- Due to low liquidity, frontier markets are highly influenced by foreign capital inflows and outflows.
- Political risks, exposure to oil, and variegate PE ratios advise against investing in frontier market ETFs.
- However, there is one low risk high reward option.
On the other hand, negative sentiment and capital outflows immediately create catastrophic declines. A great example is the Croatian stock market. As Croatia was getting closer to the EU and opening up to foreign investments, the increased capital inflows made the Croatian stock index quintuple from 2004 to 2007.
Unfortunately, the decline was even faster with the market returning to 2004 levels in less than two years as global investors pulled funds out and liquidity eroded. In today’s article, we’ll discuss the frontier markets investment thesis, analyze the current situation, and talk about the best investment options.
The bull investment thesis around frontier markets is based on the hope that their economies will grow at a faster rate than developed economies while offering increased global diversification. Economic growth and global integration should increase a country’s openness to foreign investment, transparency in the financial industry, and help to stabilize its currency. Accordingly, the frontier market should eventually be recognized as an emerging market, and see increased capital inflows and higher valuations, similarly to what happened in the Croatian example up to 2007.
However, the risks are omnipresent. Economic growth can be based only on one credit cycle which can send the country into a long recession as deleveraging is very difficult once foreign capital flows stop coming and the negative situations are amplified by low liquidity levels.
Frontier markets may have 22.8% of the global population, but they make up only 2.2% of global equity markets. The market capitalization of the complete MSCI Frontier Market 100 Index is only $84 billion.
There are several frontier market lists (FTSE, S&P, MSCI), and each of them gives a good picture of what is going on. 39 countries are considered frontier markets: 12 in Europe, 11 in Africa, 7 in the Middle East, 6 in the Asian Pacific, and 3 in the Americas.
Constituent countries are really frontier countries. Many of them are in politically unstable situations like Egypt, Ukraine, Bangladesh, Papua New Guinea, Argentina, Nigeria, etc. Unfortunately, the figure above doesn’t show better future economic perspectives than what developed markets have.
Frontier markets are expected to grow at a slower growth rate than emerging markets with 4% and even higher when considering Indonesia, China, and India. The only option for a smart investment is to look for extremely cheap valuations that justify the increased risk. I have managed to find some PE ratios to create an overview*.
Valuations are all over the place, from extremely high in the case of Romania and Croatia to relatively low but still high for frontier markets like Vietnam and Sri Lanka.
The variegate composition of the frontier markets index makes it very difficult to invest without being overweight certain sectors. Many of the above countries have economies dependent on oil and therefore the MSCI Frontier Market Index (FM) has suffered in the last two years, and has gone practically nowhere in the last 5 years.
The high political and development risks, normal to high valuations and exposure to oil, make a general investment in frontier markets a high-risk play. Investing in such an ETF might increase your international diversification, but due to the high dependency on foreign capital flows, I think that frontier markets are exposed to more downside than emerging or developed markets if things go south. As growth is also weaker than emerging markets, frontier markets aren’t a smart risk reward situation.
However, there is a way to benefit from frontier markets. The best way to approach investing in emerging markets is through a thorough fundamental analysis and increased country and situation risk knowledge. Such markets really offer undiscovered gems, but an investment shouldn’t be based on future growth. It should be based on immediate returns, be it in high dividends or extremely low price to book values.
Fortunately, the variegate valuations and liquidity issues provide some opportunities. The below figures show how valuations really are all over the place in frontier markets and investors with high country knowledge can really find gems.
Global frontier market ETFs will invest only in the most liquid names on those stock exchanges without looking at what the best investments really are.
In order to find such investments, you need to know the country and thoroughly analyze every investing option. This is usually the majority of the work, but in frontier markets you have to also open a brokerage account in the country, which usually requires traveling to the country which again takes a lot of time.
In order to gain specific market and stock knowledge, you have to also know the language and follow announcements on local stock exchanges. It’s a lot of work, but you only need a few great investments in your lifetime to achieve amazing returns.
Patience is also essential, but investing in frontier markets isn’t about waiting for them to develop, on the contrary, it is for immediate profits. The effort surrounding frontier market investing should immediately give you a stock that has a 10% dividend yield or a stable PE ratio of 5 that gives you a satisfying return immediately. It is much easier to be patient and wait for capital gains which will come when global analysts discover the gem. They will do so eventually as the market is a voting machine in the short term and a weighting machine in the long term. I always love a nice fat dividend while I wait.
Such, immediate high yield investments are the ones that should describe frontier market investing: high current and future potential returns attached to liquidity risks. However, Therefore, if you are not up to proper due diligence on a frontier market, you should avoid it altogether as there are plenty of good investment opportunities in emerging and developed markets.
It is very hard to follow all 39 frontier markets, so I follow and know in detail only one of them. In my case, it is Croatia. Croatia extremely overvalued at the moment, so I’m not invested. However, when a crisis comes around and hits the economy, I will invest again in great companies at amazing prices.
A crisis will come because the country’s investment rating is junk and the first increases in European interest rates will default it. Sectors like tourism won’t be affected and will represent a great investment opportunity. Such a situation rewarded me with excellent returns in 2003 – 2005 and 2009 – 2014. In the meantime, I’m patient and invest elsewhere.