Money Matters: What to know when investing in frontier markets

Mitchell Thomas, The Daily Record Newswire

Frontier markets are normally described as burgeoning countries with an antiquated infrastructure, a low standard of living, a highly unskilled labor force and a fragile political system. Often times, political risks outweigh the financial risk investors are willing to assume. In contrast to the challenges, these countries are beginning to offer a substantial economic advantage with lower taxes, abundant young labor and a maneuverable bureaucratic environment.

Indeed, the migration of global manufacturing facilities into these regions may provide them with an economic edge with respect to cost controls. In order to better assess the benefits and challenges to investing in frontier markets though, it is first helpful to understand the nuances between them and emerging nations.

First, it is no secret that manufacturers have long-pursued low-cost labor around the globe. Looking back into the 1950s, Asian and South American countries offered the benefits of non-union labor, fewer regulations and government’s desire for economic growth. These benefits helped the economies of these emerging nations to witness a transition of economic growth for many decades, enhancing many countries’ infrastructure and positively impacting many countries’ standards of living. Other common influences included currency appreciation and a strengthened financial and banking structure.

However, the consequences to growth were with challenges. For example, global capital inflows were not always utilized in the most efficient manner and regulations were implemented to thwart the vulnerability of sudden outside capital movements affecting the banking system. Inflation also became a predominant concern of many central banks as a result of a quickly expanding middle class who were now seeking affordable goods and services. Simultaneously, credit reviews were relatively lax and occasionally were offered to businesses and individuals that had questionable financial histories.

These trials and tribulations were a litmus test for government administrations in power. Survivability measured their acumen in successfully managing both financial and social issues. Ultimately though, labor costs in these emerging markets began to increase and their advantage of low-cost labor began to diminish. These events bring us to our current conditions within frontier markets.

Despite headwinds challenging traditional avenues of capital flow, individuals and companies alike continue to seek investment opportunities. This has led investors to assess allocating a nominal portion of their portfolios to select regions such as Vietnam, the Philippines, Bangladesh, Nigeria, Kenya and Peru, etc. In fact, many frontier nations offer low inflation and lower domestic and government debt ratios as compared to developed and emerging countries.

The price-to-book ratio on their equity markets is approximately 1:5, which is much lower than their developed counterparts and measurably half of where they were in 2008. Return on equity in frontier markets is also higher than emerging markets and corporations are channeling profits into capital expenditure projects and expecting higher margins going forward.

Demographically, frontier countries have an expanding working age population offering a precursor to a multiplying middle class, higher productivity and a growing economy. The contrary is happening in the developed nations concerning population stagnation and an aging workforce. These conditions pose a favorable scenario for a future elevated credit rating by the ratings agencies in the frontier region.

While it may prove advantageous to invest in certain frontier markets, it is important to note that investments should be taken with a long-term view, as many have limited liquidity and often have volatile movements with respect to their equity, currency and debt markets. Also, many frontier markets’ banking structures are primitive compared to their developed country brethren.

Consideration for the frontier sector should be weighed in your international equity portfolio. However, investors must assess their tolerance for risk and volatility in their search for opportunities. International equities in developed, emerging and frontier regions offer investors’ diversification along with a value and growth perspective not always prevalent in U.S. equities. Statistically, holding international equities have proven that it decreases the volatility in price movement when it is included as a portion of your total equity portfolio. A favorable allocation of approximately 30 percent to international markets is considered a recommended level.

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Mitchell Thomas is an international equity analyst/portfolio manager/head trader for Karpus Investment Management, an independent, registered investment advisor that manages assets for individuals, corporations and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534, (585) 586-4680.

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