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Frontier markets show promise for the brave

Though vulnerable to political and economic instability, investments in these smaller economies offer the potential for higher returns

Special to The Globe and Mail

As both developed and emerging markets struggle, brave investors looking for an edge might consider the frontier markets.

Like the emerging markets of the past, frontier markets, the less liquid and smaller markets, today offer the prospect of high returns over the coming decades from attractive companies in fast-growing economies, such as Argentina, Bangladesh, Vietnam and Zimbabwe.

"Frontier markets represent what emerging-market countries like Brazil, Russia, India and China were 20 to 25 years ago," said Mark Mobius, who oversees about $47-billion in frontier- and emerging-market assets at Franklin Templeton Investments. "By giving investors access to a younger generation of emerging markets, frontier markets represent a compelling investment opportunity."

Mr. Mobius and other frontier investors scour the globe, visiting factories and meeting company managers and employees in the hope of picking winning stocks and avoiding losers. Thomas Vester, who manages $800-million in frontier stocks for Bank of Montreal's Lloyd George Management in London, said he and his team visited 28 countries last year, and planned to visit Argentina, the Philippines, Saudi Arabia and the United Arab Emirates this month.

They're hunting for companies they believe will profit as individuals get richer and spend more on products and services ranging from milk, beer, shoes, telephones and cars to bank loans and insurance.

"What we want to focus on are companies that cater to the local consumer," Mr. Vester said. "When the consumer on the streets of Ho Chi Minh City [in Vietnam] or the streets of Lagos [in Nigeria] or the streets of San Jose in Costa Rica goes from having, let's say, $2 of disposable income in his pocket a week to maybe $10, 10 years from now - we want to invest in the companies that benefit."

During a visit to Ghana in January, Mr. Vester studied an ice-cream maker that, "on paper, it shouldn't really exist." The company delivers 10-cent (U.S.) ice cream sachets by bicycle in a country whose temperature averages 26 C. Yet, they provide a quick return on invested capital and "they're doing extremely well," he said.

The BMO Lloyd George Frontier Markets Strategy fund, officially launched Jan. 1, 2012, had a net return of 40 per cent in its first year and 37 per cent in 2013. Its biggest holdings are Guaranty Trust Bank in Nigeria, Vietnam Dairy Products in Vietnam, and Bank of Georgia Holdings in Georgia.

Even the benchmark for a well-performing developed market, such as the United States, didn't fare as well. The S&P 500, climbed 16 per cent in 2012 and 32 per cent in 2013, including reinvested dividends.

Frontier versus Emerging

Though frontier markets are more volatile than more established ones, they have a greater potential for growth. The MSCI Emerging Markets Index fund more than tripled from 2001 - the year Jim O'Neill, then an economist with Goldman Sachs Group, Inc., coined the term "BRIC" to show how Brazil, Russia, India and China symbolized a shift in economic power from developed to emerging countries - until October, 2007. The index then lost more than half its value over the next year and a half, and today is at its level of April, 2007. The MSCI Frontier Markets Index rose higher and fell further.

"The frontier is the last place on earth where there is unimpeded opportunity for GDP to catch up," said Larry Speidell, who helps oversee $200-million as chief investment officer for Frontier Market Asset Management LLC in California. The economies of frontier countries are expanding quickly, he said, while "China is slowing, India is a political mess, Brazil is struggling with low commodity prices, and Russia is a kleptocracy."

Mr. O'Neill himself is changing focus, saying in a Bloomberg News column in November that the BRIC countries "are already closely watched," and that he's working on a project covering what he termed the MINT economies.

"Mexico, Indonesia, Nigeria and Turkey all have very favourable demographics for at least the next 20 years, and their economic prospects are interesting," Mr. O'Neill said in the column.

Outside of mutual funds, it's difficult for Canadian individuals to invest in frontier markets. Even exchange-traded funds, which offer a way to invest in a basket of stocks, may not be appropriate for everyone, according to John Gabriel, an ETF strategist at Morningstar Inc. in Chicago. Money managers with good researchers on the ground have an advantage in this area at the moment, he said, because they can decide what to buy and what to avoid, unlike index-tracking funds that hold all the stocks in the benchmark index.

Among the ETFs that do exist are the iShares MSCI Frontier 100 ETF, Guggenheim Frontier Markets ETF, and EGShares's Beyond BRICs ETF.

Besides the potential for growth, frontier markets are appealing as a class because they aren't correlated to other countries' markets, helping to diversify portfolios. When stocks rise or fall in the U.S., the world's largest equity market, many other regions follow. But each frontier market marches to its own drum, and a swing in Nigerian or Bulgarian or Cambodian stocks will not trigger a corresponding move elsewhere.

Investors aren't the only ones betting on the potential of frontier markets. McDonald's Corp., the world's largest restaurant chain, opened its first outlet in Vietnam this month, marking the first time in two decades it has entered a new country in southeast Asia.

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RISKS: A REALITY CHECK

The most exotic place most Canadians will invest is the New York Stock Exchange, so the idea of buying stocks in a tiny country on the other side of the planet may feel risky. And it is, especially considering the S&P 500 index has more than doubled from its low during the financial crisis in March, 2009. With returns like that, why look anywhere else?

But there is a gap between the perception and reality of frontier markets, according to money managers, who rely on country visits to understand and manage risks from the likes of government, regulators, brokers and managers. Investors also need to remember that the S&P 500 plunged by more than half in the 17 months before its 2009 low.

"The most misunderstood point is that frontier markets are low risk," said Larry Speidell, chief investment officer at California-based Frontier Market Asset Management LLC. "We had an effective global financial collapse, which has made S&P 500 companies seem like the safest on earth. I think it's time to think outside the box."

Although stocks and currencies in individual frontier markets may swing up and down more than in emerging countries, as a group, they are less volatile, as measured by their five-year annualized standard deviation. As of Dec. 31, volatility stood at 18.5 per cent for the MSCI Frontier Markets Index, compared with 22.6 per cent for the MSCI Emerging Markets Index and 15.3 per cent for the S&P 500.

Frontier markets are, by definition, smaller than emerging and developed markets, with less information, lower liquidity and higher transaction costs. It's important to spend time on the ground, and find brokerages that execute trades reliably and properly, Mr. Speidell says.

Exploiting inefficiencies in pricing and liquidity is part of the strategy used by Thomas Vester, who manages $800-million in frontier stocks for Bank of Montreal's Lloyd George Management in London.

He acknowledges that scandals and fraud are possible, just as in developed markets, he said, citing the cases of Bernard Madoff, Enron Corp. and WorldCom Inc.

"You need to be diversified so you can live with abnormal events in your markets," Mr. Vester said.

For all their perceived risk, returns this year to Feb. 4 show frontier markets can add value to a portfolio. They gained 0.9 per cent, while emerging markets dropped 2.3 per cent and the S&P 500 plunged 5 per cent.

Nicolas Johnson

© 2007 The Globe and Mail. All rights reserved.

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