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Broaching Asia's frontier markets

The next generation of frontier markets is full of untapped opportunities. Five top investors tell Citywire Asia where they are invested

Emre Akcakmak, portfolio advisor, East Capital

We like frontier markets because they represent an untapped  opportunity set, including the world’s youngest and fastest-growing  markets. They should now experience a development path similar to the one that emerging markets have been on over the past three decades. In its World Economic Outlook for October, the IMF outlines its expectation for most of the frontier markets to grow by more than 4% between 2018 and 2022. Several look set to feature among the world’s fastest-growing economies.

Strong reform movements, relatively low foreign investor activity (total institutional AUM in frontier markets is just $20 billion, compared with more than $1 trillion in emerging markets), a lack of analyst coverage, an increasing number of IPOs and fairly undemanding valuations all signify attractive stock-picking opportunities. Given that the worst is over with the recent macroeconomic challenges, and given the frontier markets’ strong performance year-to-date – up 28% in USD – we believe this is just the beginning.

As bottom-up stock-pickers, we make investment decisions on a case-by-case basis. However, we generally like consumer-related companies that we think will experience significant secular growth, boosted by the rise of the middle class and changing consumption habits.

We like to take a long-term view on the stocks we invest in. For instance, Vietnamese aviation stocks are among our favourites, as we expect the country to continue witnessing considerable passenger  growth over the next two decades. We are also positioning ourselves to take advantage of growing demand for better education in the Middle East and for improvement in lifestyles via essential infrastructure investments in Africa.

Economic reform in some frontier markets is also an important driver. Exporters now benefit from weaker domestic currencies in countries such as Egypt and Argentina and are increasing their competitiveness in the global arena. As the economic recovery takes hold, banks in these countries are also benefiting from the healthy trends. Besides the attractive ROEs, which are typically north of 25%, we see strong growth prospects thanks to the low level of private sector domestic credit relative to GDP. In Argentina, for instance, this ratio is only 14%, against 62% in Brazil. Overall, we think that our frontier market
investments are still attractively priced at a 10.8x P/E ratio on 2018 expected earnings, signifying a 9% and 35% discount to emerging markets and developed countries respectively.

The article appeared in the November issue of the Citywire Private Wealth magazine.

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Claudia Calich, portfolio manager, M&G Investments

Frontier markets typically offer higher compensation for their particular level of risk. That’s because they usually have no (or very little) track record, as there are very few frontier market bonds that have actually matured. For an active fund manager, this offers specific bottom-up opportunities that are less correlated to the wider market.

From a fixed income perspective, the Asian frontier markets consist of Pakistan, Vietnam, Mongolia and Sri Lanka. We have found appealing opportunities in Asia’s frontier segment, with current holdings  including hard currency sovereign bonds in Sri Lanka. Even though it has a weaker credit rating, Sri Lanka is a country where fundamentals are starting to stabilise.

It is also taking appropriate steps to reverse its debt build-up by mobilising higher tax collection, while keeping spending in check. It is making good progress under an IMF programme that is heading in the right direction.

Elsewhere, we have recently re-opened an exposure to Vietnam,  investing in a less liquid issue that we felt offered good compensation for its illiquidity via a solid yield pick-up. As a consequence of the improved environment in emerging markets, and amid factors such as synchronised growth and the bottoming out of key economies that were in recession, investors are demanding lower compensation for credit risk, but still want the sort of income that is rare in developed markets. This has allowed some countries to borrow in the market. We continue to believe that attractive opportunities can be found on a selective basis in this area.

Comprehensive due diligence – with a focus on fundamentals, risks and valuations – is essential. Based on this approach, the main appeal of frontier markets is that they can provide higher returns than established emerging markets because the risks are higher.

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Thomas Hugger, fund manager and CEO, Asia Frontier Capital

Our focus is solely Asian frontier markets. The opportunities in these markets are quite diverse because every country has its own merits. Currently, our investment universe consists of 11 countries: Bangladesh, Cambodia, Iraq, Laos, the Maldives, Mongolia, Myanmar, Pakistan, Papua New Guinea, Sri Lanka and Vietnam.

We are very positive on Vietnam due to its macro stability, as well as its outlook for economic growth. This is backed up by rising foreign direct investment (FDI) as the country becomes a hub for manufacturing.

Samsung now produces the majority of its mobile phones in Vietnam, and the country has already seen FDI of $12.5 billion this year. We are positive on its consumer discretionary, mid-end real estate, manufacturing, logistics and infrastructure sectors.

We also like Bangladesh, where the large young population is seeing disposable incomes rise from a very low base. We therefore like sectors such as consumer discretionary, financial services, pharmaceuticals and telecom.

Mongolia has also seen a recovery this year on the back of rising  commodity prices – mainly coal and copper. Over the coming years, Mongolia will benefit from the development of existing resource opportunities, as well as infrastructure projects further connecting it to its neighbours.

