The final frontiers of investing

Australian Financial Review, July 2010

Fancy a Mongolian mining company? No? How about a nice Lithuanian bank, or a Kazakhstan gas utility? OK, my final offer: KenGen. What do you mean you don’t know KenGen? It’s Kenya’s most successful electricity company. Durr.

Frontier markets, as stock markets like these are known, require greater savvy and experience than dealing with the most grizzled of used-car salesmen. This is, no doubt, where some of the most extraordinary gains will be made: the emerging star companies of tomorrow in the emerging star countries of tomorrow. But they take the idea of risk and reward to a whole new level – particularly on the risk side of the ledger.

You may not know it, but the countries you are exposed to are dictated more than anything by a group of people sitting in an office on Pine Street, New York. This is MSCI, and it is one of the leading providers worldwide of stock market indices. One of its most well-known ones is the MSCI Emerging Markets, and it is against this index that most emerging market fund managers – including those selling such funds in Australia – are benchmarked.

Consequently, most emerging market funds tend to mirror the geographical allocations of the MSCI index fund quite closely; when a market enters or leaves the index, a lot of capital tends to flow in or out with it as emerging market portfolio managers rebalance their holdings accordingly. The table below shows the 26 nations that make up the index today; even if you don’t hold an emerging markets fund yourself, the chances are your super fund will have at least a modest allocation to it, and it is because of MSCI’s decisions that you probably have an exposure to Brazil but not Argentina, to Hungary but not Croatia, and to Morocco but not Tunisia.

“The definitions to a large extent are given to us as fund managers by the index providers, particularly MSCI,” says Peter Taylor, investment manager for Asian equities at Aberdeen Asset Management in Singapore. (Taylor’s investment decisions affect the emerging market and Asia funds sold by Aberdeen in Australia.) “They have a process and criteria, and under those, some markets are defined as developed, some as emerging, and some as frontier.”

Frontier is actually quite an odd term, because it doesn’t always mean what you might think it means: poorer countries with no established stock markets. In fact, if you look at the table showing the constituents of the frontier markets, it includes some of the richest countries in the world, such as Kuwait, Bahrain and the United Arab Emirates; these have not been promoted to more widely tracked indices mainly because of a lack of easy access to their stock markets, or a lack of maturity or depth within those markets. Also, some frontier markets have stock exchanges almost as old as Australia’s: the Colombo Stock Exchange in Sri Lanka traces its history back to 1896.

“The term ‘frontier markets’ captures a broad universe,” says Taylor. “There are things that you might consider real frontier markets – Central Asia, Mongolia, Papua New Guinea, Pacific islands – where there is an insignificant stock market or sometimes no stock market at all, with the bigger companies listed elsewhere. Then there are what you might think of as the emerging markets of tomorrow: places like Vietnam, Sri Lanka, Bangladesh, Pakistan, and outside Asia places like Nigeria, Kenya or Romania. They may have their difficulties but are sizable countries with a decent number of listed stocks already that could potentially make the leap in the next few years.” And a third category is the wealthy Gulf states. “’Frontier markets’ is not strictly an income level cut-off. If a market has certain types of controls or access problems, it won’t meet MSCI’s criteria to be in the emerging market index. That’s why you have a country like Kuwait defined as a frontier market where it is far richer per capita than, say, India.”

Frontier funds covering all these bases do exist, but they are rare and little marketed in Australia. Franklin Templeton, for example, whose fund manager Mark Mobius has long been a standard-bearer for unloved markets, runs the Templeton Frontier Markets Fund out of Singapore and has so far garnered US$299.13 million under management tracking the MSCI Frontier Markets Index. Its biggest geographical positions are, in this order, Nigera, Qatar, the UAE, Vietnam, Saudi Arabia and Kazakhstan. Its biggest picks, while household names in their own countries, are little known outside them: MTN Group, a South African telco; Kazmunaigas Exploration Production, a Kazakhstan gas company; Saudi Basic Industries, a chemical, fertilizer, plastic and metals producer; Industries Qatar; and United Bank for Africa, which is headquartered in Lagos, Nigeria.

