Urbanization is a key ingredient of the demographic dividend, given more than half of frontier populations tend to reside in rural areas. However, over the years we have seen a sharp increase in urbanization rates, with more than 257 million people expected to move to cities by 2035; a quantum equal to 78% of the U.S. population. Urbanization leads to faster adoption of modern goods and services and economies of scale for those companies that supply them. Pharmaceutical consumption is a prime example of this as people shift to modern medication from traditional home remedies as they move to cities. Yet, even today pharmaceutical consumption per capita in countries such as Pakistan and Bangladesh is below $20 per capita vs. close to $700 per capita in developed European markets, implying sizable room to improve. Urban population in these markets is also considerably more densely packed in than in most emerging and developed markets. Higher density should drive higher returns on capital for companies that operate networks of fixed-cost assets (e.g., mobile telecom base stations, distribution warehouses and transport depots, retail outlets, and bank branches) to address that population compared to companies that address much more sparsely populated geographic areas. The utilization of these assets should be significantly higher and the capital expenditure required to build out coverage of new geographic territories is paid back sooner. At the same time, urbanization places pressure on already stretched public resources, paving the way for increased role of the private sector to fill these gaps.
Despite these intriguing long-term secular themes in play, frontier investing is not without its challenges. A lack of transparency and consistent information about these markets plays a large part in the risk premiums associated with them, coupled with immature political and economic regimes, which tend to feed into volatility of returns.
It goes without saying that frontier investing requires patient capital with a long-term horizon. An unintended consequence of this information deficit is that it creates a higher likelihood of mispriced investment opportunities that can generate significant alpha if understood correctly. Furthermore, it works in favor of active managers that invest in fostering relationships in these markets and thereby developed a strong on-ground network of contacts. Such a relationship-based model provides access to data sources that are not necessarily available to every investment manager. So this feeds into the question, how does one uncover these hidden gems?
For starters, the information impediment of the asset class exposes the shortcomings of passive strategies, which simply lack a high level of analytic sophistication that is required and therefore are unable to pinpoint the most promising opportunities. Secondly, given the presence of relatively immature political and economic regimes, it is imperative to be nimble across markets. Frontier markets tend to have a very low intra-correlation and remain largely insulated from global events. While this makes them an excellent avenue for diversified uncorrelated returns, it also means that one has to be highly cognizant of the intrinsic dynamics of the particular individual markets. Finally, the structure of index compositions such as MSCI means typically only the largest, most liquid names make it to an index, which may not be reflection of the underlying opportunity set. A good example is the return of the consumer staples sector in Pakistan, which has delivered a 40% annualized U.S.-dollar return between 2010 and 2020 while the emerging market indexes' Pakistan constituents have declined 3% on an annualized basis.
The ability to counter the information deficit not only makes the case for active management but also implies scope for implementing more mainstream ESG methodologies as part of the due diligence process. Exclusion is perhaps the most common application of ESG implementation — namely, removing companies involved in gambling and adult entertainment or manufacturing alcohol, firearms and tobacco, to name a few. In fact, two-thirds of total global assets under management in responsible investment strategies are invested in strategies that simple adopt a negative screening approach. While exclusion is a step in the right direction, we believe an approach that combines exclusion with a comprehensive ESG integration approach is integral to having a holistic view of an investment opportunity.
It should be emphasized that the end result is not merely about having a rigid scoring system that feeds into another layer of exclusion, per se. A score is an assessment of the present but what is more important is the future. From a financial perspective, an investment's potential is gauged from its future cash flows, so why shouldn't a similar approach be adopted to assess its ESG outlook?
That is why engagement can be a highly effective tool in these markets as management teams are more likely to be receptive to dialogue and being educated on the merits of adopting ESG parameters in their corporate strategy. Third-party ESG analytics providers can be of great help here. Introducing companies to third-party analytic providers encourages management teams to adopt a proactive mindset and understanding the parameters a more sophisticated investor base is evaluating them on. At the same time, they are able to gauge how they compare to local and regional peers, creating additional incentive to show improvement.
Mohammed Ali Hussain is head of research at Frontier Investment Management Partners Ltd., Dubai. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.
