In the run-up to the global financial crisis and economic meltdown, many large institutional investors shifted focus from global and emerging economies to the frontier markets.  These markets had historically outperformed key indices like the NIKKEI, HANG SENG, DJIA, among others.  But even with the sterling performance by the frontier markets, conservative institutional investors still shied away due to key underlying weaknesses. The risk tolerant investors, especially large fund managers who went ahead did so knowing too well the underlying political risks and governance challenges that are synonymous with most of them.  But as they say, the larger the risk, the higher the return. 

Indeed, most frontier markets posted huge returns following the recovery from the global financial crisis.  Some of the frontier markets like Uganda and Sri Lanka posted returns of up to 73 percent.  The best performing of the emerging markets on the other hand posted a return of about 50 percent while most of the global markets were at a single digit to negative returns.  That is not to say that all frontier markets performed well. Bahrain for example posted a return of -23 percent. 

But what are these frontier markets and why are they gaining so much significance over time? A new wave of developing nations spanning the Americas, Africa, Europe, the Middle East, and Asia is slowly emerging.  Frontier countries have some of the world’s fastest growing economies and equity markets. They have little in common other than being in roughly the same stage of development, which has led to their being grouped together by economists and indexers. The MSCI, which is a global provider of investment decision support tools worldwide, has an index that tracks the performance of key markets.  The 25 countries below fall in its frontier markets listing and track their performance using the MSCI Frontier Markets Index. 

But what really is the key driver to the growth in these economies? 

On overall, these countries are posting high growth rates over period of time than the global and the emerging markets.  A good example is Korea and Taiwan that were very small some 20 years ago.  Today, Taiwan’s GDP/capita is around USD. 30, 000 ahead of some then large economies like Spain, Italy and Greece.  This is just an example of the ongoing shift from some traditional investment havens to smaller markets with greater upward potential. 

Notably, the ongoing structural adjustments in most of the countries have been a key driver to growth. These structural adjustments have enabled these countries position themselves in the global map. Take for example Kenya that through IT is slowly positioning itself as a regional IT hub. In doing so, it has been able to fast track growth in with IT being a key driver to this.  Increasingly, the country still remains a key manufacturing base for most of the multinationals owing to resource availability and a good business environment.   

Further, domestic consumption in these economies has been on the increase. Steady rises in per capita income are typically related to consumers spending more on discretionary items and less on basic items like food. This has helped put pressure on a cyclic development pattern with a positive effect on the overall economy.  The push has mainly been necessitated by a rising middle class. 

Increasingly, more and more frontier markets are becoming export oriented.  Their openness to international trade has made them key targets to trading partners thirsty for import grounds.  Data available from the World Bank on exports as a percentage of GDP shows higher ratios for frontier than it is for developed economies.  Estonia is still the highest at 70 percent, Nigeria at 37 percent, Kenya at 27 percent.  Comparatively, India (a BRIC economy) stands at 20 percent, US at 11 percent.   These figures are a clear indication that frontier markets are soft targets for future global expansion and growth.

As more and more frontier markets try to fit into the global business playing field, the institutional environment is also improving.  In fact, in as much as the rule of law and political instability is still an issue in countries like Kenya, Nigeria, and Pakistan an improving regulatory environment is increasingly taking its toll on development. Notably, freedom of expression has pushed citizens to the streets in Tunisia to call for reforms and better standards for all. 

One test case in Kenya has provided a global case study. The use of the mobile phone has enabled farmers at the bottom of the pyramid compare prices in different markets using the mobile phone, receive payments for supplies using the same technology and make payments for supplies.  According to academic studies by the London Business School, each 10% increase in a county’s mobile penetration is tied to a 0.5% in increase to a country’s GDP.

It is however noteworthy that most investors still shy away from these markets owing to their size.  Out of the over 30 markets, only 5 countries have a market capitalization of over US$. 40billion. Compare this to Apple (a NYSE listed company) whose market capitalization is at over US$. 300bn.  This reduces the appetite by most large institutional investors.  Adding the risk of political tensions and weaker governance structures presents a much bleaker picture for them. 

Typically, one would argue that frontier markets are expensive. On a historical-price-to-book multiples, frontier markets trade at over 20 percent discount to emerging markets. On a price-to-earnings basis, frontier markets are still much less cheaper on the basis of performance following the 2009/2010 recovery from the recent global crisis.  All in all, frontier markets still trade at a discount compared to their emerging peers. 

So, where should investors look out for best returns in frontier markets?  Credit Suisse, in its recent research worked out a model ranking frontier markets using 3 equally weighted categories. These categories include macroeconomic strength, valuation and human welfare and political stability.  Kenya, of all the 25 frontier economies in the list falls at the bottom of all the three categories. Tunisia and Nigeria received an equal score of 6 on macroeconomic strength while Mauritius received a score of 10 on Valuation and 12 on human welfare and political stability. 

Arguably, having some exposure to a broader cross-section of frontier economies may enhance an investor’s return and help lower overall risk of an investment portfolio owing to the low correlations between frontier markets and other major indices. 

Michael Musau
Investment Analyst
[email protected]