Frontier Markets: less volatility than the FTSE or S&P?

Country weightings & investment criteria

Nigeria remains the biggest country represented in BlackRock Frontiers. “At the beginning of 2012, Nigeria was one of the team’s most favoured countries. Although we remain excited by the immense long-term potential of Nigeria, which we expect to benefit from its favourable demographic profile, valuations look less attractive after a 50% rally year to date. We think now is the right time to consider frontier markets in Asia. Countries like Bangladesh and Vietnam have all of the long term growth drivers, but they are also becoming much more competitive on a global scale, as the costs of production surge elsewhere in Asia. For example, Taiwanese manufacturers are looking to move their production to countries like Vietnam, where the minimum wage in Hanoi, is $95 a month. By contrast, in China’s cheapest province for manufacturing, Jiangxi, wages are approximately $137 per month.”

“Only 14-20% of our fund is in natural resources and this is because a lot of them will never make any money. Either someone will steal them, these are frontier markets after all, and we are not always going to profit from what is in the ground. The most interesting place for us from a commodities point of view is Iraq. It`s one of our biggest conviction calls, a lot of the risk is priced in there. Outside of that commodities aren’t exciting because investors can access them in many other ways and through other markets”.

The price is right

In terms of the investability of individual countries the BlackRock team look for countries where there is change that is congenial from an investors stand point. It doesn’t mean they are good countries in the sense of having the equivalent level of regulation, rule of law and infrastructure as developed or developing markets but where the direction of travel is positive. “The key for us is risk return. For us when you are buying stocks at 4-5 times earnings, as against something like 20 times earnings then there is very little risk in the price. And that’s the difference between frontier markets and emerging markets.

The fastest growing countries in the world are in frontier markets. There`s been 4 major scientific studies looking at GDP growth and subsequent market performance. Contrary to popular belief there is no correlation between GDP growth and market performance. What I would say though is that when GDP falls markets do badly. When GDP grows markets `may` do well. This is how I like to think of it. There’s no guarantee of that performance”.

A good example of Vecht’s point is China. The MSCI China index is below where it was in 1994, despite the Chinese economy growing for the last 30 years at 8, 9 11% per year.

Demographics

The demographic trend in frontier markets is entirely congenial. While emerging markets might be a wee bit better than developed markets in the West on the demographic front, frontier markets are even better. “The way I view demographics” explained Vecht, “is the same way I view GDP growth. Bad demographics are bad for markets, good demographics `May` be good for markets. It’s no good having lots of young people if they`ve no jobs. As we`ve seen in parts of the Middle East it can create a time bomb”.

Recovery

In frontier markets the recovery is yet to happen. That is to say the stock markets have yet to recover and break through previous highs. Their economies however have recovered. But it hasn’t filtered down as yet to the stock markets. “What we`re selling here in frontier markets is really not something that has gone up very much because it hasn’t, no what we`re selling is something that is cheap and that’s when you want to buy a closed ended investment trust; buying something that has done badly rather than something that has done well.

Correlation

The MSCI Emerging Market index is almost completely correlated with the major indices in Western markets, whereas MSCI Frontier markets index is not. “So you tell me what the S&P does and I’ll tell you what Brazil, Russia, etc does too”.

“Frontier markets are not correlated with any of these. In fact they are not correlated with each other either. Which is why they have a lower overall volatility than developed Western markets such as the FTSE 100 or the S&P 500. This is because what happens in Saudi Arabia has no impact on what happens in Bangladesh. What happens in Argentina has no impact upon what happens on Vietnam. There just isn’t a person in London that looks at what Merkel says and presses sell and you get a wave of ETF selling across the developed and emerging markets worldwide. These frontier markets today, and I stress today have very low correlation to other markets”.

Vecht and his team have been running the investment trust for just short of two years. In this time on only 3 occasions has the market moved by more than 2% in a day. Even 1% moves are rare because the different market constituents offset each other. “This is a very low correlated market in which to invest” said Vecht.

Size of the market

The total AUM (assets under management) for emerging markets worldwide is $850 billion. This is for active and passive investments. In frontier markets, the total AUM is about $10 billion. “So if you think about it like this, 2 billion people around, and so far they’ve only attracted $10 billion of investment. That’s only going to grow. At the moment, these markets are illiquid but that is going to grow”.