Despite the current political noise, we are still very positive on Pakistan thanks to initiatives such as the China-Pakistan Economic Corridor (CPEC), which will add significant power capacity. This will lead to significantly higher FDI and will translate into higher GDP growth. We are positive on consumer discretionary and infrastructure-related companies in Pakistan, and will continue to invest in the country even after its inclusion in the MSCI Emerging Market Index.

The state of its infrastructure and economy still make it a true frontier market. Frontier markets are generally under-researched relative to emerging and developed markets, and many still do not have much foreign participation in their stock markets. For example, foreign participation in the Dhaka Stock Exchange in Bangladesh is well below 10% of daily turnover. This gives investors a chance to get into  companies early and cheaply.

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Jean-Charles Sambor, deputy head, emerging market debt, BNP Paribas Asset Management

We see Asian frontier markets in hard currency as expensive, particularly Sri Lanka, Vietnam and Mongolia. From an investment perspective, we are very selective in the frontier market risks we take, particularly in Africa, as some of these trades are already quite crowded with a very narrow exit door.

We selectively favour frontier markets in Latin and Central America, given that these opportunities are usually less crowded and come with tangible diversification benefits.

We don’t think it can be a top-down asset class call. In-depth bottom-up credit research is key. Genuine opportunities offer high yield, and under-researched opportunities lead to mispriced bonds with occasional overestimations of the default risk. Correlation with mainstream EMD is usually low. On the local currency side, these markets are usually under-owned by foreigners and could be a source of alpha generation for nimble asset managers.

On the other hand, we are also cautious on frontier markets where we feel the market is buying them for supposed diversification reasons; people are often just hungry for yield. In this instance, active management and deep credit research is key.

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David Dali, portfolio strategist, Matthews Asia

Global emerging markets are back. So far this year, global emerging market stocks have registered some of the highest returns as the world’s two largest economies, the US and China, have underpinned global growth, stabilized commodity prices and supported stronger emerging market currencies.

What’s more, corporate earnings have been accelerating across emerging markets, especially in Asia. This has reminded  investors that emerging market valuations are relatively attractive versus their developed market counterparts.

But does this mean it’s time for investors to further diversify into frontier markets? Not only are frontier economies growing faster than most traditional emerging economies, but their annualised five-year returns to the end of September have been stronger than aggregate emerging market returns. Market volatility in frontier markets has also been generally lower than in global emerging markets, and frontier markets have tended to have fairly low correlation to other global stock markets.

It is important to remember that most companies within frontier markets are largely unknown to investors and sell-side analysts. These companies rarely appear in broader benchmarks, making frontier markets a potential source of alpha and a paradise for those managers with the resources to conduct in-depth research on the ground.

However, not all frontier markets are the same. The MSCI Frontier Market Index is still fairly cyclical, with nearly 50% of its holdings in financials and the materials sectors as of the end of September. This makes it susceptible to economic ups and downs.

The MSCI Frontier Markets Asia Index, on the other hand, has significant exposure to the burgeoning consumer theme, with more than 50% in the consumer staples and healthcare sectors.

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Alexander Benard, CEO, Schulze Global Investors

First of all, we believe that the best opportunities in frontier market are to be found in private equity, as opposed to in publicly traded companies. There are many reasons for this, but primarily it is because most of the good businesses in frontier markets are still privately held.

In private equity, we see investment opportunities in four key areas. First are consumer-facing businesses. Populations in frontier markets are growing at a faster pace than in the more developed economies. Per capita incomes are also rising, with people spending more on basic consumer goods and services.

Second is infrastructure. Many frontier markets are investing heavily in roads, bridges, railways, and other large infrastructure projects. Although the projects themselves are often driven by the public sector, they create opportunities for private companies in construction, building materials and equipment.

Third is manufacturing. Many frontier markets are poaching manufacturing from countries such as China, where the labour cost has been rising. For example, Ethiopia is establishing industrial parks with the specific aim of developing a manufacturing base. Fourth is energy. In frontier markets, demand for electricity tends to grow at a rate of 1.5x GDP growth, with both retail and industrial consumers pushing up demand. As a result, many frontier markets offer attractive off-take arrangements, particularly for clean energy solutions such as solar, wind and hydro, to incentivise investment in these  assets.

We believe it is exactly the right time to focus on frontier markets. In an era of  low yields, frontier markets are still demonstrating strong growth. Indeed, in 2016, 18 of the world’s 20 fastest-growing economies were frontier markets.

At the same time, frontier markets are also becoming less risky, with more stable GDP growth, lower levels of inflation and fewer geopolitical conflicts.

And yet, despite their solid fundamentals, we find that frontier markets remain tremendously undervalued relative to the traditional emerging markets. Most investors shy away from them, so there is still a shortage of capital relative to the abundance of opportunity. Early movers can acquire high-quality assets at attractive prices.

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