- A broad, thematic search for GDP growth in the 2010s led some investors to frontier market investing.
- In my view, economic growth alone cannot provide equity performance; long-term investment returns are best created by entering positions at reasonable, if not attractive, valuations.
- It may not be growth that makes frontier markets a viable investment destination, but their potential for under-appreciation, mispricing, and cheap valuations.
In my role as Managing Director of Business Development and Client Services at Seafarer Capital Partners and in roles at prior firms, I have been fortunate to spend the last 15 years working with investment professionals with deep knowledge and experience in the developing world. I have also attempted to stay well read and informed as to how other investors in the emerging markets are communicating with their clients.
To help developed market investors understand the emerging markets, many asset managers resort to describing broad themes as the sources for identifying investment opportunities. This approach is helpful when introducing a concept that is completely foreign to many investors but can lead to misunderstandings of the more nuanced realities in these rapidly evolving economies. I am proud to work with members of Seafarer’s investment team, who attempt to embrace these complex realities and provide a balanced view of the risks and opportunities in our focus markets. I am writing from this client-focused perspective to discuss a theme in the developing world that, while popular immediately following the Global Financial Crisis, is now broadly considered a bust.
The Ill-fated Search for Growth in Frontier Markets
One of the hottest parts of the developing world in the years after the Global Financial Crisis was the idea of frontier markets. Think back to the year 2010: China had completed another decade of high gross domestic product (GDP) growth coinciding with equity market returns. Chinese stocks then recovered rapidly in the aftermath of the financial crisis. Projections for Chinese GDP and currency growth were elevated, and valuations were starting to look a bit stretched. At the time, many clients I worked with were starting to question how long this growth in China could last. I was often asked if China was about to hit the Middle Income Trap, a situation in which average income per capita stalls before reaching thresholds associated with developed economies. This concern caused many of these investors to seek out the next country – or set of countries – with the potential to create the type of GDP growth that China had produced for the twenty years prior.
This search for GDP growth led some investors to frontier market investing. Many new funds were launched to address this growth opportunity. Assets flowed into these funds seeking high returns. Ten years later, we now know that the idea didn’t pan out. Over the last decade, the frontier markets have underperformed emerging markets, which themselves have significantly underperformed the developed markets. Most of the funds launched to address the “frontier market” growth opportunity have been shuttered and their investors bitterly disappointed.
It would make sense that if GDP growth is what made the emerging market (EM) asset class – led by China – such an outperformer for the first decade of the 21st century, investors should seek out markets that had the potential for elevated GDP growth. This thematic approach had investors searching for countries in earlier stages of development under the assumption that those economies would become richer, experience GDP growth, and provide equity performance.
The first problem with this thematic approach is that underdeveloped markets do not always get their economic houses in order to become “rich.” Secondly, it was not GDP growth which created the EM equity performance of the 2000s, but rather publicly traded companies growing their earnings. In many cases, frontier markets are too small to produce domestic companies able to service their local economies. These countries are often mostly served by multi-national brands and small “mom and pop” shops. Finally, and most importantly, growth alone cannot provide equity performance. As capital flowed rapidly into these small, illiquid markets, valuations quickly ran to high levels. By the time most investors could access these markets via funds, they were buying in at particularly high valuations. No matter the stage of economic development of the country in which an equity is listed, I believe that long-term investment returns are best created by entering positions at reasonable, if not attractive, valuations. Identifying reasonable prices is very difficult to do on a broad thematic basis; it is best done by in-depth security-by-security analysis.
Value Investing in Frontier Markets
An investment approach that focuses on identifying attractive valuations is a very different animal than the broad, thematic growth approach which led investors to rush to the frontier markets. Particularly in the developing world, when investing in equities trading at low valuations, investors need to ensure that the stock is not cheap for a reason. Many bad businesses trade cheaply, but are cheap for a reason and are likely to become worse – this is known as a value trap. Stocks trading at a discount to a fair value with the ability to provide performance by appreciating to a fair value are actually quite rare. To successfully implement a value approach, the investor must research and know each security individually; as a result, they should understand why the security is trading where it is and what could cause the security to appreciate to a higher valuation. In the end, the fact that a stock trades in a smaller, out-of-the-way country could contribute to the stock trading at a discount to its intrinsic value.
Seafarer’s Paul Espinosa, Lead Portfolio Manager, identifies seven sources of value in his white paper On Value in the Emerging Markets. One of those sources of value is a criterion he calls Segregated Market. He describes these markets as being smaller or out of the mainstream view. These markets tend to have fewer analysts covering companies, allowing for stocks to be lost in the shuffle and mispriced. Often securities in these markets have lower liquidity profiles than securities in larger markets. This lower liquidity is a risk of which investors must be aware; however, investors with longer time horizons can benefit from lower liquidity levels.
Frontier Markets, Revisited
For this reason, ten years of disappointment later, the opportunity to find unique investment opportunities in the frontier markets may finally be upon us. The reasons why the frontier markets could now be an interesting destination for capital is completely opposite of why investors went to these markets before. It is not growth that could make these markets attractive, but their potential for under-appreciation, mispricing, and cheap valuations.
To be fair, most cheap stocks in these markets will turn out to be value traps. Investors will need to do the work at a bottom-up, security-by-security level to understand why each individual security is trading at its valuation level, in order to identify those which have the potential to appreciate to higher valuations. In addition, the opportunity set in frontier markets is likely far too small to be considered an asset class of its own. Ironically, it is possible that frontier markets could be an additive part of a well-diversified global equity portfolio, but primarily in the context of a highly selective value approach instead of a top-down growth theme.Daniel Duncan
- The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.