Ignored

Look at bulge bracket banks and at how many of them cover companies. If we look at Barclays ABSA, its South African subsidiary, it is quite well covered, its Kenyan listed subsidiary however is not covered at all by the bulge bracket banks. We can do the same with Telenor, the Norwegian telecom company, its Russian subsidiary Megafon is well covered, but its Bangladeshi subsidiary is not covered at all.

“If you look through the latest factsheet or our annual report at the companies we’re invested in, you won’t have heard of many of them. We`ve been invested in many of these companies for 8 or 9 years. Not in the investment trust, that hasn’t been around that long but in other types of fund structures. It’s very important to realise we won’t invest in a company unless we`ve been to that country and visited. People don’t always tell us the truth in frontier markets, in fact they rarely tell us the truth. For us it’s really important to spend time on the ground, meeting the politicians, the journalists and the competitors. On the other hand we don’t believe it to be important to be based there. In fact we think that`s a disadvantage. We have a strong view that people who sit locally and live locally often cant see the wood for the trees”.

Controversy

On the prognosis for emerging or developing markets rather than frontier Vecht said “I head our EM (emerging market) team so I have a vested interest in being positive about EM. Although Em`s appear to be cheap on a P/E basis, they are far from being cheap at a Cashflow basis. Many EM’s today generated no free cash flow last year. Brazil last year generated negative free cash flow, so did China. EM trade about on about 50 times price to free cash flow. Free cashflow is not the only way of looking at things and many people don’t look at this metric at all. And if you`d invested purely on this metric you’d have lost a lot of money over time but it’s a great way of measuring if companies are investing profitably over time. Over the last 5 years the return on invested capital in EM has gone down from 18% to 12%. That’s basic economics, more and more cash chasing less and less returns. At 50 times price to free cashflow, the P/E might be cheap but the cashflow isn’t”.

Value investing

“What we strive to do in emerging markets is to buy cheap assets. If we go back a few years to Vietnam, 5 yrs ago it was a disastrous time to be buying Vietnam. 4 years ago it was Dubai, that was a disastrous time to be buying Dubai.

What we strive to do in our EM funds is buy cheap assets or buy assets in countries that aren’t about to have huge political problems, it’s as simple as that”.

Nigeria at the beginning of this year really wasn’t in vogue. We were buying banks at 3 times earnings because people thought they’d never recover but we were buying. And we’ve had a good year.

We`re still buying though with the market up so much and some of our bank stocks up 50 or 70% we`re perhaps less positive now, we`re not negative but valuation is the most important issue for us now, a point that’s often lost on people who are looking for stories or themes in markets, valuation is the very, very central point for us”.

“Value has massively outperformed growth in EM. Surprising for many people but true. We`re not value investors but it is a very interesting point.

The great thing about frontier markets is you can buy domestic growth very cheaply, where as in EM its 35 times earnings. In FM its 8 times earnings. FM markets are not as diversified. The first to be privatised tends to be banks so financials dominate.

Fees & leverage

Due diligence adds to cost in frontier markets so investment trusts in this sphere are not as cheap at some of the larger EM investment trusts. Blackrock Frontier charge 1.1% annually, with a 10% outperformance for beating the MSCI Frontier index. That gives a total on-going charge of 1.25%. Much lower than equivalent open ended frontier investment funds.

BlackRock Frontiers can gear up to 15%. If this is called correctly, gearing can enhance an investment trusts performance, enabling it to benefit doubly from rising share price and increased value of shares purchased with borrowed funds, usually borrowed for a very low rate of interest. Conversely it can be a value trap and compound losses if share prices decline.

Commitment

At WhichInvestmentTrust.com we like to see managers personal financial commitment to their trusts. Sam Veight only one holding in his SIPP, which is his frontier investment trust.

WhichInvestmentTrust.com view

Whilst it is a given that frontier markets are more risky, if not more volatile than developed and emerging markets when investments are spread across them, the fact that they are trading on such lowly valuations at present tempts me to dip my toe in the frontier waters. Whilst I would only allocate a small percentage to this area of investing exciting opportunities for substantial growth in share prices exists in frontier markets today.

It is impossible to say when that growth will kick in but for long-term investors such as us would be wise to consider allocating a few percent of their portfolios to this are of investing.

BlackRock Frontiers Investment Trust Metrics