Frontier Markets

“Frontier Markets” is an economic term coined by IFC’s Farida Khambata in 1992.  It is used to describe a subset of very small emerging markets.  They have lower market capitalization and less liquidity than more developed emerging markets. The IFC’s definition of frontier markets is wider than that of the index providers.  IFC’s strategic priorities include a focus on frontier markets: low income countries rated high-risk by investors, where there are very limited private capital flows. The IFC provides financing to sustainable private sector enterprises, sometimes in partnership with institutional investors like Cordiant, and then further supports these enterprises through its Technical Assistance and Advisory Services.  Frontier market index providers, on the other hand, restrict their index components to countries with functional stock exchanges that are open to foreign investors, but do not meet the volume and liquidity requirements for being included in the emerging markets composite.

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

However, these and other Frontier Market Indices, like MSCI Barra, are not homogeneous since they include countries as diverse as Bangladesh and the United Arab Emirates or Vietnam and Estonia.  They include stock markets as small as Uzbekistan’s, with a $700 million capitalization, and Nigeria’s with more than $25 billion.

From 2000 through 2009, Frontier Markets represented 17 of the 20 fastest growing economies in terms of average annual GDP growth.  For several frontier countries, the GDP growth in 2011 is forecasted to be greater than China’s and India’s, like Qatar 16%, Ghana 13%, Mongolia 12%, Eritrea 10% and Ethiopia 9%. As documented by this year’s UN publication ‘World Economic Prospects 2011’, developed economies declined in 2009 by 3.5%, while developing countries reduced their GDP growth rate to 2.4% and, interestingly, the ‘least developed countries’ reduced their superior growth rates to only 4.0% in 2009. Looking ahead, the same UN publication estimates this and next year’s growth rates, for all countries and regions, to be lower than in 2010 with ‘least developed countries’ being the sole exception, showing accelerating growth rates through 2012.

Do these, admittedly insufficient, statistics suggest that young small economies tend to grow faster than large ones, like small cap stocks grow faster than large caps? Young organisms grow faster in percentage terms than old ones. This applies to plants, animals, humans and social organisms. As a child completes his fifth year, he grows at a rate of 20%, while a person celebrating his/her 50th birthday only grew by 2%. One should remember, though, that the mortality rate of young organisms is higher than that of mature ones. So much for the ‘small-size premium’.

Frontier markets have adequate liquidity in bull markets, but liquidity is sharply reduced or disappears in bear markets.  The 2010 Ibbotson Yearbook contained, for the first time, a well researched chapter by Roger Ibbotson on liquidity. It clearly demonstrates that ‘less liquid securities have higher expected returns’. From 1972 to 2009, of all stocks traded on the NYSE, AMEX and NASDAQ, the least liquid quartile returned 16% p.a. with a standard deviation of 20, while the most liquid quartile returned 8% with a SD of 29. Perhaps this proven ‘illiquidity premium’ also applies to stock exchanges, particularly in frontier markets.

If your Frontier Market Public Equities Fund only holds sound and conservatively levered companies with a proven dividend growth history and good growth prospects, you don’t have to be concerned with liquidity, if you follow disciplined rebalancing guidelines. Assuming, for example, a frontier market policy allocation of 5% and a rebalancing band of 3.5% to 6.5%, you will find – after a 30 percent market appreciation – all the liquidity needed to scale your holding back down to 5%. On the other hand, if your frontier portfolio has dropped by 30 percent to 3.5% of your total portfolio, you will easily be able to bring it back up to 5% because there will be many panic sellers and no bidders.

Frontier markets account for 22% of the world’s population and 7% of the world’s GDP, but only 3% of the world’s market capitalization, compared to emerging markets with 63% of the world’s population, 42% of world GDP and 42% of market capitalization.

The following chart shows the 15-year annual returns of US, EAFE, Emerging and Frontier markets:


The frontier market index outperformed the EM index in six of nine years of up-markets and in five of six years of down-markets. For the 10-year return to December 2010, the SDs and correlations with the S&P 500 were as follows:

The population demographics in frontier markets are even more favourable than those in emerging markets.  The valuations of these markets are lower than most developed and emerging markets, like Bulgaria with a PE of 6x, Serbia 7x and Kazakhstan 8x.

