A Frontier Too Far?
The African markets are still considered a frontier too far for many, but over the last 12 months a number of managers have entered the space, on the back of roaring commodity prices and capital inflows from China and India.
“There are 200 corporates in Africa but these are under-researched opportunities,” says Stuart Culverhouse, chief economist at Exotix, a securities dealer in frontier markets. “Some markets have had reasonably good runs like Kenya and Ghana, and Zambia’s index doubled last year. Nigeria has also had three years of relatively good growth. But new funds are being set up to invest in this area every week, which helps explain why the performance has been so good.”
Mark Mobius, manager of the Templeton Emerging Markets Investment Trust, is cautious about many of the Sub-Saharan African markets, but is upbeat about their future prospects. “The growth potential in Sub-Saharan Africa is very great so we will be doing more there as we go forward, but it is going to take time,” he says. He warns that within each market there is an incredible variation in valuation and liquidity, whilst in many cases local investors still dominate.
Infrastructure push
Despite a mixed political backdrop, he sees Nigeria, Kenya and Ghana as amongst the most interesting markets. “Kenya has a pretty good history of capital market development, but we’ll have to live with political problems for a while in this region. The good news is that it is attracting a lot more investment than it has before, particularly with the Chinese, Russians and Indians moving in. And whenever you have that kind of push, you start to get infrastructure working.”
But he adds that markets like Namibia are still too small to be of interest: “When I first went there, the stock exchange was in a shopping centre,” he recalls. “And when I first went to Botswana, I walked into a broker’s office and said: ‘Where’s the stock exchange?’ And he said: ‘Turn around, you’re in it!’ I turned around and there was a list of stocks. This is the kind if thing you have.”
By contrast, Nigeria has attracted a lot of the initial interest from foreign investors because of a healthier financial sector. “Banking and insurance reforms are encouraging institutional domestic investment in Nigeria,” says Culverhouse. “The market has been led up by banks, but 8 percent non-oil GDP growth is helping the stock-market.”
Stephane Bwakira, manager of the Standard Africa Equity Fund, which invests across the continent and now has some $330 million under management, says that the recapitalisation programme in Nigeria has led to a lot of consolidation, with the number of banks in Nigeria falling from 89 to 23. “Most of them now have at least $1 billion in capital which has made them stronger and able to take on big transactions in the oil and gas sector, and the big infrastructure projects,” he says. “Historically these have gone to foreign investment banks, but the local content requirement has helped.” This says that a percentage of any business undertaken by the big conglomerates must be transacted through the local banks.
Credit expansion
The banks have also ramped up their businesses following debt write-downs, and are now taking on real risk. “The banks are competing for the same corporate business so their margins are thinning out, and therefore they are now starting to lend to retail customers,” explains Bwakira. “We are seeing mortgages, car loans and credit cards creep up. There are still some legal issues to be sorted out but the banks are expanding their footprints by opening more branches to get more clients onto their books.”
He adds that it is a similar picture in Morocco for mortgage lending, and property developers are seeing a big increase in business due to government-sponsored low income housing programmes which offer developers tax incentives. Meanwhile, the growth of housing in Egypt for the young professional classes is also supporting the expansion of real estate and mortgage lending.
Bwakira’s fund is not untypical in spreading its net wide, including stocks listed on other exchanges that transact the majority of their business in Africa, as well as MNCs with local listings. Despite the high risk associated with these small, illiquid markets, Bwakira argues that diversification across the continent offers a natural hedge. This means that when Kenya experienced violence following the disputed election earlier this year, this had no ripple effect on Zambia, and a positive effect on Mauritius, which inherited some of the tourists that might otherwise have gone to Kenya: “There is very little correlation between markets and currencies.”
He too is upbeat about the future for this region: “We have seen a lot of interest and flows, whereas three years ago it was very difficult to get anyone to even look at it, but the perception is quite different now. Africa is the last frontier market, but people are buying the long-term growth story.”
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A question of perception
When is an emerging market no longer an emerging market? Is it when it attains investment grade status? Or is it more philosophical, more abstruse than that? For specialist debt investors like Jerome Booth, head of research at Ashmore Investment Management, it’s a rather specious issue.
“You don’t go from being an emerging to a developed market because your creditworthiness improves,” he says. “That’s a total myth. You go from being an emerging market to a developed market because the investor base allows you to deteriorate your creditworthiness if you want.” For example, Romania recently joined the EU, and is therefore viewed as becoming “developed” but is heading for a 14% current account deficit this year. “There is no way that they would be allowed to get away with that if they were an emerging market. It is about risk perception,” Booth argues.
Booth says that the credit crunch, triggered by the implosion of sub-prime securitised debt, has put the real value of unleveraged emerging market paper into perspective. “No one ever bought Brazil without thinking it was risky – including Brazilians. But I believe Brazil has a lower default risk than Italy over the next 10 years. If Italy does leave the euro, one of the obvious ways to do that is to translate all the bank accounts into new lira, which would be an active default.”