Other funds might pursue a specialist opportunity. In Australia, AMP Capital developed the Vietnam Real Estate Opportunity Fund, for example, investing in direct property there, although funds like this tend to limit access to sophisticated or institutional buyers rather than general retail.

Since few pure frontier funds exist, investors are more likely to get exposure to the frontiers when emerging market fund managers decide to dip their toes in the water of markets outside their benchmark, whether in expectation that those countries will eventually be promoted into true emerging markets and hence become part of their mandate, or simply because they think there are good returns there. In this respect, emerging markets fund managers are most interested in the chunk Taylor labelled the emerging markets of tomorrow, and this is perhaps where the biggest opportunities might lie for bold investors too. “We are quite bullish on prospects for both Vietnam and Sri Lanka long-term,” says Peter Sartori, founder of Treasury Asia Asset Management. “We think it will take longer than many people expect for both markets to become more mainstream or institutional – we expect it is five years away rather than one to three years – but it will likely happen.”

Managers differ on which markets they think offer the real opportunities. “There are a decent number of interesting stocks, particularly in markets like Sri Lanka and Kenya, which have a very long tradition of equity markets,” says Taylor.  “We find more interesting companies in Nigeria and Sri Lanka than we find in Vietnam. Vietnam is everybody’s favourite exotic market, but it’s not a place we find a lot of good companies, whereas places like Nigeria and Sri Lanka have had listed companies forever, with subsidiaries of multinationals listed there, and the local banks.” Aberdeen pursues these opportunities particularly through an Asian small caps fund – this holds stocks in places including Sri Lanka and Pakistan – and to a lesser extent in its broader emerging market funds too.

If you’ve noticed Sri Lanka keeps popping up in this story, that’s a useful point to consider. What’s really changed in Sri Lanka for everyone to be talking about it? It’s not that its companies, which have been around for more than a century in many cases, have become suddenly better – it’s because a crippling civil war has ended. Fund managers with a really long-term view will look at macro considerations like this in deciding whether exposure to a market might eventually make sense. “There has been a tremendous increase of interest in Sri Lanka but it’s got nothing to do with it graduating [to an emerging market definition – which, by MSCI, it still hasn’t],” says Taylor. “People were dismissive of it because of civil war, and suddenly it’s become exciting. We’ve been invested in Sri Lanka forever and that was not a set of investments that have performed very well for many years but suddenly it’s come good: all our stocks have been two or three baggers in the last 18 months.” That is, they’ve doubled or trebled.

Correctly calling the end of a civil war with any accuracy is clearly beyond most of us, but there are other similar factors that are easier to see coming: the world is getting more interested in Mongolia as transformative mining deals (including a vast mine backed by Rio Tinto) get closer to completion, which should lead to greater foreign involvement, faster economic growth and a more developed stock market, for example.

Still, in unpredictable places, these transformative economic moments can go both ways. “People think of emerging markets as a one way bet, but that’s not the case: you do have some emerging markets that go in the wrong direction.” The two key examples at the moment are Pakistan and Argentina, both of which in the recent past have been investment darlings – Pakistan in particular, which for a brief time was a poster child of foreign investment and privatisation before the political and security situation worsened. Both those markets now languish in the frontier indices rather than the emerging market ones, with a consequent loss of interest from international capital. Similarly Kazakhstan was for several years considered a barometer for the emergence of Central Asia, and attracted a lot of attention as it liberalised its banking sector – which pretty much went broke in the financial crisis, taking a lot of foreign money with it.

No Australia-based investor in their right mind would seek to buy a stock listed in Ulaanbaatar or Lagos without a great deal of prior knowledge, but there are other ways of getting exposure to odd parts of the world through a single stock. To stick with the Mongolia example, more and more of the world’s most powerful investors – such as Temasek, Singapore’s sovereign wealth fund, and China Investment Corporation, its equivalent in Beijing – are trying to get a foothold in companies and mining interests there in expectation of growth. One of the companies that sovereign funds have bought into, South Gobi Resources, has since been listed in Hong Kong, which can be easily reached by Australian investors and is a well-governed exchange. (It’s worth noting, though, that the stock has crashed 30% since listing, although the rest of the market is well down too.) You don’t even have to go that far to get exposure to some frontier markets: here in Australia, Lihir Gold gets most of its revenue from a gold mine in Papua New Guinea, and much of the remainder from Cote d’Ivoire. A great many mining companies, BHP Billiton and Rio Tinto included, have some exposure to the frontier mining idea.

