Frontier markets, once given a wide berth by investors because of their poor market infrastructure and high geopolitical risks, are fast becoming a sought-after investment, even more so in the current challenging environment for global equity markets.
So far this year, the MSCI Frontier Markets index has gained 19.8 per cent, compared with the MSCI World index, which has returned just 3.8 per cent.
For investors who have opted for an index-based strategy, this is certainly something to write home about.
However, prior to the United Arab Emirates (UAE) and Qatar being promoted to emerging markets status, the MSCI Frontier Markets index was dominated by three large Middle East Gulf markets – namely Kuwait, the UAE and Qatar – which accounted for more than half of the index.
In fact, as many as 15 countries had less than a 2 per cent weighting in the index.
Many of those smaller markets hold phenomenal promise for long-term investors, as do those markets not included in MSCI’s definition of frontier, most notably Saudi Arabia, whose stockmarket dwarfs those of its peers.
Following the rebalancing at the end of May this year, the country concentration of MSCI’s Frontier Markets index has become even more acute. Kuwait now makes up more than a quarter of the index.
Furthermore, Nigeria accounts for 19.2 per cent and Argentina 7.6 per cent, leaving passive investors with more than 50 per cent exposed to just three countries, highlighting the concentration risks inherent in pursuing an index-based strategy in frontier markets.
Kuwait, with an economy almost entirely dominated by oil, is among the more expensive frontier markets. Valuations, combined with troubled politics and a lack of spending by the government, mean the long-term outlook for returns from the Kuwaiti stockmarket is challenging relative both to its more dynamic Middle Eastern neighbours and other frontier markets further afield.
Kuwait also suffers from a tense history with neighbouring Iraq, having been temporarily annexed by that country under Saddam Hussein.
When it comes to Nigeria, a lot of the focus recently has been on large-cap consumer goods companies. However, many of these firms now look fully priced, as companies such as Unilever Nigeria and Nestlé Nigeria are all trading on current year price-to-earnings multiples in excess of 30 times.
On the flip side, the Nigerian banking sector does look good value, offering some of the highest growth at the lowest valuations in frontier markets.
In Argentina, the stockmarket will continue to be driven by politics until elections in late 2015.
While we are positive on the prospects for a recovery in asset valuations on the back of the political change that is likely to occur as a result of those elections, any number of negative surprises could impact markets between now and then.
The economy continues to struggle under the burden of high inflation and irrational economic policy.
While the larger frontier markets should not be ignored, a well-diversified portfolio would also allow investors the opportunity to gain access to some of the smaller frontier markets that offer compelling fundamentals and reasonable valuations, along with greater opportunities to uncover interesting companies.
