Frontier Markets: The New Emerging Markets

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Stockholm (HedgeNordic) – Frontier markets represent the next generation of emerging markets, offering greater return potential than both emerging and developed markets over time. “The frontier markets we focus on are the ones that are farthest behind. The long-term theme is that these markets will, sometime in the future, repeat what China, Japan and other countries achieved in the distant past,” says Mattias Martinsson (pictured), the CIO of Tundra Fonder.

“We look at the world according to the World Bank definition, which divides the world into four income groups: high-income countries, upper-middle-income countries, lower-middle-income countries and low-income countries,” explains Martinsson. The Tundra team focuses on the two categories at the bottom: lower-middle-income and lower-income countries. “These countries account for about half of the world’s population today, but only around 2 percent of the world’s market capitalization.”

“These countries account for about half of the world’s population today, but only around 2 percent of the world’s market capitalization.”

“In 50 years, these countries will represent two-thirds of the world’s population and all added workforce, people aged between 15 to 64 years, will come from these two categories over the next 50 years,” Martinsson tells HedgeNordic. This demographic dynamic is expected to create significant economic growth for lower-income countries. “We expect that economic activity in terms of building factories, hospitals, roads and many other activities will be higher going forward,” says the CIO of Tundra. “We observe strong economic trends in our markets, characterized by growth rates that are higher than in higher-income countries and a young and rapidly growing middle-income class.”

“We observe strong economic trends in our markets, characterized by growth rates that are higher than in higher-income countries and a young and rapidly growing middle-income class.”

Since economic growth does not always translate into good investment returns, particularly in frontier markets, Martinsson views careful stock picking as essential for generating attractive returns in frontier markets. “From there, our job is to find very good companies with very strong managements that can take advantage of the growth conditions because not all companies will,” says Martinsson. “We cannot emphasize that enough. You cannot just buy a basket of old giants in these markets and expect good returns,” he continues. “You need to find the new energetic companies with good entrepreneurs who are willing to change and adapt to how the world changes.”

“You need to find the new energetic companies with good entrepreneurs who are willing to change and adapt to how the world changes.”

Security Selection Process

Mattias Martinsson and his team predominantly look for three main characteristics when searching companies to populate the portfolio of its Tundra Sustainable Frontier Fund, a SEK 2.15 billion fund launched back in early 2013. “First of all, we want companies with strong sponsors in the form of responsible majority shareholders, and good management teams,” starts Martinsson. “That is a hard-core precondition to ever consider an investment.”

“Second of all, we want companies that are subject to structural growth,” he continues. “We do not want exposure to old industries such as oil and gas or old utilities based on fossil fuels. We are looking for companies operating in sectors that will account for a larger share of the economy in the future than today,” Martinsson tells HedgeNordic. The healthcare industry, in which Tundra Sustainable Frontier Fund has a 20 percent allocation, is one such sector. “Healthcare spending in absolute numbers and as a percentage of GDP is significantly lower in frontier markets than developed markets,” says Martinsson. “When these countries become wealthier, both the absolute figure of spending and the relative number in terms of spending as a percentage of GDP will increase.”

“We are looking for companies operating in sectors that will account for a larger share of the economy in the future than today.”

“The third part, which is the core of our ESG work, is that we want companies whose success is beneficial for the countries where they operate,” claims Martinsson. “This is not primarily for us to make the world better, we are trying to mitigate the impact of the state governance risk, which, aside from the corporate governance risk, is one of the biggest risks in markets like Pakistan, Sri Lanka, Vietnam, et cetera,” he emphasizes. “We are looking for companies that actually do good for the country, that are good employers, lead their sectors in terms of environmental work, and have strong corporate governance in place. The politicians want those companies to succeed. Such companies face a lesser risk of the taxman knocking on their doors.”

“We are trying to mitigate the impact of the state governance risk, which, aside from the corporate governance risk, is one of the biggest risks in markets like Pakistan, Sri Lanka, Vietnam, et cetera.”

Major Risks Associated with Frontier Markets

In addition to the traditional market risks associated with any stock investing, frontier markets also exhibit higher corporate governance risk and state governance risk. “In order of relevance, the corporate governance risk is followed by state governance risk. And then, of course, you have all the risks that any fund manager investing in equities faces,” says Martinsson. “However, the most common question that we get is about the currency risk.”

“Based on my 25 years of experience of investing in these markets, one should expect the currencies to depreciate over time because inflation rates are higher, these countries are vulnerable on the current accounts, and their balance of payments sometimes balloon to the moon,” acknowledges Martinsson. “Over time, the currencies in the ten markets we have been invested in have depreciated by four percent annually versus the U.S. dollar. And that will continue for the foreseeable future,” he continues. “What investors sometimes fail to see is that there are many well-run companies that are able to compensate for all the risks, including currency risk.”

“What investors sometimes fail to see is that there are many well-run companies that are able to compensate for all the risks, including currency risk.”

One of Tundra Sustainable Frontier Fund’s most successful investments since inception was Pakistan-based Systems Limited, which operated in an environment with severe currency depreciation in recent years. “It has been one of our most successful investments despite the Pakistani rupee devaluing significantly,” says Martinsson. “The reason behind the success was that 80 percent of their sales came in U.S. dollars from exports. You need to take all the macroeconomic risks into account, but that does not mean you cannot find companies that are thriving in difficult market conditions.”

“I would love to have the opportunity to hold only 20 holdings, but in reality, the lower liquidity in frontier markets forces us to have a less concentrated portfolio.”

Tundra Sustainable Frontier Fund currently maintains 41 names in the portfolio, which is predominantly exposed to Asia at the moment. “We want to be as concentrated as possible without compromising the liquidity of our daily-traded fund,” says Martinsson. “I would love to have the opportunity to hold only 20 holdings, but in reality, the lower liquidity in frontier markets forces us to have a less concentrated portfolio,” he continues. Tundra Sustainable Frontier Fund also maintains about 80 percent of its portfolio exposed to Asia for a range of reasons, one of which involves the more developed stage of their stock exchanges. “You can find good growth in Africa as well, but the continent has somewhat less developed stock exchanges.”

Expectations

“With the risk of sounding cautious, one should expect all equity markets in the world, including frontier markets, to return between eight to ten percent a year on average over time,” says Martinsson. “Then there is the manager’s ability to add alpha beyond the average market return. After all fees and costs, we have generated a return that is higher by four and a half percentage points versus our benchmark,” he points out. “Stock picking is essential for successful investing in frontier markets.”

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Eugeniu Guzun
Eugeniu Guzun
Eugeniu Guzun serves as a data analyst responsible for maintaining and gatekeeping the Nordic Hedge Index, and as a journalist covering the Nordic hedge fund industry for HedgeNordic. Eugeniu completed his Master’s degree at the Stockholm School of Economics in 2018. Write to Eugeniu Guzun at eugene@hedgenordic.com

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