Frontier and emerging market investors have to contend with currency risk, which presents unique challenges relative to investing in more developed countries or the domestic market, but can also present opportunities to buy stocks on the cheap. As portfolio manager at Africa Capital Group, the specific currency issue I have been dealing with in 2013 is the decline of the South African rand.
The rand has been a real headwind for investors trading on the Johannesburg Stock Exchange. The rand has fallen by 8.9% against the US dollar since the end of April, and it has lost 14.1% of its value year to date. There are winners and losers from a currency in free fall, as exporters and tourism benefit and companies that rely on foreign imports suffer. On balance, however, a weakening rand is a negative for investors in the short-term, as they need to translate their rand holdings to dollars.
Several factors underlie the fall of the rand. First, the domestic economy has been negatively impacted by labor unrest in the mining sector, a widening current account deficit, and a tepid growth outlook. Secondly - and this is connected to the unfavorable domestic economic environment - there has been a breakdown in the correlation between the volatility index (VIX) and the rand. Whereas over the last decade the rand has moved in lock-step with the VIX, this year that correlation has broken down, as the rand has dropped in value whereas the VIX has moderated. This is not to say that the rand should appreciate, but rather that the rand's weakness is not a function of global fears, but is unique to investor sentiment towards South Africa.
A third and final head wind for the rand is the prospect of an end to the Fed's easy money policy. This is not unique to South Africa, however, and affects all emerging markets. As US rates rise, foreign investors retreat from emerging markets as yields improve at home and risk (funded by cheap credit) is dialed back.
The flip side of this decidedly negative coin is that as long-term investor there are more opportunities to find attractive stocks when they are priced in a cheap currency than when they are priced in an expensive currency. A focus on fundamentally sound companies will mitigate any short-term currency risks and in fact provides interesting opportunities to get into stocks at bargain prices.
The opportunity for US investors is the confluence of cheap emerging market stocks - with ETFs such as Market Vectors Africa Index (NYSEARCA:AFK) and the iShares MSCI Emerging Markets (NYSEARCA:EEM) down 7% and 12% respectively in 2013 - and a weak rand. This might make investing in an ETF such as the iShares MSCI South Africa Index (NYSEARCA:EZA), down 17% year to date, particularly attractive.
At the same time, it is sub-Saharan Africa, rather than South Africa, that has the greatest potential for growth. Therefore, a viable strategy might be to supplement an investment in EZA with directly investing in OTC traded stocks of South African companies with pan-African exposure, such as Standard Bank (OTCPK:SGBLY), Vodacom (VDCMY), and Shoprite Holdings (OTCPK:SRHGY). All these companies will benefit from both the mean reversion of the rand and the growth of African markets and can be bought on the cheap today.
Disclosure: I am long OTCPK:SGBLY, VDCMY, OTCPK:SRHGY. 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.