What follows are two examples of sound companies, which I have taken from Larry Speidell’s Frontier Market Select Fund portfolio:

Swissport, Tanzania, handling the airport’s cargo, with a PE of 5, a ROE of 53%, a Yield of 15% and Earnings Growth of 15%. Auditor: PWC.

Searle, Pakistan, manufacturer and marketer of pharma products and baby food, with marketing agreements with Pfizer, Forest Labs, 3M England and others. EPS have grown from $2.92 in ’06 to $11.96 in ’10, ROE 27%, PE 4x, PB 1x, Yield 7.3%.

The total portfolio of the Frontier Market Select Fund, for instance, has an average market capitalization of $628 million, a PE of 8x and an ROE of 22%.

While I am generally a strong advocate of passive investing in developed markets, through fundamental index funds, value-oriented active investing in frontier markets has proven to produce substantially better results than the respective indices.  Over the three years to December 2010, the Frontier Market Select Fund had a return of 17.3% with a Standard Deviation of 14%, compared to S&P Frontier BMI ex-GCC of -54.8% with a Standard Deviation of 25%.  Other fund managers have had similar experiences.  The Templeton Frontier Markets Fund has returned 65.4% since launched, compared to the index of -13.6%.  Over the same time period, the Morning Star Sector Average produced 64.6%, which confirms that value-oriented active investing pays off handsomely in frontier markets.

The number of frontier market managers is still small and includes Frontier Markets Fund Managers, a Mauritius-incorporated company jointly owned by Standard Bank and FMO, the Dutch Development Bank and Emerging Market Partners of Washington, DC;  Schroders Frontier Markets Equity Fund was launched earlier this year; Swiss and Global Asset Management, a subsidiary of Julius Bear of Switzerland; and the above mentioned Frontier Market Asset Management of La Jolla, CA.

When selecting a frontier market equity fund, make sure that its manager is a skilful bottom-up fundamental analyst and not a top-down arbitrageur between country markets.  His/her portfolio should consist of sound companies with a history of, and prospects for, growing dividends.  The portfolio should consist of consumer staples, food, drink, pharma, manufacturing, telecom and financials, but should have little or no exposure to natural resources and other cyclical sectors.  Your chosen portfolio manager should follow a ‘buy-and-hold’ strategy with a portfolio turnover of not more than 25 percent.

There are also a number of ETFs available, like Claymore/BNY Mellon Frontier Markets and PowerShares MENA Frontier Countries.  Barclays Global Investors will soon launch a BGI Frontier Market Fund for institutional investors that will invest in 15 Frontier Markets and will be benchmarked to the MSCI Frontier Market Index.

Let me remind you that Frontier Markets remain overlooked and misunderstood by most investors.  As some Emerging Markets will be moving into the Developed Market category, so will some Frontier Markets move into the Emerging Markets category.  In planning your long term asset allocation, let us not forget that, by 2030, the developing world’s middle class will equal today’s combined population of Europe, Japan and North America.

When planning your asset allocation policy, do not restrict your emerging and frontier market exposure to public and private equity funds.  Include floating rate debt funds with emphasis on infrastructure debt.  That is an area Cordiant, in partnership with multi-lateral International Financial Institutions, has been active in for 10 years.  During that period, we have made nearly 200 floating rate loans to 30 private sector industries in more than 50 developing countries and have not experienced one single write-off.

One of Cordiant’s particular areas of expertise is infrastructure projects in developing countries.  These projects offer a better risk profile than the ones in developed countries because the former are supported by favourable demographics and rapidly growing tax bases.  Furthermore, they are not encumbered by the need to tear down existing infrastructure in order to replace it.  Infrastructure debt, when done in partnership with multi-lateral IFIs, has superior risk return characteristics compared to infrastructure equity financing.


April 2011