There is little doubt that the past five years or so has been one of the worst periods for investors in emerging market equities.
Headwinds such as slowing growth, falling commodity prices and geo-political risks have all contributed to the MSCI Emerging Markets index’s losses of close to 10 per cent over the last half a decade – a period when developed markets are up 60 per cent.
However, as the graph below shows, frontier markets (which are commonly viewed as riskier given they are economies in an earlier stage of expansion) have managed to deliver a gain of 13.79 per cent despite concerns facing the developing world.
Performance of indices over 5yrs
Source: FE Analytics
However, with the MSCI Frontier Markets index down more than 15 per cent over the past 12 months, many investors may feel the bad news has finally caught up with the asset class.
The research team at Numis Securities, however, says the recent falls have thrown up a very attractive entry point for investors as the low valuations on offer compare very favourable to the high growth potential these economies offer.
“The investment case for emerging markets includes strong and sustainable GDP growth, favourable demographics, low corporate borrowings and under-developed mortgage/credit markets. For frontier markets, these factors are even more compelling, in our view,” Numis said.
“Indeed, we believe that frontier markets have similar characteristics to emerging markets 25 years ago, when they were first identified as an investable universe (the MSCI EM Index was created at the start of 1988). The potential of frontier markets is illustrated by the fact that they make up just 0.3 per cent of global market capitalisation and 4 per cent of GDP, but represent 12 per cent of the global population, with annual population growth of 1.5 per cent per annum.”
In this article, the team highlights the five major reasons why investors should consider frontier markets within their portfolios and give its favourite trust to gain access to them.
Positive demographics
First and foremost, the analysts say the young but growing populations that can be found in areas such as Africa, the Middle East and South America make frontier markets, as an asset class, an attractive long-term proposition.
They say this trend, combined with an increasingly wealthy middle class, should boost growth.
“Under 15s make up over 30 per cent of the population versus 24 per cent in emerging markets and 17 per cent in developed markets. Rising incomes, combined with increasing urbanisation, means that there is potential for significant growth in domestic consumption in frontier markets,” Numis said.
Rising investment
Partly as a result of the first reason, Numis says the fact more and more foreign investors are putting money into frontier markets is another very positive dynamic.
“Many frontier markets countries are beneficiaries of increased foreign direct investment (e.g. Chinese investment in Africa and Japanese investment in Vietnam reflecting the wage gap versus China).”
“This investment in infrastructure and manufacturing supports high levels of economic growth. Frontier markets countries are also the beneficiary of the rapid adoption of technology through services such as mobile banking and payments.”
Low debt levels
One of the major reasons why many investors are negative on emerging markets is because debt levels are increasing.
In fact, many warn that a repeat of the Asian financial crisis of the late 1990s is on the horizon given the flows out of emerging markets, falling commodity prices, the chances of tighter monetary policy and the fact most of the debt is denominated in dollars.
Performance of sectors during the Asian financial crisis
Source: FE Analytics
However, the team at Numis points out that this isn’t an issue in frontier markets.
“Historically, high sovereign debt levels have been associated with emerging market crises. However, sovereign debt levels across frontier markets average 40 per cent of GDP, which is similar to emerging markets, but compares to around 100 per cent in many developed economies.”
“Private debt is also relatively low in most frontier market countries, partly a reflection of under-developed banking systems.”
Less susceptible to US interest rates
The other major reason why investors are cold on emerging markets is due to the potential for higher interest rates in the US.
The fears surround the concern that tighter policy would strengthen the dollar, which would hurt those economies holding dollar-denominated debt and especially those which are running current account deficits.
Again, though, Numis says frontier markets would escape relatively unharmed from a tightening cycle.
“Global capital flows have had a major impact on emerging markets countries in recent years, both in terms of markets and exchange rates. This has not happened in frontier markets to the same degree as these do not have liquid debt markets.
Market inefficiencies
The final point, according to Numis, is that very few investors are chasing frontier market stocks meaning there are opportunities to unearth undiscovered gems.
“Many frontier market stocks have little or no research coverage, resulting in significant opportunities for investors who have the resources to carry out their own fundamental research.”
However, one of the major reasons they are so under-researched stems from the fact they tend to be quite illiquid – something Numis says investors need to keep an eye on.
“While the potential is clear, in our view, it needs to be recognised that frontier market countries are typically at an earlier stage of development, both economically and politically. Liquidity can dry up at a time of rising risk aversion, as illustrated during the global financial crisis in 2008.”
Performance of indices during the global financial crisis
Source: FE Analytics
Numis added: “In addition, individual markets are often prone to periods of boom/bust as governments struggle to balance credit growth/inflation and economic growth.”
Numis’ recommendation – Advance Frontier Markets
There are two London-listed frontier market investment trusts (BlackRock Frontiers and Advance Frontier Markets). The team at Numis are currently recommending the Advance trust, which is trading on a 7.13 per cent discount to NAV.
Advance Frontier Markets seeks to maintain a far more diversified portfolio than the MSCI Frontier Markets Index, which is heavily weighted towards the Middle East (33 per cent) and the financials sector (53 per cent),” Numis said.
“Advance Frontier Markets invests through ‘best-of-breed’ open and closed-ended funds providing access to experienced managers, many of which are locally based.”
“The aim is to add value through a combination of manager selection; asset allocation; and exploiting discounts. 30 per cent of the portfolio is currently invested in closed-ended funds, trading on an average discount of 23.6 per cent.”
According to FE Analytics, the five crown-rated trust has beaten its benchmark over five years with gains of 14.28 per cent but is struggling against the index over more recent timeframes.
Performance of trust versus sector and index over 5yrs
Source: FE Analytics
It counts the likes of VinaCapital Vietnam Opportunity, SCM Africa and Advance Copernico Argentina as top 10 holdings. Numis likes this fund of funds approach, as while it may not be as punchy as BlackRock’s straight equity offering, it allows for greater expertise at a regional level.
Advance Frontier Markets has gearing of 2 per cent and ongoing charges figure, excluding a performance fee, of 1.58 per cent.