Booth argues that corruption is not just an emerging market phenomenon but in emerging markets, the risk is priced in. For Booth, this is one of the fundamentals of investing in this space: “Where we see political and macroeconomic developments impacting asset prices, we can use our expertise. But where the domestic investor base doesn’t even think about their country’s own sovereign risk, that is not an emerging market, and our skills won’t add any value.”
This is also why he sees the credit crunch having an important impact on asset allocation – it’s a case of rethinking the map. “Pension funds will have to accept that in the next 15 years emerging markets will be much more important, but they are still massively under-represented in institutional portfolios.” Booth wants to see institutional investors allocating some 35% of their portfolios to emerging markets, across asset classes. “This isn’t just peripheral any more. This is a wake up call for asset allocators – maybe they shouldn’t be buying so many US Treasuries or US and European corporates.”
Corseted currencies
The current opportunity in emerging market debt revolves around the anticipated appreciation of emerging market currencies against the dollar, and this has led to high inflows into local currency paper over the past year. “A lot of the emerging markets have got semi-pegged exchange rates, or there has been restrained appreciation, and like a corset, that has forced a lot of the dollar’s weakness against the euro,” says Booth.
He expects to see greater currency appreciation in the next 12 months as emerging markets try to get inflation under control. “The US needs to be realistic about what is possible,” he warns. “You can’t expect these countries to appreciate their currencies without selling dollars and that’s going to be painful. But there comes a point where you don’t want to be throwing good money after bad.”
Some two-thirds of foreign capital flows into emerging market debt is going into the $3 trillion local currency sovereign bond market at present. But there is also a growing sub-segment of corporate debt, worth some $2 trillion. The longer-standing hard currency sovereign debt market is worth about $1 trillion, but doesn’t offer great value, according to Stuart Culverhouse, chief economist at Exotix, a broker for frontier market securities.
“Up until the credit crunch, spreads had narrowed across most emerging market hard currency debt so there was less value there. That reflected better fundamentals and liquidity conditions,” he says. “Since the credit crunch, these have widened out a little but not as far as developed high yield or investment grade corporate credit, so this is still not seen as offering great value. For example, you are looking at 7% to 8% yields for low ‘B’ rated credits in Sub-Saharan African countries and people would generally expect more from these markets, such as 10% to 12%.”
Some investors have instead sought to add value by picking up some of the new corporate issuance which has come onto the market recently. At the start of the year, corporate issuance was down, but in Q1 this rebounded, especially out of Russia. “Those deals were interesting, but with some reservations,” says Claire Husson, portfolio manager and research analyst in emerging markets debt at the Franklin Templeton fixed income group.
She adds that corporate debt from former state-owned enterprises often offer an interesting credit risk premium, but a number of financial issuers weakened following the credit crunch, and are now coming back at attractive levels. “This is the sector where we see the highly leveraged names and this is where the risk could erupt,” she warns.
New issuers
Although she has some exposure to corporates, Husson favours a mix of sovereign debt from established and new issuers in frontier markets in Africa and Central Asia. In the past 12 months new issuance has come from sovereigns that don’t necessarily need to borrow, such as Georgia and Gabon: “They are coming to market to access relatively cheap financing, and by doing so, expect to raise the profile of their industry and banks, thereby stimulate the economy. That has been an interesting development in Africa and Central Asia,” she says.
Husson believes that these small upcoming economies, who want a piece of the globalisation pie, tend to be much more prudent than people might expect: “They make strong efforts to disclose their financials and are improving their corporate governance. They are also fine-tuning their loan systems so that potential creditors have some recourse in the event of default.”
But Booth says Ashmore prefers to invest in these markets via real assets, through its Global Special Situations Fund, or originating its own transactions in is Emerging Market Corporate High Yield Fund. “Traditionally the Special Situations Fund was distressed debt, but now a lot of it is private equity,” he says. “Over the last 10 years the average rate of return on exited deals has been 37 percent, and that is all non-leveraged. And because it is event-driven it has not been impacted by the credit crunch at all.”
He expects these assets to be supported by a flow back of funds from emerging markets investors who have traditionally put money abroad. But he concedes that it is not easy to get access to the good deals – a constant refrain for Western investors hunting for real asset investments in emerging markets.
“A lot of money is chasing the infrastructure deals but in a lot of cases the spreads are very unattractive,” he says. “To get the really high rates of return you need to have a strong relationship with decision-makers in emerging markets going back years.” He says the fact that Ashmore specialises in emerging markets has proved advantageous in terms of getting deal flow.
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Welcome to the new frontier
Emerging markets may still be hotter than a freshly-baked biscuit, but to some asset managers they are already yesterday’s soggy leftovers. No, for the real adventurer, frontier markets are where it’s at. These markets may be shallow, illiquid, or hedged around with foreign ownership restrictions, but the prize for finding the next BRIC is just too good to pass up.
