From the February 2011 issue of Investment Advisor • Subscribe!

Advisors Without Borders: A Guide to Frontier Markets

A rush to invest in emerging market countries has veteran investors and fund managers all over the map in their quest for global client returns. What they found will surprise you

Few may know or even care to know that the West African nation of Nigeria has one of the lowest consumption rates of sugar worldwide, and that the government requires all sugar to be fortified with vitamin A. But this is the kind of trivia that a frontier markets investor like Daniel Broby, CIO of London-based asset management firm SilkInvest, is interested in. It is the sort of detail he considers key intelligence for anyone who wants to invest successfully in frontier markets and the reason why SilkInvest—which runs three frontier market equity funds and a frontier market fixed income fund—is invested in Nigerian sugar company Dangote Sugar.

Dangote not only has an 80% market share in Nigeria and the capacity to further increase penetration both within the country and in neighboring West African nations, but is also, Broby says, the only company in Nigeria to have the capability to fortify sugar with the vitamin A component mandated by The Nigerian Agency for Drug Administration and Control.

“If you factor the de facto monopoly that Dangote has and put it in the context of a country that’s growing, and if you extrapolate that potential to the earnings level—well, the potential is enormous,” Broby says.

The Dangote Sugar story is also exemplary of the kind of potential that frontier markets—a group of outlying countries that may still be off the radar screen for even veteran emerging markets investors—offer, Broby says. In today’s increasingly flat world, finding yield is extremely difficult, and even though nations like Brazil, India and China—countries that 20 years ago were frontier markets themselves—will have sufficient traction left in them for some time to come, those investors who are looking for the next great opportunity should be focusing now on the peripheral emerging market countries that are in the early stages of the industrialization process. They need to be looking to the far corners of the world; to countries like Mongolia, Kazakhstan, Cambodia, Bangladesh, Nigeria, Ghana, Georgia and Estonia—nations that in many cases, would not even be thought of as tourist destinations by the majority, let alone investment targets.

But international investment gurus like Mark Mobius, executive chairman of Templeton Asset Management, believe that these markets are the only places to be for investors with long-term investment horizons.

“In the future, we expect these markets—at least some of them, to become quite important and to eventually become full-fledged emerging markets,” Mobius says.

For Mobius and many others, one word sums up the frontier market story: Commodities. Because they are rich in all manner of natural resources and are leading producers of, among others, oil, gas, minerals and precious metals, many frontier market countries are well positioned to benefit from the strong demand for these resources from high-growth countries like China and India, Mobius says. Demand for these resources boosts economic growth in frontier markets, he says, which then enables their governments to increase spending in infrastructure, thereby creating interesting investment opportunities in the construction, transportation, banking, finance and telecommunications industries.

“The economic drivers across frontier markets are diverse and [they] ensure a diversified portfolio,” Mobius says.

But while commodities may well be the engine of growth for frontier markets, Mobius is equally interested in the growth of consumer demand in these countries. As a result of economic growth, middle class expansion and the deceleration of population growth has triggered a rise in per capita income in many countries, he says, and has resulted in an increased demand for consumer products and a positive earnings outlook for consumer-related industries such as the food and beverage industry.

As frontier markets continue to industrialize, as their economies continue to grow and their middle classes benefit from more and more disposable income, the demand for goods and services will also increase. This dynamic is one that most frontier market investors are looking to make the most of.

“In the world today, there really aren’t a great many countries left to industrialize, so in a sense, investing in frontier markets is the last big asset management call in emerging markets,” Broby says. “We view investing in them as a once-in-a-lifetime opportunity.”

But while there is no denying the importance of commodities and the impact of consumer demand upon growth and expansion, Paul Herber, manager of Seattle-based Forward Management’s Forward Frontier MarketStrat Fund, believes they are only a part of the frontier markets story (in fact, the correlation of commodities to frontier markets is only 0.5, which is actually the same for both the S&P 500 and the emerging market indices, he says).

For Herber, the greatest frontier markets story is how far removed these countries are from the rest of the world, and how what goes on in other equity markets really has no material impact upon them. Investors—himself included, he says—were surprised at how little volatility frontier market nations went through last year and what positive growth many of them experienced.

“While there may be volatility going on inside an individual frontier market, what is going on in Bulgaria has nothing to do with what is going on in Vietnam, which again has nothing to do with what is going on in Nigeria,” he says. “By the same token, what goes on in the U.S. affects Brazil and China, since these equity markets are all correlated, but what goes on in the rest of the world means nothing to places like Bangladesh and Nigeria. For any investor who wants diversification, then, the non-correlated nature of frontier markets makes it the ideal asset class.”

Then again, benefiting from that diversification play doesn’t come without its share of risk. Many frontier markets are small and their stocks are highly illiquid, Mobius says. They are also difficult to get into and navigate, and on a macro level, their political frameworks are fragile and can easily disintegrate. Many of these countries often lack established legal, political, business and social frameworks to support securities markets, and information flow can be quite poor.

