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osiris316
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Amateur investor. CFA level 3 candidate. Avid small cap and macro follower. Keen on a special situations and distressed investing. Currently seeking entry into the asset management industry. No prior professional investing experience. Adherent of Graham's value(fundamentals) investing ethos.
  • Investing In Frontier Markets 0 comments
    Oct 7, 2013 8:42 AM

    With the Federal Reserve deciding not to taper, there has once again been a flight of capital to developing economies. However, it is quite obvious that these countries will not be able to deliver the pre-recession level of returns and once these investments' returns are adjusted for risk their attractiveness drops even further. Consider the table below showing equity risk premiums (including country risk premiums) for the BRICS and select ASEAN nations and their post-recession market level of returns

    Country

    Stock market index

    Country risk premiums (%)

    Equity risk premiums (%)

    YTD return (%)

    2007 - DEC YTD gain (%)

    Brazil

    IBOVESPA

    2.63

    8.43

    -11.29

    43.6

    Russia

    MICEX

    2.25

    8.05

    +3.73

    19.2

    India

    SENSEX

    3.00

    8.80

    +3.67

    47.1

    China

    Shanghai Composite

    1.05

    6.85

    -0.15

    96.7

    South Africa

    FTSE/JSE

    2.25

    8.05

    16.18

    16.2

    Vietnam

    VNINDEX

    7.50

    13.30

    +21.28

     

    Thailand

    SET

    2.25

    8.05

    +6.21

    26.2

    Thailand is considered a developing market, but Vietnam is a frontier market. It is plainly evident from the table that these so called high risk markets have delivered superior risk adjusted returns in the post-recession era as compared to the popular developing markets.

    The case for investing in frontier markets

    The flight of capital from the developing markets out of fear that the Fed will roll back QE is evidence enough of their lack of credibility as sound investments. Pouring capital back into these economies will only be beneficial in the short term as the numerous institutional investors reacquire their favorite developing market stocks and bonds. Any wise investor would then pocket the profit and flee before another scare crushes asset prices. The underlying issues with these economies cannot be solved quickly as they require drastic structural reforms which most governments would be reluctant to implement. As such, it is left to the intelligent investor to find other assets in which to park his capital; assets that will be more resilient to changes in developed market policies.

    The underlying factor that drives asset price appreciation is GDP growth. The negative correlation between GDP growth and equity market returns is due to overenthusiasm. Investors rush into high growth markets to capture the returns from growth leading to an overshoot in asset prices and an inevitable correction. If the economic fundamentals are weak such a correction could lead to a panic and a run on the market. The wise investor should stick to his profit targets and bail when targets are reached so as to avoid the bubble rather than trying to time the exit. A little regret from missing returns is better than the despair of incurring a loss.

    Frontier markets can deliver superior risk adjusted returns as compared to developing economies. However, it is tough to decide which frontier markets deserve your money. What criteria should be used? Once cannot just chase GDP growth or market returns. If the underlying economics is bad then the slightest scare can lead to a market crash. At the same time, a healthy but low growth economy would not deliver the returns to compensate for an investment in a frontier market. The balance has to be right to get a sound investment.

    Political risk has always been an issue when considering investments in frontier market. However, stability indices point to a low likelihood that your investment will turn sour due to a localized market crash on account of social or political instability. Returns are more likely to wilt from poor asset selection or staying invested in a bubble. But the intrepid investor looking to actively select assets in frontier markets is likely to run into problems in acquiring the required data due to low transparency.

    Two frontier markets

    For those investors who are looking for alternatives to developing markets, I propose they look to the frontiers; and in the remainder of this article I will make the case for investing in two frontier markets: Kuwait and Oman.

    Country

    Stock market index

    Country risk premiums

    Equity risk premiums

    YTD (%) returns

    Kuwait

    KWSE

    0.75

    6.75

    37.83

    Oman1

    MSM30

    1.28

    7.08

    19.68

    Both countries have delivered high GDP growth. Although there are countries that have higher GDP growth than the aforementioned ones, what sets these countries apart is their low debt to GDP ratio, low external debt, budget surpluses and strong economies - having low inflation and low unemployment . Neither country has a current account deficit and being oil exporters, are unlikely to run a deficit in the foreseeable future.

    The majority of investors in these economies should be less likely to withdraw their capital in a moment of fear (Fed's tapering decision) since these markets will continue to provide superior risk adjusted returns as compared to the developed economies. In fact the returns are on par with pre-recession BRICS returns.

    Ideally to profit from frontier markets one has to be an insider with direct access to the information necessary for making investment decisions. Such an investor will be able to exploit the inherent inefficiencies in the frontier markets and thus achieve the much sought after alpha returns. The average investor should use ETFs or invest in companies active in the region to gain exposure to frontier markets. To protect against regional stock market volatility, pairs-trading strategies are recommended: going long local assets or the index and short a group of regional market indices or a broad ETF related to the asset. For example, if you choose to go long a petroleum company in Kuwait, short a frontier market ETF that includes several GCC markets and short a petroleum sector ETF. Thus, you can capture the growth due to the company's activities in Kuwait. Please note that even if the economy is good, it is folly to expect that all assets will do well. A poorly chosen asset will do badly regardless of the economic conditions, so be wary of the assets you select.

    Liquidity risk is always an issue for frontier market assets. For investors who are afraid of low liquidity there are ETFs available as an investment option. And for the even less adventurous, there are ETFs for ASEAN and high GDP African economies which are more widely covered by analysts. But in my opinion it would probably be better to invest in China than those high-growth, overpriced markets with unhealthy economies.

    The data shown below provides further evidence that frontier markets are not as risky are they are generally considered to be.

    General macroeconomic data

    Country

    GDP Growth - 2012 (%)

    Inflation (%)

    Unemployment (%)

    Public Debt to GDP (%)

    External debt to GDP (%)

    Kuwait

    6.1

    2.9

    2.72

    6.2

    17.5

    Oman

    5.0

    1

    15

    5.5

    13.3

    Uzbekistan

    7.5

    3.3

    4.8

    8.7

    17.8

    China

    7.5

    2.7

    4.1

    23

    9.38

    Brazil

    3.3

    6.27

    5.6

    65.1

    16.64

    United States

    1.6

    2

    7.4

    102

    102

    Credit Ratings

    Country

    S&P

    Moody's

    Fitch

    DBRS

    Dagong

    Kuwait

    AA

    Aa2

    AA

     

    AA

    Oman

    A

    A1

    B

     

    B

    Uzbekistan

        

    BBB

    China

    AA-

    Aa3

    A+

     

    AAA

    Brazil

    BBB

    Baa2

    BBB

    BBB

    A-

    United States

    AA+

    Aaa

    AAA

    AAA

    A

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Additional disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it.

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