also has a loose correlation with the US interest rate cycle, but there appears to be better news on this front. Last year, frontier markets came under pressure because of dollar strength, particularly those with dollar-denominated debts. However, comments made by Federal Reserve chairman Jerome Powell in late November have been interpreted by investors as a loose promise that interest rates will be kept on hold for the time being.

“If there is no interest rate rise in the near term, it provides a bit of respite for emerging and frontier markets,” adds Mr Sweeney.

Appetite for risk

Although frontier markets offer some good opportunities these come with considerable risks. These markets are less liquid, typically have lower standards of corporate governance and can experience periods of political instability. If you are considering allocating money to frontier markets you need to work out whether you are likely to receive enough in the way of returns to compensate for the extra risk, advises Andrew Wilson, chief investment officer at wealth manager Lockhart Capital Management.

“Each individual investor has to include a notional risk premium or margin of safety when investing in this asset class and comparing it to others," he says. "This is because there is enhanced political, regulatory and liquidity risk involved, and this needs to be accounted for.

While 2018 was a challenging year for most asset classes, not least frontier markets, some commentators argue that fewer inflows and outflows into frontier economies makes them less susceptible to the big risk-on and risk-off flows that happen in other markets. Despite this, any investor considering investing in frontier markets should still have an appetite for risk and a long-term investment horizon. The developments taking place in these economies are likely to take years, so patience is key.

Mr Sweeney says a time horizon of five years-plus is needed, so frontier markets could be a consideration for someone in their 20s or 30s who is investing their pension.

Mr Lowman says someone with a higher risk appetite could have a small allocation to frontier markets within a broader portfolio. “As emerging markets continue to evolve and mature, frontier markets provide a new compelling investment story and offer higher levels of economic growth, an ever-rising consumer base and a lower correlation to other asset classes,” he explains.

But Mr Wilson says: “I suspect that most investors don’t need the hassle of frontier markets, as there is not that much that is unique that it's worth the risk.” 

Generalist versus specialist funds

You can get exposure to frontier markets via a number of broad emerging market funds or investment trusts. The reasons for doing it this way includes that the fund you hold doesn't expose 100 per cent of its assets to frontier markets risk. 

Mr Sweeney holds RWC Global Emerging Markets (LU1336213936), managed by John Malloy. It invests across emerging and frontier markets. Although the fund had a tough 2018, performance has picked up this year.

“There are 59 stocks in [this fund] and 35 per cent [of its assets are] invested in frontier markets such as Zambia," says Mr Sweeney. "These are not [the typical] areas that an emerging market fund looks to get exposure to."

There are also dedicated frontier market funds, which are Mr Lowman's preferred way to get exposure. He highlights the advantages of backing a specialist and experienced investment team, which understands the complexities of each market.

Options include Templeton Frontier Markets Fund (LU0768359852) run by Franklin Templeton, which is known for its expertise in emerging markets. Like many frontier market funds, it had a tough 2018. It has about 44 per cent of its assets in financials, in line with other frontier markets funds, providing access to the financial inclusion investment theme. The Philippines are the fund's largest country exposure at about 13 per cent of assets, followed by Kuwait at 11.5 per cent.

If you are concerned about levels of liquidity in frontier markets you may feel more comfortable getting exposure to them via an investment trust. These types of funds are listed on the stock exchange, so investors can buy and sell their shares in them to other investors through good and bad times. However, during the latter you are likely to have to sell at a depressed share price – maybe less than you paid for the trust – and a discount to net asset value (NAV).

You can redeem your units in open-ended funds on a daily basis. But as it is the fund that buys them back off you rather than other investors, the fund may have to sell its assets to meet the redemptions, meaning its managers may have to sell holdings when they do not wish to at unfavourable prices. 

Investment trust options include BlackRock Frontiers Investment Trust. Its managers, Mr Vecht and Ms Fletcher, run a diversified portfolio that offers exposure to over 20 frontier and emerging markets countries. The trust is trading at a premium to NAV of about 4.6 per cent, which compares to an average discount of 8.2 per cent for the Association of Investment Companies (AIC) Global Emerging Markets sector.

Fund performance