Gains with frontiers

Barings manager Michael Levy tells Beth Brearley that frontier markets are one of the most exciting areas of the financial markets, with a diverse group of investable companies

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The fund launched at the end of April, what were the reasons for rolling it out at this time?

The decision to launch the fund had been planned for some time. It is an area of the financial market we expect to grow substantially for years. Barings has a history of investing early in emerging markets and frontier markets. We are often the first movers in an asset class. From an investment perspective, the frontier markets are one of the most exciting areas of financial markets. I certainly think they are the next growth frontier.

This year there has been a surge of money being invested in frontier markets, what has been driving these flows and do you think it will continue?

I really believe that people recognise that in frontier markets there are a diverse group of companies which are increasingly investable. GDP growth rates and corporate earnings growth have vastly improved over the last few years and have excelled their peers in the emerging and developed markets. Frontier markets are very uncorrelated to emerging and developed markets. People are seeing them as a way to diversify their asset allocation. Emerging markets such as Brazil and South Africa are dependent on the China growth story, and as the growth opportunities slow down the markets and economies are affected. However the frontier markets are not reliant on the global economy but are dependent on their domestic markets. They offer not only growth but also a dividend yield, which is 5.5 per cent on aggregate. This is in a world where yields are low and competitive. There are high payout ratios as many companies have partial government ownership and want cash flow and a lot of companies have also been developed by families and they are keen to see cash flow. 

Do you think this could be a record year for fund flows into frontier markets? Are they the new emerging markets?

The flows data year-to-date are encouraging but it is still a small asset class. There is a long way to develop and go. They have the capitalisation of the emerging markets in the early 1990s. They show the characteristics of emerging markets two decades ago when they were a specialist asset class and they have the potential to grow like emerging markets for reasons such as the under penetration of consumer goods and services. For example only 10 per cent of households in Kenya have a refrigerator. Population growth is strong and the population is young – which is good for the labour force – and increasing in urbanity. These countries are also well endowed with resources. Nigeria are oil producers and in East Africa more oil sources are being developed. There is also agricultural land – there is a massive amount in Ukraine. However we must see frontier market governments implement good policy, structural reform and strong governance.

 

Is governance risk still a big problem in frontier markets?

It is very different country to country. But overall the trend is good. This year Pakistan successfully held democratic elections and for the first time a civilian government served a full term. Kenya also successfully held elections this year with no violence. So we are seeing positive trends in terms of government improvements.

What is your investment process?

It is Garp-orientated – growth at a reasonable price. We look for companies which can deliver a positive earnings surprise with strong corporate governance and where the management can allocate capital so that returns are above the cost of capital. Companies where there is a clear competitive advantage which is sustainable and driving future earnings growth and earnings surprise potential. We meet companies on a regular basis and alpha is generated from stock selection results. The fund has between 45 and 75 holdings; currently there are 60 so it is reasonably concentrated. As an active manager if we have conviction in a company we should take active bets. We do not pay too much attention to the benchmark, the MSCI Frontier Markets, as we are very conscious it is not a good representation of the market. For example Saudi Arabia is not in the index but there are a lot of investment opportunities there. We consider any country which is not in the MSCI World or MSCI Emerging Markets indices.

Qatar and the UAE were recently upgraded to emerging market status while Morocco was downgraded to a frontier market. Do these moves by MSCI represent opportunities for the fund?

The upgrade of Qatar and UAE is very good news. We like it when markets reach the stage of maturity. It allows us to transition the portfolios and to exit positions opportunistically. The upgrade will drive up valuations. We already have knowledge of Morocco from our Baring MENA fund but we do not have any holdings as there are no interesting investment opportunities. But we will look at it on an active basis.

How is the fund currently positioned?

We have a large overweight to the healthcare sector. In the Middle East there is plenty of wealth and money is being spent on healthcare. There are a lot of problems linked to obesity, and this is driving the healthcare providers to grow their models as people are increasingly using healthcare products. There are very strong growth opportunities and these are supported by governments who are happy to see private provision.

We also like consumer themes. The under penetration of consumer goods and services means there are many opportunities in Asia, Eastern Europe and Africa. Consumer staples have been highlighted as expensive but we are finding a lot of value.

Our biggest overweight is Saudi Arabia at an 8.9 per cent overweight, driven by bottom-up opportunities. There are a lot of interesting, well-managed companies. Lots of Saudis are educated in western universities and understand how to manage a business. There are well-managed businesses with strong growth opportunities. Countries we do not like include Kuwait where we are 15 per cent underweight. It is a very index heavy country but we are really struggling to find interesting opportunities there. The corporate structure is complex and valuations are high relative to other frontier markets.