A Few Thoughts On The Top Frontier Markets' Stock Exchanges Of 2012

by: Ulysses de la Torre

Recent attention to the best performing stock exchanges of 2012 warrants some consideration of these markets and just what exactly we should be concluding from some of these statistics.

At the top of the list is apparently Venezuela. For anyone paying attention to recent news from there, the second biggest story appears to be that its stock market has amazingly gained some 300% in 2012. Visually, this makes for a rather distorted image when comparing returns from last year's top frontier markets' stock exchanges, as we can see in the chart below:

Top 10 Frontier Markets Stock Exchanges vs DJIA

There are a lot of problems with this 300% number, and Miguel Octavio sums them up better than anyone else I know (here), but the long and short of it is that rampant inflation combined with a disorganized (to put it diplomatically) capital controls regime is yielding a wildly overstated performance result.

Looking at the real GDP growth of these 10 economies against the backdrop of their respective stock exchanges should emphasize this point even more:

2012 Stock exchange performance vs. real GDP growth

So for the sake of this discussion, I am going to ignore Venezuela, since this headline 300% figure can only be described as misleading at best.

What follows is of principal relevance for iShares MSCI Philippines (EPHE), iShares MSCI Thailand (THD), Market Vectors Egypt Index ETF (EGPT), and iShares MSCI Turkey index fund (TUR), and to a lesser extent, Market Vectors Africa (AFK), BNY Mellon Frontier Markets (FRN), Vanguard MSCI Emerging Markets ETF (VWO), and iShares MSCI Emerging Markets Index (EEM).

The following chart depicts the remaining top nine stock exchanges against the Dow Jones Industrial Average (DIA):

Top 9 Frontier Market stock exchanges vs DJIA

Of these nine countries, just four--the Philippines, Thailand, Egypt and Turkey--are tradable on a retail basis through an ETF. To what extent these country ETFs were ever intended to track local stock market behavior I do not know, but as we can see in the charts below, while 2012 ETF performance has loosely mirrored underlying local stock markets, the final returns by the end of the year left some rather noteworthy differences:

2012 Turkey stock exchange vs TUR

2012 Thai stock exchange vs THD

2012 Philippine stock exchance vs EPHE

2012 EGPT vs Egypt Case 30

The following chart illustrates more clearly just how different country ETF performance was from local stock market performance:

EGPT, THD, TUR, EPHE vs local stock markets

The double-digit leads EPHE and TUR have over their respective stock exchanges are worth taking a closer look at for a moment. I cannot see how either of these could continue running away from their home indices, but whether this means the ETFs retreat, the stock markets catch up, or some combination of the two is anyone's guess. If this were a more developed market, the obvious answer would be to turn this into an arbitrage play, but the impracticality of doing this in either country is yet another example of what makes underdeveloped markets "underdeveloped."

With those statistics established, and without burying ourselves in the local minutiae of these economies (an effort I will undertake at a later date in this space), there are a few broader macro points to consider before getting too excited about the potential of frontier markets.

1. Availability. Most of these stock markets are inaccessible to not just the average retail investor, but even many institutional investors. This leaves two primary roundabout ways of gaining exposure to these markets:

a) buy shares in blue chip companies who conduct business in these countries. The obvious caveat to this is that returns may be diluted owing to whatever business operations the company engages in elsewhere in the world;

b) invest through a specialized private fund. This option will likely be closed to the average retail investor, but for those who do go this route, be ready for a due diligence process that will be above and beyond the vetting process for even the riskiest of propositions in more developed markets.

2. Liquidity. Even for the countries here tradable via ETFs, the most liquid of these--Turkey--has an average volume that still only averages in the 200,000-300,000 range. THD and EPHE tend to be slightly less traded, while EGPT, AFK and FRN on most days struggle to even approach 100,000 shares traded, seriously staggering the price discovery process. Since Turkey's sovereign credit rating was upgraded to investment grade two months ago, trading volume has broken the half million mark on just four days, the first of which was not until a full week after the news broke. And by that point, TUR's share price had already dropped below its pre-upgrade level. By contrast, EEM and VWO, both of whose holdings are overweight in emerging and developed Asia plus Brazil, routinely turnover at the rate of tens of millions of shares daily.

