How The Frontier Became The Mainstream: Why Investing Further Afield Is Generating Better Returns And We Might Soon All Be Invested In Iran And Iraq

Apr 29 2014, 4:42am CDT | by

Nigeria. Kazakhstan. Qatar. Pakistan. Estonia. Rwanda? Iran? Iraq? The investment universe for the curious buyer grows bigger by the day, and in recent years, ignoring the bigger indices has produced better returns than more familiar names.

Frontier markets have strongly outperformed emerging markets in 2013 and 2014, to the point where the MSCI Frontier Markets Index has moved to a 12-month forward P/E premium to the MSCI EM Index. According to Renaissance Capital, $22 billion of fund assets are now committed specifically to frontier markets, which have evolved into a reasonably large bloc: the 35 markets Renaissance looks at in the frontier sphere have a population of 1 billion between them, nearly $2 trillion of market capitalization and a daily turnover of $3.8 billion. They will be driven in future, Renaissance says, by two things in particular: one, demographics, with the working age population in five African countries and Iraq expected to rise by 15-21% in the next five years at the same time that it will fall by 1% in China and 6% in Russia. And two, “most importantly, 7 billion people now have an education level that can propel per-capita GDP higher in the coming decades,” Renaissance’s Charles Robertson says.

Renaissance runs a complex, multi-faceted model to look for the best frontier opportunities, combining macro conclusions about the country itself with metrics on valuation, growth, liquidity and analyst opinion. The outcomes are sometimes surprising. While Nigeria, which comes out on top in this model, is increasingly familiar to frontier-spirited investors, Kazakhstan, which ranks second, is much less so. The GCC countries – something of a special case, since they are rich and a long way from being frontier or even emerging, but have limited market access so don’t tend to appear in mainstream indices – all look strong, in particular Qatar and Saudi Arabia. In Asia, Pakistan and Bangladesh look much better options than Sri Lanka and Vietnam, while the best frontier Europe call is Estonia, and even thoroughly off-index bets like Georgia and Rwanda look promising.

At the furthest frontier, Iran and Iraq may well be on all our investment horizons within a few years, and in this respect, Renaissance is not alone. In recent weeks I have written on both of these countries for the Financial Times, here and here. In March, FMG, an emerging market and frontier research group, wrote an investment report on Iraq arguing that “there is a more promising side to Iraq.” This report noted that in the past decade Iraq has tripled its oil production, posted GDP annual growth rates of around 10 per cent, and seen the market capitalisation of its stock exchange almost triple in three years. Iraq’s own central bank is expecting 9.4% annual growth in GDP to 2016, Bank of America Merrill Lynch has said the economy could triple in size by 2024, and Citi has forecast it could become a $2 trillion economy by 2050 on the back of oil exports. The problem, of course, is security – hundreds can routinely die in bombings in a single month. But the uncomfortable truth is that this has had no impact on market behaviour: no country has shown faster EPS growth rates in the last five years than the Iraq Stock Exchange.

As for Iran, it has 9% of the world’s oil reserves, a broad manufacturing base and a large current account surplus. There is a reformist team at work both in the government and the central bank. “This looks to us,” says Robertson at Renaissance, “like a potential re-rating play that could – in an investable scenario – attract those investors who have recently invested in Saudi Arabia, like those who invested in Turkey after 2001 and Russia since the 1990s.” It becoming investable requires both a removal of sanctions and a growth in investor confidence around the repatriation of funds, but when that happens, Iran’s roughly $170 billion market cap is about the same as Poland’s; its $30 billion free float is bigger than the MSCI free floats in either Nigeria or Kuwait.

Frontier markets are not for everyone. They are by definition unpredictable. But a basket that combines a lot of them does offer the potential for some interesting themes: the emergence of Africa, and of frontier south Asia; demographic shifts; fund flows that have eschewed bigger emerging markets; and of course diversification. Nobody would be recommended to pile all of their money into Iran or Rwanda, but there is an increasing view that frontier markets have a place, however modest, in a diversified portfolio.

 
 
 

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