I was recently asked the question, "What is a Frontier market?" So, today I thought I'd follow up on our recent post, Cambodia - The New Emerging Market..?, wherein we had a conversation with the CEO of Leopard Capital, Doug Clayton, and answer this question as best I can.
Frontier Markets are those which are less developed than Emerging Markets. They are distinctly different from "Failed Markets," which are popularly referred to as "failed States" by the media. Examples of "failed Markets/States" would include Afghanistan, Somalia and Honduras.
At the risk of annoying a few folks (a risk I don't particularly give a hoot about) I could add to this list, "Failing States." In this category I would include the United States of America, the United States of Europe, and the United States of Great Britain. These "States" just haven't quite figured out that they're failing yet. Fear not, reality comes to all.
There exists a couple of core, or guiding concepts that have led me to invest so enthusiastically in Frontier Markets, and I wanted to share those with you today:
- It is my contention that people all over the world are pretty much the same when it comes to the desire to increase their own living standards;
- Each incremental dollar earned has a converse effect on the desire to earn an additional dollar once certain thresholds are met. Take for example a country such as Rwanda, with a per-capita income of somewhere around US$600. Earning one additional dollar per day translates into a 61% increase in income. I don't know of many people who would not wish to increase their income by 61%. Incentive is therefore high. At the same time in a country such as Qatar, with a per-capita income of roughly US$109,900, earning an additional $1 per day translates into a minuscule 0.3% net income increase. Hardly an incentive, and certainly nothing that will have any noticeable impact on the spending habits of a Qatari;
- Finally, but just as importantly, I want to invest in markets with as little correlation to the "Failing States" mentioned above as possible. It's a paradox that the countries that have been closed off to the global market place are less affected by trouble in the world's developed markets. At the same time some of these countries are moving towards opening their markets. The base level at which they are starting at is likely to rise even in an environment where the world's developed markets are de-leveraging. The risk/reward setup is greatly in my favour in certain Frontier Markets in comparison to developed western markets.
Closely related to point 2 above is the fact that frontier markets, since they are coming off of such a low base, allow for any small increase in per-capita income to create a disproportionately large return for investors.
With that said, there are Frontier Markets which can languish for many years and simply drain your capital. What is required is a trend change. Things need not necessarily get "good," but merely get less "bad" for an investor to make multiples on their money.
Some factors to consider when investing in Frontier markets
There are significant nuances to investing in Frontier Markets that are 180 degrees different to investing in developed, liquid capital markets.
Contracts are often worthless. Even if you're armed with lawyers, have realms of documentation and can cite the "laws" of the land ad nauseum, all of that is more often than not a waste of your money and time. If there does not exist a reliably functioning judiciary, you as a foreign investor will ALWAYS find yourself drawing the short straw. Instead, we believe it is better to focus on people, and acquiring a reliable network of locals to assist in transactions.
Often times in Frontier Market countries the social stigma of a poor reputation, and what it means to the person that is stigmatized, is your greatest weapon. Reputation has meaning to people within a small community. As a disconnected foreigner you are just an outsider, and often it is seen as being acceptable to "rip you off." Not so for a local.
So, finding local partners whom you can trust decreases your risks substantially. Try to find people with a lot to lose if their reputation is tarnished. They will typically be people who are successful from having added value to people's lives.
In Frontier Markets price discovery is difficult and erratic,and liquidity is poor. Both of these "disadvantages" are arguably the strongest reasons to invest in frontier markets!
Price discovery - The argument has been made that an outsider cannot better understand price than a local. This is a false assumption. As an outsider you often have a broader arsenal of experience available than a local does.
Bringing with you that broad view of the world, and having the ability to supplant knowledge, capital and expertise into a frontier market, allows an investor and or entrepreneur the ability to see how adding (technology, capital, marketing, product distribution, etc.) value can increase cash flows. Rising cash flows are a precursor to rising asset values, which will ultimately provide multiples on your capital investment.
It is far easier to find deeply undervalued and miss-priced assets in Frontier Markets than in well-developed, normally functioning markets. The lower the FDI (Foreign Direct Investment) in a country, ceteris paribus, the greater the opportunity to find and negotiate favourable terms as an investor.
Liquidity - Emerging Markets have liquidity, Frontier Markets have little to none. As such, the stresses associated with the daily, weekly or monthly price fluctuations inherent in liquid, deep markets allow an investor to focus on the fundamentals of a particular investment. The lack of liquidity itself goes hand in hand with the price discovery discussed above.
Non - Correlation - Traditionally frontier markets have shown a very low correlation to highly-developed markets. This is often due to isolation. Frontier Markets have often been cut off from the rest of the world. As a result they are often somewhat insulated from things like global recession, or even depression. These countries will not feel those effects, but rather manage to grow less-rapidly than they might when the outside world is booming.
So, coming full-circle, any incremental increase in living standards in Frontier Market countries has the very real potential to create significant returns on an investor's capital.
This is the present day situation in countries such as Myanmar, Rwanda, Cambodia and Zimbabwe. There are others that are at differing stages of advancement, like one of our favourites, Mongolia.
Consider that as little as 10 years ago investing in China, India and Brazil was considered "risky." Those were exotic investment markets not long ago, yet today they occupy large percentages in many a fund managers portfolio, and have provided the early investors and speculators with life-changing returns.
- Chris"our studies show that the frontier markets do not necessarily have greater risk. That's because in many of these markets, the volatility is not as great as in other markets, including developed markets, since the markets are not so liquid." - Mark Mobius