3. Past results do not guarantee future performance. Specific to frontier markets, and particularly Africa, the proliferation of bullish-sounding prognostications (one of many examples can be found here) should give any prudent investor pause. The reality is that until some critical developments in areas ranging from infrastructure to competitive practices to rule of law take place, many of these markets will remain excessively dependent on economic activities that history has shown have limited ability to sustain real development. Commodities exports, as sexy as they can be in boom times, do not always translate to improved conditions on the ground. One of the more blatant testaments to this fact is that in the past decade, as gold prices shot up more than 600%, South African gold mining stocks actually lost value. Which leads to the next point...

4. Beware of Dutch Disease. Technically speaking, this is not just about oil, though that's usually the filter through which this phenomenon is discussed in a global economy context. Financial infrastructure in many frontier markets is still nascent enough in a way that has not been familiar to developed countries since before many of us were born. What this means is that price volatility for natural resources exports can have a disproportionately large effect on that country's ability to diversify away from whatever its rainmaker export is. From the above list of countries, Nigeria is the clearest example of this, despite some bright spots in its entrepreneurial class. Given the cyclical nature of demand for many commodities, this may be an even stronger argument than the previous point that past results definitely do not guarantee future performance.

5. "Markets can remain irrational a lot longer than you and I can remain solvent." That famous quote, from John Maynard Keynes, applies every bit to today's global macro environment as it did when he said it last century, perhaps even more so. How it applies here is that just because the price of, say, EGPT, is rising does not necessarily mean that Egypt is finally finding its long-awaited footing; it may just mean capital flows are choosing what momentarily appears to be the least bad among many bad options for allocating funds. And when a better option resurfaces, that money will no doubt move on, which brings us back to the liquidity question raised above in point 2.

6. Political Risk. Attention to this topic in investment circles has been rising and rightfully so. From my experience, this is without a doubt the most misunderstood risk when investors assess frontier markets opportunities and I have yet to find anyone who has defined it to my liking. So following is a brief note on how I currently think about political risk based on what I have seen and heard over the years.

In a sentence, political risk is the risk a country's change in political structure or policies will result in a loss on an investment in that country. Under this very large umbrella, I further break down political risk into two sub-categories:

6a. Governance-related political risk. This is the risk of a counterparty--from either the public or private sector--altering or breaching a contract. Implicit here is adherence to rule of law as well its flip side: to what extent corruption governs how business is conducted (bluntly, how much palm-greasing is required for the government or whatever ruling authority to allow you to keep your asset or contract?). Practically speaking, this can take the form of fluid tax laws, tariffs, asset expropriation, anything a legislature might fight over, restricting profit repatriation or how ownership is defined--this last one has become increasingly more prominent in countries dependent on natural resources. But even within the ownership question, another question presents itself: does a particular asset stand the risk of being taken over directly by the government (Venezuela, Argentina, Ecuador, Bolivia) or simply by a "private" sector business that happens to be run by someone friendly with the government (Russia)? Governance-related risk is also strongly related to the notion of political stability but note that democratic processes and/or freedoms need not exist for a country to be considered politically "stable" (UAE, Qatar).

6b. Conflict- or security-related political risk. This has to do with the risk of an investment losing value or outright vanishing as a result of armed conflict (suicide bombings, civil unrest, riots, war) or potentially violent security-related events such as kidnapping, hijacking, narco-trafficking, piracy (the high seas kind) and robbery. Here too, a further drill-down question arises: is the conflict internally-sourced (i.e., arising from local instability, as in Pakistan, Nigeria, Mexico, the Sudan and all things Arab Spring-related) or externally-sourced (arising from the threat of infiltration or invasion by outside parties, a la Lebanon, Iran, Iraq, Israel)?

The bottom line: don't stop at the headlines. One of the biggest challenges to frontier markets investing is acclimating to information standards that bear very little resemblance to the normalized metrics of blue chip investing. Given the soundbite-driven nature of today's global capital markets and a natural preference for optimism over realism, there can be a tendency to oversimplify or even ignore the nuances underlying many of these markets.

Those unconcerned with any timeframe beyond the next five minutes, today's close or even the current quarter would probably do well to stay away or at most just spin the wheel and take whatever short-term gains or losses that may accrue from a short-term outlook. Those inclined toward a longer time frame should realize by now that there is no catch-all formula, and getting the research right requires an effort far surpassing that required for more developed markets. Not all of the top stock markets of 2012 will continue outpacing their developed market counterparts, but not all of them will reverse course either. The question remains: which ones have the best chances for long-term sustainability and why?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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