Yet frontier markets are also countries where a single event—either political or macroeconomic—can oftentimes turn things around in an unprecedented manner, Herber says, and set a nation going in a completely new direction.

He cites the example of Bangladesh, a country with one of the lowest GDP per capita incomes in the world and one that some years ago, suffered a coup that resulted in a military dictatorship. Last year, the country held democratic elections, and since then, Heber says, it has been on an extremely positive course. In fact, the Bangladeshi stock market was up 45% in 2010.

Herber also gives the example of the Caribbean island nation of Trinidad and Tobago, which a few years ago successfully attracted a whopping $5 billion in foreign direct investment to build a massive liquid natural gas plant. Today, that plant has become one of the most important contributors to GDP growth in the country.

“If a country can get investors to commit that amount of money, it is set for growth,” Herber says.

For sure, continued investment into frontier markets, coupled with increased spending by local populations will help foster their growth. Investments by agencies such as the World Bank’s International Finance Corporation (IFC) and the Overseas Private Investment Corporation (OPIC), which mobilizes and facilitates American private capital and skills in developing countries transitioning from nonmarket to market economies, can help bring about the necessary social, economic and capital markets structures needed to strengthen these countries further.

Broby, Herber and Mobius are all seasoned international investors and each one accesses frontier markets in different ways, but regardless their approach, the one thing they have in common is their conviction of the great potential these markets present.

Mark Mobius, Executive Chairman, Templeton Asset Management
It wouldn’t be stretching the truth to say that Mark Mobius, executive chairman of Templeton Asset Management, is the pioneer emerging markets investor. For the past 30 years, Mobius and emerging markets have been almost synonymous, and investors everywhere have looked to Mobius to point them toward the best opportunities in the emerging markets world.

Today, Mobius believes those opportunities exist in the outlying emerging markets, and the Templeton Frontier Markets Fund that he manages seeks long-term capital appreciation by investing at least 80% of its assets in the securities of companies located in these markets. The fund follows the universal Templeton strategy of searching globally for stocks that are selling at prices Mobius and his team believe are low relative to their value, and that are selected only after a rigorous, bottom-up and fundamental research process.

Above all, the fund has a long-term investment horizon, and its holdings are selected based on a company’s potential for earnings and growth over a five-year period. “As long-term investors, we practice patience, believing it’s better to adhere to a sound investment strategy than jump in and out of the market,” Mobius says. “We believe this disciplined strategy is what drives the potential for long-term results and reduced volatility for our shareholders.”

Currently, the $800 million Templeton Frontier Markets Fund—which was launched in October 2008—has the greatest amount invested in African and Middle Eastern companies that are located in countries like Nigeria, South Africa, Kenya, Saudi Arabia, Syria and the United Arab Emirates. Based on the idea of the “Two Cs—commodities and the consumer,” Mobius invests in companies that are strong producers of oil, iron ore, aluminum, copper, nickel and platinum, and he also scouts out the best opportunities in growing industries like retail, automobiles, finance, banking and telecommunications (the fund’s largest single holding is South African mobile telecom company, MTN Group).

Mobius has a penchant for Africa, not just because it has vast and plentiful resources that are aggressively pursued by countries like India and China, but also because the continent’s agricultural potential and the abundance of water that it has may well determine the rise and fall of nations in the future.

He is particularly keen on Nigeria, a country with a population of between 140 million and 160 million people that’s rich in oil and gas reserves and has lots of fertile land, a good climate and plenty of raw materials. Nigeria has already benefited and will continue to benefit from high commodity prices, and its economy is slated to grow by 6% in 2011.

Kenya, Botswana, Ghana, Morocco and Tunisia are also markets that interest Mobius, and he’s keen on Kazakhstan, Cambodia and Vietnam.

“In Vietnam, we are seeing much opportunity, particularly in the private equity market,” Mobius says. “The private sector continues to grow and has become more important to the development of the economy, and with a population of about 85 million, more than half of who are under the age of 35, it can be considered to be one of the most attractive frontier markets because of its very rapid economic growth.”

Because Franklin Templeton has been investing in emerging markets for so long, it has a proven ability to navigate relatively new and sometimes volatile markets. Mobius himself is always on the road and he makes sure to get down on the ground in every country he goes to, so that he can get to know companies and their management (recently, he was down a mine shaft in Kazakhstan). He visits shopping centers and market places, and chats with locals to get a sense of a country’s true culture and essence. This is key to successful international investing, he says.

Templeton has over 40 investment professionals working in 17 different locations across the globe. “Frontier market investing often requires additional time and due diligence to assess the quality of management teams, including more frequent on-site visits to evaluate the business effectively,” Mobius says. “Our local analysts are able to address such issues because they not only understand the local languages and culture, but they get to know the companies and the market environment by meeting with company management teams, understanding the impact of local regulations and talking with local customers and competitors.”

Paul Herber, Portfolio Manager, Forward Management
The main goal of Forward Management’s Forward Frontier MarketStrat Fund is to provide investors with the purest and broadest frontier markets exposure at the lowest possible cost.

