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Beyond the Frontier of Emerging Markets

Stockholm (HedgeNordic) – Frontier markets, often characterized by their smaller size, low-income economies, growing populations and underdeveloped infrastructure compared to emerging or developed markets, are increasingly vital in shaping the future global economy. Despite facing numerous challenges, these markets offer significant growth potential and investment opportunities. Tundra Fonder, a Swedish asset manager specializing in frontier markets, aims to “make these inaccessible new emerging markets accessible for anyone.”

Tundra Fonder’s definition of frontier markets encompasses lower-middle-income and lower-income countries, typically with a GDP per capita below $4,500. “These countries currently account for 50 percent of the world’s population and that figure is projected to rise to two-thirds in 50 years,” explains Tundra Fonder’s CIO, Mattias Martinsson, currently on a six-month trip to various frontier markets in Asia. “This demographic growth is going to require a lot of infrastructure development, including electricity generation, road construction, hospitals, supermarkets, and all the basic components of functioning societies,” he elaborates. “Therefore, we anticipate higher economic activity in this part of the world.”

“These countries currently account for 50 percent of the world’s population and that figure is projected to rise to two-thirds in 50 years.”

While frontier markets present attractive growth prospects, it is essential to acknowledge and understand the risks associated with investing in these regions. “These markets typically exhibit lower average corporate quality, significant liquidity challenges, management integrity issues, and unstable legal systems,” acknowledges Martinsson. The inherent challenges of these markets also include boom-and-bust cycles, political instability, frequent currency devaluations, and other uncertainties. Rather than attempting to avoid crises by continuously shifting investments, Tundra Fonder’s approach involves “trying to find the best companies in these markets that are well-positioned to navigate the specific problems of their respective countries.” 

“[we are]trying to find the best companies in these markets that are well-positioned to navigate the specific problems of their respective countries.” 

With Tundra Fonder focusing on eight to ten markets at a given point in time, each may face unique challenges, according to Martinsson. For instance, in Pakistan, nearly 40 percent of Tundra Sustainable Frontier Fund’s exposure is in an IT company that generates 85 percent of its revenue from foreign markets. “This company benefits from sales in foreign currencies while incurring 85 percent of its expenses in Pakistani rupees, mitigating the impact of Pakistan’s historical average annual devaluation of 7 percent over the last three decades,” Martinsson illustrates. “This devaluation is not a problem for this company; in fact, it works in their favor,” he emphasizes. “We seek to identify companies suitable for each country, capable of weathering known challenges over multiple business cycles, rather than attempting to avoid them altogether.”

Tundra’s Three Pillars: Corporate Quality, Growth and Positive Impact

At the heart of Tundra Fonder’s investment philosophy lie three core pillars: corporate quality, growth prospects, and positive societal impact. Recognizing corporate quality as the primary risk factor in frontier markets, the asset manager’s initial criterion for investment selection is the assessment of governance quality. “If the corporate quality, both related to the owners of the company and the management team they put in place, is not up to our standards, there is no point in moving forward with an investment regardless of how exciting the business is,” emphasizes Martinsson.

“If the corporate quality,…, is not up to our standards, there is no point in moving forward with an investment regardless of how exciting the business is.”

Another vital consideration for Martinsson and his team is identifying structural growth within the underlying business. “We are seeking out growing businesses with structural growth, companies that will be more important for the economy in the future by growing faster than the local economy,” explains Martinsson. This emphasis on growth-oriented businesses not only results in easier value creation and retention of strong management teams but also diminishes the risk of investing in value traps. “It’s much easier to keep a strong management team together, retain the best talent, and also attract other investors if there is a growing business,” he elaborates.

“We are seeking out growing businesses with structural growth, companies that will be more important for the economy in the future…”

The third pillar of Tundra Fonder’s selection process revolves around evaluating a company’s positive impact on society within its operating environment. “If a company serves as a good employer, pays its taxes, attracts favorable international media coverage, and contributes to the country’s export revenue, it becomes indispensable regardless of the political landscape,” argues Martinsson. Politicians are incentivized to support or at least not hinder such companies as they enhance their image and prospects for reelection. “Politicians are not going to make life hard for those companies,” he elaborates. “We believe these companies must contribute positively to the societies in which they operate.” This is crucial given the challenges posed by state governance, including potential regulatory changes, tax reforms, and other unforeseen disruptions.

“If you have these three key pillars in place, the specific nature of the business becomes less significant, as these markets have consistently demonstrated robust growth over the last four decades, outpacing developed economies by multiple folds,” argues Martinsson. The growth potential is inherent in frontier markets; however, a significant portion of this potential is squandered on underperforming companies and inefficient sectors. “By strategically focusing on these pillars, you increase the likelihood of making successful long-term investments,” he continues. “I firmly believe that this region of the world holds immense potential.”

Uncovered Markets and Limited Correlation

In addition to the enticing high-growth, high-return potential offered by businesses in frontier markets, the information asymmetry creates an attractive hunting ground for investors like Tundra Fonder. “The reality is that the limited number of foreign investors results in lower coverage, making our independent research even more important,” argues Martinsson. Tundra Fonder maintains a team of four individuals stationed in two key markets, with the Stockholm-based team frequently conducting fieldwork as well. “The process of researching and eventually adding a new company to our portfolio typically spans several months. Our local presence and my frequent travels are key for ensuring long-term success.”

“Our local presence and my frequent travels are key for ensuring long-term success.”

Another advantage of investing in frontier markets is the limited correlation to larger emerging markets and developed markets, as well as the minimal correlation between frontier markets themselves. For instance, despite assumptions of high correlation between markets such as Pakistan and Bangladesh, the reality is quite the opposite, according to Martinsson. “They share common themes, including a growing middle-income class and demographic trends favoring higher growth rates,” he highlights. “However, they have exhibited zero or even negative correlation over extended periods, acting as short-term hedges by putting them together in a fund.”

“It’s not meant to replace one’s emerging markets fund, but rather serve as an additional component. Frontier markets can be the second part of that emerging markets exposure.”

Given these factors, Martinsson argues that exposure to frontier markets can complement an investor’s existing portfolio which may already include exposure to emerging markets. “It’s not meant to replace one’s emerging markets fund, but rather serve as an additional component,” he explains. “If you have concerns about overexposure to specific markets like China or stretched valuations in India or believe that South Korea and Taiwan are not emerging markets anymore, frontier markets offer a compelling alternative,” concludes Martinsson. “Frontier markets can be the second part of that emerging markets exposure.”

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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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