Frontier markets were all the rage a few years ago, as rising risk tolerance and a quest for outperformance drove investors to consider economies they had previously avoided. Then in late 2014 came the collapse in commodities prices, particularly oil, and inflows turned to outflows as money managers retreated for safer havens. Now it looks like the trend is primed to reverse again, according to Andrew Howell, who leads the Citi squad to first place in Frontier Markets on the 2016 Emerging Europe, Middle East & Africa Research Team, Institutional Investor’s annual ranking of the region’s best sell-side analysts.
Survey participation supports his optimism. A Frontier Markets category was added to the ballot last year but did not garner sufficient voter response to warrant publication — whereas this year we have a full roster.
Howell, who earned a bachelor’s degree in comparative literature at the University of Pennsylvania and an MBA from France’s INSEAD, worked in Moscow as a management consultant for Deloitte before joining Citi in 2002. Although this is the first time he and his associates have earned recognition in the Frontier Markets category, the 45-year-old is certainly no stranger to the survey. He has appeared six times before, as leader or co-leader of equity strategy teams that ranked in every region this survey encompasses. Thomas W. Johnson, II’s Director of Research, asked the New York–based strategist to explain why investors are reconsidering their approach to frontier markets and which economies in particular hold the most promise.
Is investor interest in EMEA frontier markets increasing?
We are starting to see some signs — helped by the stabilization in global commodities prices and risk appetite — that frontier markets may indeed be coming back into focus for some investors. Encouragingly, frontier funds saw a net inflow in March for the first time in 18 months, and a number of fund managers that we speak with mention a pick-up in interest among their clients. We will see if this revival proves to be a flash in the pan, or something more durable.
What impact, if any, is tightening by the U.S. Federal Reserve likely to have on investor interest in this asset class?
Conventional thinking goes that higher U.S. interest rates pose a risk for emerging and frontier markets, as they will suck capital out of these economies as investors seek higher returns in the U.S. We see it the opposite way and say bring it on. In our view, tighter Fed policy — and more importantly a steeper yield curve — would signal growing confidence in global growth, which is a key ingredient in the success of frontier markets. This is very consistent with the historic pattern, in which higher bond yields correlate closely with the relative performance of frontier markets.
What are investors’ greatest misconceptions about allocating money to frontier markets?
Probably the greatest surprise for investors that come to the frontier markets is just how well run many of the companies are, even in these remote geographies. It is true that most frontier economies are less developed economically, with weaker infrastructure and institutions — and as a result, can be unpredictable, volatile places to do business. But despite this volatility, or perhaps because of it, many frontier markets CEOs and their management teams tend to be adept at identifying profit opportunities and shielding their businesses from downturns. Take Ukraine: the country has spent the last couple of years in recession, reeling from a currency devaluation and near default. And yet two of the larger listed Ukrainian companies — agricultural businesses Kernel Holding and MHP — generated near-record cash flows over that period. That’s quite an achievement. A related point is that many of these companies are much more accessible to investors than you might think, with audited financial statements, quarterly investor calls and access to management, in many cases.
On the other hand, one consideration that investors may initially overlook, but which can be a major constraint on investing in frontier markets, is trading liquidity. Perhaps the greatest shortcoming of many of these markets is that they simply do not trade very much — a feature that has worsened over the past couple of years. We expect volumes to recover over time; indeed, this expectation is core to our bullish thesis for the entire asset class. But for now it can be difficult for investors that identify a good investment idea to buy the stock in any size, and acquisition of a meaningful stake can take a long time. The converse is even more true: it can be harder to get out of an investment that is not working. This is something that investors in Nigeria have learned this year.
For several years now our survey participants have identified Romania as their favorite frontier market in emerging Europe. What is your view of Romania?
Romania captures many of the elements we look for in a frontier market: an improving growth profile, a reform story anchored by an International Monetary Fund program, reasonable valuations and some good quality companies. The biggest challenge for investors is finding ways to access this compelling top-down story through the stock market. The banking sector is an obvious starting point, but much of this sector has been acquired by European parents, with not a lot of listed free float remaining. Other sectors that investors would normally look to for domestic exposure — telecommunications and consumer staples, for example — are even less well represented in Romania. Utilities is a more investible sector and is quite an attractive area. We quite like Electrica, which focuses on electricity distribution and offers decent growth — thanks to volume increases and cost cutting — and attractive valuations, including a dividend of more than 7 percent, which we see as sustainable.
Morocco is the respondents’ favorite in the Middle East & North Africa region. Do you share this optimism?
Morocco is another compelling economic story that is not only growing at a decent pace but has seen a steady improvement in its economic imbalances in recent years. The equity story is more mixed. The banking and telecoms sectors, which dominate the index, tend to be relatively mature, with a defensive, lower-risk profile compared with many frontier markets. This has made them decent stocks to own over the last couple of years. However, there is not much growth to be had, and the valuations — in part due to a large domestic pension system — look relatively stretched.
One market that is looking more interesting to us these days is Kuwait, which has historically been a laggard within MENA. We are seeing more signs that a long-pent-up capital spending program is finally getting under way. Paradoxically, this economy may see an increase in capital investment in this period of lower oil prices, supporting growth, in contrast with neighbors such as Saudi Arabia and Qatar, which are seeing a very significant slowdown.
What about Southern/Sub-Saharan Africa — any opportunities?
Sub-Saharan Africa has become a much more difficult story to sell to investors over the past year. This is due primarily to the struggles of Nigeria, which has become a challenging place to invest, to say the least. Availability of foreign exchange has become very tight as policymakers have stuck with a fixed exchange rate in the face of lower oil prices. Although there are signs that the FX policy may be loosening a bit, we remain cautious in the near term, as the government that came into power last year has been slow to articulate a cogent economic policy.
Kenya is a better economic story, and companies there are doing better; we quite like the outlook. Other countries such as Côte d’Ivoire and Tanzania also have good economic stories to tell. However, beyond the two larger markets — Nigeria and Kenya — liquidity tends to be constrained and market access can be difficult, restricting access to a small number of specialized Africa investors.