Cross Over to Frontier Markets

New CFA Institute research says it's time to invest.

August 3, 2011

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1100586_safe_walk signMany years ago, in the heyday of the Internet, I less-than-consciously typed in ASE.al into my web browser, hoping I’d find the website for Alberta Stock Exchange. Instead, I got the website for the Albanian Stock Exchange. I thought .al was the Alberta short form (then again, Tirana, Taranto and Toronto sort of sound alike).

Would it have made a difference if I’d gotten the address right. Perhaps not. The ASE was a frontier market – one or the other or perhaps both of them.

It’s hard to tell these days, what’s a frontier market and what’s not. Greece shouldn’t have been, once it accepted the sloppy embrace of Europa. But now it’s on the dog side of the Mediterranean, having long ago given up Spartan discipline. Then again, the U.S. markets, after centuries of working themselves up into the largest capital bazaars in the world are, thanks to truculent politicians more concerned to fish for votes on Lake Wobegon are about to be relegated once again to a Davy Crockett status.

But that was always true, Lawrence Speidell writes. He’s the author of a book-length essay on frontier markets, published on the CFA Institute’s Reseach Foundation website.

“It is easy to read articles with negative headlines and decide to avoid these markets. It is easy to think of only ‘big men’ dictators and desperate poverty. But a traveller who reads only the headlines might also avoid Los Angeles and New York City. The truth is that most people in frontier countries are hard workers. They are trying to get an education, get a job, raise a family, and live in peace. They know all about Hollywood movie stars, basketball, and the World Cup. And they know a lot about getting by with less. It has been said that ‘they’ve been doing so much with so little for so long, they could do anything with nothing.’”

So the headlines don’t really count – otherwise, who would invest in U.S. equities or debt. What does count? Says Speidell: “My view of these markets is that they present a long-term secular opportunity that should not be confused with a short-term bargain. “

What’s interesting here is that he plays on the representativeness of various indexes that assert they cover the investable universe. But index providers have their own methodologies – and to some extent, may be regretting that. MSCI let Portugal and Greece into the developed world indexes – which covers but 24 countries — a decade or so ago – and kicked Malaysia out, thanks to the Asian currency crisis.

Who now is the better credit risk?

MSCI also has an emerging markets index – covering 22 countries – but five had been relegated: Sri Lanka, Venezuela, Jordan, Pakistan and Argentina. On the other hand, South Korea, Taiwan, China and Brazil are still  part of the emerging, not the developed market index.

Speidell argues that, when considering purchasing power parity, many of the frontier markets, such as Slovenia, have per capita GDPs that  are close to the upper tiers of the emerging markets index, and the bottom tiers of the developed market index. And they do have stock markets.

Here he makes his case:

“When stock market capitalization as a percentage of GDP is plotted against PPP GDP per capita, the result is that higher incomes imply dramatically higher levels of stock market capitalization.3 Thus, with a rise in economic prosperity, the stock markets of these smaller, neglected markets can grow at an even greater pace than their economies. For example, a rise in PPP GDP per capita from $1,000 to $5,000 implies a stock market increasing to roughly 89 percent of GDP, versus 44 percent at the $1,000 level. With a fivefold increase in PPP GDP per capita, the stock market could be expected to grow more than tenfold as the financial structure of the country becomes more significant.”

What’s more, Speidell adds, is that frontier markets represent a significant portion of the world’s GDP and population, which is not yet reflected in stock market capitalization.

“Today, frontier countries account for 21.6 percent of the world’s population, 6 percent of its nominal GDP, and only 3.1 percent of world market capitalization. Even with this imbalance, a naive investor using cap weights as his or her guideline would still want to have 3.1 percent of a global portfolio in frontier markets. Those making a targeted portfolio allocation to a blended emerging/frontier segment should keep in mind that frontier markets represent 11 percent of the combined total of developing country markets on a capitalization-weighted basis.”

Is this a growth trap? After all, investors in China have seen little for their investment in one of the world’s fastest-growing economies over the past decade. Speidell offers a qualification, a sort of second-mover caveat, since he thinks stocks are leading indicators of economic growth.

“Overall, I believe that declining economies are likely to disappoint investors, whereas growing economies will prove rewarding only if the market prices are not “irrationally exuberant.” Research suggests that investors should look closely at countries in which conditions are falling into place such that future economic growth will be higher than past growth and higher than current expectations.”

Are there risks. Yes? Just as there are in developed countries (viz: Greece, Ireland). Or even the U.S. What’s key is to distinguish politics from companies. And there are roughly 300 companies – with a float of $100 million  or more — now included in frontier market indexes offered by the main service providers, and many are in unexpected places: Latvia, Malta, Tanzania and Kyrgyzstan. Others, perhaps, may be expected: the Gulf oil States. “One could consider them ‘frontier’ only in the sense that they are outside the normal investment universe of developed and emerging markets.”

As always, and as the U.S. debt debacle demonstrates, know the risks, and then triple-check for neon swans flashing warnings the overconfident somehow seem to miss.

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