The Fat Pitch Lurking In Frontier Markets

by: Sean Wilson, CFA


Frontier Markets were no exception to poor performance in 2015 with the average FM Index down 13.4%.

Value stocks within Frontier Markets underperformed FM growth stocks by 1,600 bp in 2015.

Valuation of value stocks relative to growth stocks in Frontier Markets are near historic lows.

The last time value stocks in Frontier Markets were this cheap was January 2009 and outperformed growth stocks by an astounding 4,200 basis points during the following 12 months.

The Fat Pitch Lurking in Frontier Markets

2015 was a challenging year for most investors as global growth concerns reduced risk appetites globally. Frontier Markets were no exception with all major Frontier Market indices posting double-digit negative returns.

That said, I have not been this excited about opportunities within Frontier Markets since 2008 and the work recently completed confirms my enthusiasm. To borrow a phrase used by my former boss and mentor at GMO, Jeremy Grantham, there is a "fat pitch" lurking in Frontier Markets - a baseball reference to game situations when odds of getting an easy pitch to hit are high.

This fat pitch is in value stocks in Frontier Markets. Relative valuations of Frontier Markets value stocks are near their 2008 low relative to Frontier Market growth stocks. We define "value" as the bottom two quintiles of our investible Frontier Market universe based on price-to-book and "growth" as the top two price-to-book quintiles. By creating "value" and "growth" indices, we analyzed the yearly returns of each subset of stocks. The value and growth indices were rebalanced each quarter and were calculated both by equal weighting and market capitalization weighting the constituents. The results are as follows:

For the period of 2007 to the end of 2015, the value index had an average price-to-book discount to growth stocks of approximately 70% ranging +/- 10% over the nine-year period. Not surprising, value does not do well during periods of heightened market risk. Regardless of whether the indices are weighted equally or by market capitalization, value massively underperformed during 2008 and 2015 relative to growth stocks. In fact, value stocks performed abysmally, underperforming by 1,600 basis points versus growth stocks in both years.

The performance of value versus growth when market risk abates and valuations mean revert is powerful. During 2009, value stocks trounced Frontier Market growth stocks by a whopping 4,200 basis points. This is remarkable and highlights the low intra-correlation among Frontier Market stocks given that the two indices are created from the same Frontier Market universe and are not separate asset classes such as stocks and bonds. In addition, by comparing the difference in performance between the market cap weighted value index and the equal weighted value index, it is clearly evident that large cap value does much better than small cap value during subsequent rebound periods. Admittedly, this is a small sample size, but it is hard to make an argument why today value should be permanently impaired.

Some investors may find it psychologically easier to allocate to an asset class as it is rising. However, the recent sell-off has provided a plethora of undervalued Frontier Market stocks that are less exposed to global uncertainties. For long-term investors, the recent market rout may prove to be an excellent entry point for those who have been contemplating an allocation to Frontier Markets.

Disclosure: I/we 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. I have no business relationship with any company whose stock is mentioned in this article.