Of course, there are a lot of small markets out there, and some may just trundle on for years without industrialising. So how do you decide which to target? Well, Credit Suisse Research recently developed an index to identify key global frontier markets and resolve this conundrum.
Credit Suisse argues that whilst the BRIC countries represented just 4 pct of global market cap at the end of 2003, this figure has now risen to over 14 pct, which is more or less equivalent to their share of global GDP. At the same time, their valuations have risen. “Emerging markets used to trade at a 50 pct discount to developed markets five years ago, but this valuation gap has now almost closed,” says Lars Kalbreier, head of global equities and alternatives research at Credit Suisse. “Furthermore, in regions such as Asia ex-Japan, some emerging markets are now starting to trade at a premium relative to developed markets.”
Indeed, some countries that are still generally referred to as emerging markets, such as South Korea and Taiwan, now have a very similar economic profile to developed countries, and have arguably emerged. Kalbreier points out that Korea has a GDP per capita that is higher than those of Greece or Portugal, and computer ownership per head is higher than in Italy.
Instead, Credit Suisse argues that investors should be looking at countries that are still at an early stage of development, as many of these markets have been overlooked or difficult to access. “In order to be successful, investors have to identify those markets that demonstrate the same characteristics as the traditional emerging markets did before they improved their economic status,” it says.
Credit Suisse’s index selects frontier markets according to the following criteria – macroeconomic potential, population well-being, financial market development and political stability. It includes African states Botswana and Tunisia, LatAm’s Peru and Colombia, one-time investor darling Vietnam, and former Soviet republics Ukraine and Kazakhstan. S&P’s similar Select Frontier Index also finds room for Cambodia, Pakistan, Panama and the UAE.
Favourite frontiers
Managers cite the diversity of this asset class as a hedge against volatility, but certain markets come up again and again. The unlikely-named Ho Chi Minh Stock Exchange has seen frenzied activity from foreign investors in the last 12 months, as its low cost base is viewed as attractive to manufacturers who worry that Chinese inflation will erode their margins.
“Although Vietnam still has a communist government, the leadership seems open to business and keen to emulate the kind of rapid development they’ve seen in neighbouring countries,” says Giles Keating, global head of research for private banking and asset management at Credit Suisse. But as Keating warns, there are risks attached to this market, and those risks need to be reflected in an attractive price. “The market has fallen back a little recently, which is good news in terms of putting new money in as it offers a more attractive entry point, but there are moments when Vietnam looks as if it has attracted a bit too much investor attention,” he says.
Whilst too much attention can make a small market swell too quickly, too little activity also poses problems for frontier pioneers. Andrea Nannini, manager of the HSBC New Frontiers Fund, which launched at the start of February, has a three-year track record in these markets and is used to sourcing stock through different channels.
“The liquidity in these markets is still poor, particularly in Sub-Saharan Africa, where some stocks don’t trade less than 100,000 usd a day,” he says. “In such a case, you have to establish relationships with a few of the local players and find brokers or investors with blocs of shares that they are willing to sell, and negotiate terms with them.”
He adds that liquidity has improved in the Gulf states and some of the former Soviet satellites as more foreign investors are operating in these markets, so the turnover is higher. “Also, there has been a high number of IPOs in the last couple of years with more companies coming to market, and in 2008 and 2009 the pipeline looks very big.”
Foreign ownership quotas
Another problem in accessing these markets is that there can be restrictions on foreign ownership levels. “The Middle East does have quotas on what percentage of the share capital can be owned by foreign investors,” confirms Nannini. “There are a few stocks where the limit has been reached and in those cases there is not much you can do, but a number of companies have gradually increased their limits and that is definitely the trend.”
He predicts that in a few years most of the restrictions will have been removed, especially in the case of the non-government related companies. For markets like Saudi Arabia, which is still closed to investors, the only approach is to buy local mutual funds or synthetics on the whole index.
The recent turmoil in Pakistan and Kenya is a reminder that political risk also remains an issue, but Nannini argues that investing across a variety of countries and regions helps diversify this away. For example, in January, the segment as a whole was flat, whilst everything else was down by 15 or 16 pct. “This is because although Kenya and Pakistan were going down, the Gulf states and Nigeria were going up, so this lack of correlation within the asset class is a very strong proposition.”
He sees the main risk to frontier markets this year coming from commodity prices because most frontier markets are also big commodity producers, and relative to the size of their economies, commodity prices matter. However, he thought it unlikely that commodity prices would fall back to the levels of 2001 or 2002, at the beginning of the rally.
Ultimately, it comes down to good corporate governance and clued up management, and Nannini says he makes sure he travels as much as possible to be as close as he can to the companies: “This how you find interesting ideas – going places where no one has gone before.”
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