It’s also very easy for Australian investors to invest in the USA, and doing so gives you access to the greatest range of exchange-traded funds (ETFs). These behave like buying a single share, but they reflect the performance of an entire index. Providers in the US such as Vectors, PowerShares and Claymores offer frontier ETFs, or ETFs tracking particular areas such as the MENA area, which means Middle East and North Africa. Examples are the Claymore Frontier Markets ETF (whose New York Stock Exchange symbol is FRN), PowerShares MENA Frontier Countries ETF (on Nasdaq, code PMNA) or Market Vectors Africa ETF (NYSE, NFK). Be aware that an ETF gets you exposure to the dross as well as any diamonds that might be found, and also that buying an ETF in America from Australia also exposes you to currency movements. iShares, the biggest provider of international ETFs sold in Australia, covers several individual Asian emerging markets in its Australia-listed products (Taiwan and Korea, for example), but for more far-flung stuff you have to go to their New York-listed products too: they have ETFs for Peru, Chile and South Africa, for example.

Otherwise, real frontier investing tends to be the preserve of private equity players who bring chunks of daring institutional money together to put into very new markets with a long-term timeframe. Examples are Altima Partners, the former Deutsche bank equity special situations group which peeled off from the bank in 2004 and has since launched funds including the Central Asia Fund, covering Armenia, Azerbaijan, Georgia, the Kyrgyz Republic, Tajikistan, Turkmenistan and Kazakhstan; the Dubai-based private equity specialists Abraaj Capital, which runs the Abraaj/BMA Pakistan Buyout Fund alongside a local Pakistan bank; and a group called Acap Partners, run by a former McKinsey staffer called Pierre van Hoeylandt, who runs a truly frontier-spirited entity, the Afghanistan Reconstruction Fund. It takes big money and immeasurable patience and risk appetite to participate in these sorts of ventures.

Generally, though, the idea of wanting to get in early to markets that will grow in importance, liquidity and influence is sound enough, and allied to the broader trend of Asian or emerging market growth. “Asia ex-Japan has only been on the radar for most Australian institutions for the last five years,” says Sartori. “It will definitely remain on the radar and will continue to grow in importance as the region continues to grow relatively stronger than elsewhere in the world and Asia gets larger in global indices. The frontier markets will contribute to this, but are a few years away from being more meaningful.”

BOX: The Middle East

The Middle East, which for investors is chiefly the big oil-rich markets of the Gulf Cooperation Council (GCC), is an odd case. Massively wealthy, their stock markets do not appear in global indices because by and large their markets either lack suitable access for foreign money, or because they are too small or immature. Saudi Arabia’s market doesn’t even make it into the frontier index because foreigners cannot buy Saudi shares (although they can create the effect of doing so synthetically with new investment structures).

There are funds that do invest exclusively in these markets: one of the biggest is the Schroder Middle East Fund, sold within its International Selection range, whose biggest positions are in Turkey, Saudi Arabia, Kuwait, the UAE and Qatar. “The long-term case for investing in the region remains strong,” says Rami Sidani, fund manager at Schroders in Dubai. “Middle Eastern countries are at a relatively early stage in their development and have strong growth potential. While many of these countries continue to benefit from oil and gas riches, they are investing in new products and skills to diversify away from reliance on energy exports. The region has a young, fast-growing population which should also contribute to a more rapid economic development.”

But emerging markets managers often consider the Gulf’s position in frontier indices an anomaly given that, as highly wealthy states, their future growth profile is likely to be quite different to a Vietnam or Sri Lanka.

In any event, MSCI has been talking for some years about adding some Gulf markets to the emerging markets index; Kuwait, the UAE and Bahrain are the ones that are most frequently mentioned, even though Saudi Arabia has much the biggest market in the region by market capitalization. It will be an interesting day when it happens, because calling Kuwait an emerging market – with its high performance luxury cars, bounteous oil revenue and soaring per capita income – seems just as odd as calling it a frontier.