Fast-growing GDP, excellent demographic profiles, low government debt and a substantial commodity endowment make frontier markets an unrivalled investment opportunity
Frontier markets are undergoing the same trends which transformed global emerging markets over the course of 25 years from a niche asset class to a mainstream investment destination. Previously isolated economies liberalised and grew at a phenomenal rate, lifting millions out of poverty and creating a new generation of consumers.
With the expansion of domestic capital markets, local companies sprang up to take advantage of the new opportunities, successfully adapting Western products and business practices to fit their underpenetrated home market. Investors benefited as these markets were rewarded with rising capital flows while companies improved their corporate governance. We believe the opportunity exists for frontier markets to follow the same development path that we saw for mainstream emerging markets.
In recent years, investors have been buffeted by stresses across asset classes from equities to fixed income. The developed world has struggled to emerge from the effects of the global financial crisis, creaking under the debt load built up in the preceding years. Mainstream emerging markets have also disappointed, as previously export driven economies have struggled to find new engines of growth amidst structural challenges. Investors have endured a bumpy ride and in some cases, are nursing losses.
Although returns and yields have fallen, correlations and volatility have risen, and investors have found it increasingly difficult to find diversification. Interestingly, frontier markets, ie those countries that are viewed as neither developed, nor even emerging, have begun to outperform, and have shown significant divergence from the sharp sell-off across other equity markets.
Since the start of 2013, frontier markets have returned over 20 per cent, while emerging markets have disappointed investors again, returning minus 4 per cent in sterling terms. Importantly for those averse to wild market swings, this outperformance has not come at the price of increased volatility. It often comes as a surprise to investors that at only 7 per cent the volatility of the MSCI Frontier Market Index is lower than that of both emerging and developed markets, at 15 and 12 per cent respectively, which is testament to the lack of hot money currently following into frontier markets.
The majority of frontier market participants are local investors. The assets under management of international institutional investors in frontier markets is approximately $20bn, a fraction compared with an estimated $1tn in emerging markets. Thus, in the main, frontier markets are not driven by investors who are chasing the ‘risk-on/risk off’ trades that have characterised both developed and emerging markets in recent years.
Given that frontier markets are not fully integrated into the world economic system, local factors are far more significant to these markets than global economic challenges. Domestic developments in most frontier markets have been largely favourable to investors. Several frontier economies have emerged from their own crisis of previous years and have embarked on ambitious programmes of reform whilst sustaining political stability. Frontier banking systems are largely liquid and well-capitalised.
Despite this, valuations remain attractive, especially when compared with mainstream emerging markets. Well-run companies, operating very profitably, in some of the fastest growing economies in the world, from Nigeria to Bangladesh and from the United Arab Emirates to Vietnam, trade on valuations of under 9 times price-to-earnings supported by high dividend yields in excess of 7 per cent.
We believe the valuation disparities offered across markets are highlighted by the fact that currently the market cap of the African brewer SABMiller, is greater than the entire market capitalistion of the Nigerian stockmarket. In aggregate, the holdings of the BlackRock Frontier Markets Investment Trust trade on a forward price-to-earnings of under 9 times and a dividend yield in excess of 4 per cent.
In summary, we believe that frontier markets represent a compelling opportunity for long-term investors. The combination of the countries with the fastest growing GDP, the best demographic profiles, the lowest government debt and a substantial commodity endowment provides an unrivalled investment opportunity. The low correlation between frontier markets and all developed and emerging markets mean the inclusion of a frontier markets fund within a portfolio can bring significant diversification benefits. As more investors recognise this it looks increasingly likely that 2013 will be the breakout year for frontier markets.
Sam Vecht is manager of the BlackRock Frontiers Investment Trust