The fund has a 95% overlap with Morgan Stanley’s benchmark MSCI Frontier Markets Index, which actually outpaced the firm’s benchmark MSCI Emerging Markets Index by nine percentage points in 2010, the widest gap since the second quarter of 2005.

Wherever possible, Herber says, he buys ADRs and GDRs. Companies in countries like Lebanon and Kazakhstan have ADRs listed in London, he says, and Argentina—which was dropped from the emerging market index and put into the frontier market index when the government imposed capital controls on the currency—has ADRs listed in the United States. In fact, Argentina and Pakistan (which also dropped out of the emerging markets index and into the frontier markets index), were the two best performers in 2010, Herber says, so the index really benefited.

In managing the $150 million Forward Frontier MarketStrat Fund, Herber’s greatest concerns are the costs and risks associated with investing in frontier markets, so minimizing them is top on his list. In addition to purchasing ADRs and GDRs, Forward has also partnered with a number of top investment banks like Barclays, BNP Paribas and Deutsche Bank—all of which have significant frontier market capabilities—and through purchasing their swaps, is able to get exposures to countries, regional indices and individual companies.

“This way, we don’t have to go into the local markets, we just get the return via the swap on a particular security,” Herber says. “The operational costs are borne by our counterparty, because obviously a firm like Barclays has far greater ability to navigate, for example, the Kenyan equity markets than we do. We just get the returns and this way, we don’t have to put more costs on our customers.”

Because Forward has an indexed approach to frontier markets, issues like liquidity—or lack thereof—in frontier markets are not really a concern to Herber. However, not performing bottom-up research does mean that he may be missing out on opportunities in certain markets that are difficult to get access to. Nevertheless, the index allows for diversification among countries, regions and individual companies, he says.

Currently, Herber is trying to get exposure where he doesn’t have any, in countries like Bangladesh, which was added to the MSCI Frontier Markets Index last November, Ukraine and Serbia.

“In frontier markets, banks and real estate companies are the most numerous and the most attractive,” he says. “Banks, whether they’re private or government-run, are lending to the largest corporate entities in the country—they are lending hard dollars to shipping companies and steel companies, and they’re usually the first companies to be listed. Now, though, we are starting to see more consumer companies, telecom and utility companies in frontier markets, and they offer a good way to get exposure to fast growing segments of the domestic market.”

Daniel Broby, CIO, SilkInvest
When Daniel Broby began his career in 1985, all of today’s emerging markets were frontier markets. Through the years, he has learned that not following any index and going off-benchmark is the best way to get the greatest yield.

Of course, going solo means having to do extensive and detailed research—but that’s something that Broby, his London-based colleagues and SilkInvest’s global team take as part of the course.

“When you’re investing in frontier market companies, you have to really know the management, you have to really be able to trust them and know what they’re doing,” he says. “We spend a lot of time on the road making sure of this.”

Being on the road and meeting with both company management teams and government officials provides SilkInvest with a unique level of insight into frontier markets. While there has been an increase in the availability of research on these economies, it doesn’t go into the level of detail that SilkInvest requires, Broby says.

“By way of example, I was recently reading a research note from a bank on the Nigerian brewing industry and it states that the penetration in Nigeria is half that of Kenya, but they’ve failed to realize that half the Nigerian population is Muslim,” Broby says. “It’s important, therefore, to have a team with local market expertise who know these sorts of things.”

Starting with the given that all frontier markets present above average political risk, Broby and his team focus on the potential of countries to industrialize, and assess individual companies within this context. Unlike many others who look at frontier markets as commodity plays (“I don’t need to go to a frontier market when I can buy a mining company in Canada or Australia,” Broby says), SilkInvest is more interested in playing the consumer card and capturing the growth of the middle class through investing in industries in countries that have successful economies and where the rule of law applies. Zimbabwe would not make the cut, Broby says, even though it has had an operational stock market for many years, but a country like Ghana, where the stock market is functional and the rule of law applies, is a good bet. And in Ghana, a company like Fan Milk—a dairy company with solid earnings and the capacity to grow as the Ghanaian economy does—is a good investment, he says.

The Middle East and Africa (“there are over 2,000 companies in Africa alone,” he says) are the two regions that hold the greatest amount of interest for Broby. Unlike most other frontier market investors, he believes the Vietnam story is over, and he’s looking instead at places like Mongolia and Georgia, a very well-run country with an international outlook and cheap stocks.

There are, of course, many challenges to investing in frontier markets, and even if a country is attractive there might not necessarily be anything that a foreign investor can buy.

“We feel it’s best to buy local companies with a local listing, but it’s not always easy,” Broby says. “Saudi Arabia, for instance, is the largest frontier market but we can’t own direct equities there, we have to buy swaps with a local institution.”
But for a keen investor, structuring and working around the available parameters is not an issue, Broby says, and “these days, you can do far more than you could even a decade ago.”    

Savita Iyer-Ahrestani is a freelance writer and regular contributor to Investment Advisor and AdvisorOne.com based in New Jersey.

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