Look beyond macro story to find equity returns in frontier markets

Frontier markets typically are underdeveloped, with strong prospects for growth and capital market expansion.

Often perceived to be the “next generation” of emerging markets, frontier market countries as a whole are experiencing soaring GDP growth. Seventeen of the 25 fastest growing countries in the world are in the frontier region. Many are experiencing a period of “catch-up” (economic convergence) as they rapidly integrate into the global marketplace.

Investors should rightly be cautious, however, about assuming that strong economic growth will translate into equity returns. Many studies have shown this link is tenuous at best and hard to predict with any accuracy. But the frontier asset class should not be relegated to simply an economic growth story.

Frontier countries represent not only the fastest growing economies in the world today; their companies are among the fastest growing as well. Over the past several years, earnings-per-share growth in the frontier markets has exceeded that of companies in both emerging and developed markets. In fact, eight of the top 10 countries with the fastest growing companies are frontier.

Even more notable, many frontier companies are achieving this EPS growth with stronger margins and lower levels of debt than either their developed or emerging market counterparts.

To what extent can these reported figures be trusted?

Prospective investors often inquire about governance and international standards in less developed markets. Many are often surprised to learn that governance risk in frontier markets aligns fairly closely with that of many emerging markets. Transparency International's Corruption Perception index, as an example, shows little difference in its average ratings for frontier and emerging markets. While both are less transparent than developed markets, the argument that an investor is taking on appreciably more governance risk in frontier does not hold true by this measure.

Governance at the corporate level is improving as well. One indicator is that frontier countries are rapidly adopting the accounting standards that international investors require. Driven by regulation that supports international investment, the vast majority of countries in the frontier markets today (27 of 34) have adopted International Financial Reporting Standards. Even in Saudi Arabia, an exceptionally large market that is yet to liberalize, IFRS accounting is required of all banks and insurance companies.

In an extension of the virtuous cycle, this standardization in reporting is helping to drive improved frontier data quality more generally. Acadian's experience is that reporting errors and revisions are down sharply since we began managing frontier assets in 2007.

One measure of market inefficiency is the magnitude by which fundamental metrics, systematically applied, have been rewarded. We have seen strong evidence of this in frontier markets over time. Currently, we find that there are meaningful spreads in the values of return drivers across the frontier universe. This gap between the most attractive and least attractive stocks is significant - almost double what we see in our emerging markets universe. This is true whether attractiveness is defined by value, quality or growth.

The return potential of frontier stocks is one important driver of our belief that frontier exposure is well warranted in a broad asset allocation plan. Despite the recent strong returns of the frontier asset class and its attractive earnings growth, a valuation discount persists. We believe the current period remains an attractive entry point. Looking beyond the macro story, investors might consider frontier markets instead for the robust, diverse stock selection opportunities that they offer. n