Finding high-quality, undervalued companies is getting increasingly difficult. As mainstream markets continue to climb, so do their price-to-earnings ratios. Over the past 12 months, the S&P/TSX composite index’s P/E has risen 5.2%, while the S&P 500’s P/E has jumped nearly 11%. Many stocks are now overpriced, and the best companies to own in such a volatile environment—financials, consumer staples and other defensive stocks—are delivering only modest growth. It’s a difficult situation for investors, and it’s unlikely to change soon.
One can still find galloping growth at bargain prices, but today’s investors have to look farther afield. Most fruitful are what are called the frontier markets, consisting of still-developing countries in Africa, Latin America, the Middle East and eastern Europe. “Frontier markets today are what emerging markets were 20 years ago,” says Stephen Mack, managing director with Chicago-based Frontaura Capital, a firm that specializes in next-tier markets. While there are risks in these countries that you won’t find elsewhere—political and social upheaval, for instance—they are also home to many reliable and stable companies that have been delivering strong returns for decades.
If you ignore frontier nations, you’re missing out on a large part of the global stock market, Mack points out. The MSCI All Country World Index, which consists of 45 developed and emerging countries, captures only part of the public equity universe. The MSCI Frontier Markets Index tracks another 33 nations. Andrew Brudenell, a portfolio manager based in London, England, with HSBC Global Asset Management, says that for this reason these markets should be part of a well-diversified portfolio. “Consider this a part of your emerging-market exposure,” he says. Moreover, these countries are cheap. The MSCI Frontier Markets Index is trading at about 12 times earnings, while the All Country World Index is trading at 14 times. The S&P 500 and the S&P/TSX composite, meanwhile, are trading at 15.6 and 15.2 times, respectively.
Of course, there are reasons why the valuations are so attractive. Many of these markets are small and illiquid. Political instability and social unrest pose a threat to business continuity. Since these issues prohibit many institutions from buying in, retail investors and mutual funds often have these markets to themselves. There may not be much analyst coverage of the companies either, though that’s starting to change. All that adds up to lower valuations, but they should rise over time. Indeed, the P/E on the Frontier Markets Index has risen 9% over the past 12 months.
Investors should look at this part of the world the same way they would look at the emerging-market space. This isn’t a place to make a quick buck, but many of these countries are opening up their markets to foreign investment, and many are getting wealthier. For example, Nigeria has seen its GDP per capita rise by 178%—from $970 to $2,700—between 1990 and 2012. (By comparison, Canada’s GDP per capita has climbed 78% over the same period.) Brudenell adds that many of these countries are also on the “right end” of the demographic shift. Their populations are young—about 63% of Nigeria’s population is under 24; only 32% of China’s population is under that age—and today’s kids will grow up wanting a western lifestyle. “If you can bring in a young workforce like that, then you can get a situation where you can sustain GDP growth,” says Brudenell. “They’ll eventually have disposable income, and then you’ll get an aspirational middle class.”
While it could take a while for these societies to develop, many companies are already seeing attractive growth. The Bank of Georgia, a leading bank in the Eurasian country, has had a return on equity of more than 20% for a number of years, despite trading at book value. Christine Tan, a portfolio manager with Excel Funds Management, says Vinamilk, a major Vietnamese dairy and one of her favourite frontier market operations, should see 15% earnings growth next year. In April, Nigeria’s Guaranty Trust Bank reported a 65% increase in profits over the same period the previous year.
In addition to earnings growth, many frontier market companies pay—and grow—dividends. That may come as a surprise to some but not to Tan, who hails from Malaysia. “There’s a culture of dividends in these markets that people underestimate,” she says. “People expect to be paid.” While it’s not hard to find yields nearing 10%, Tan prefers companies that pay between 2% and 4%. She wants to see a payout ratio between 20% and 30%. As in developed markets, if the yield is too high, or if the payout ratio doesn’t leave room for reinvestment, there is a risk the dividend could get cut.
Investors without local knowledge should consider owning a mutual fund. However, you should keep an eye on the management expense ratio—if the fees are too high, any upside will go to the fund manger, not you. Another option is to find a broker who specializes in these countries, but such brokers often charge high commissions, notes Serge Pépin, vice-president of investment strategy at BMO Asset Management. As well, some markets allow investors to buy and sell only at certain times of the day or month. Finally, you can buy an exchange-traded fund, such as the iShares MSCI Frontier Markets ETF (NYSEArca: FM). But because these markets aren’t as efficient as those in developed countries, a case can be made for active management. “In a relatively inefficient market, mutual funds work better than passive investments,” Pépin says.
You need to do your due diligence. The sectors a fund holds shouldn’t be that different from your domestic equity portfolio. Brudenell likes banks, telecoms, large utilities and big conglomerates. These are usually stable, dividend-paying operations with predictable cash flows. Pépin likes firms that can grow their cash flow by around 25% a year. Also be sure that the companies held are the top one or two businesses in their sector, and that their growth is driven by domestic demand. Tan likes consumer goods companies because they’re able to grow along with the population. Companies should be in regions that are relatively stable and open to investment. Mack dislikes Venezuela, for instance, because the country hasn’t shown a willingness to work with foreign investors.
Most of Mack’s investors put about 1% to 2% of their money in his frontier fund, which is appropriate for these markets, he says. Once you invest, though, leave those assets alone. “We wouldn’t invest this just for next year,” says Brudenell. “Put this in the bottom drawer of your filing cabinet and enjoy the ride.”
The CB Hotlist
Guaranty Trust Bank (LON: GRTB)
P/E: 7.7 | Yield: 10.3% 1-year total return (C$): 77.6%
One of the best-run banks in Nigeria, says Brudenell. Earnings should rise as the population matures and incomes rise.
Safaricom Ltd. (KN: SAFCOM)
P/E: 15.7 | Yield: 3.4% 1-year total return (C$): 119%
This Kenyan telecom is a pioneer in mobile financial transactions. Vodafone has a 40% stake.
Viet Nam Dairy Products (VN: VND)
P/E: 17.8 | Yield: N/A 1-year total return (C$): 116%
Better known as Vinamilk, this dairy is the Vietnamese equivalent of Saputo. Tan expects 12% earnings growth.
Bank of Georgia (LON: BGEZ)
P/E: 7.5 | Yield: 3.8% 1-year total return (C$): 58.2%
Tbilisi’s Bank of Georgia is one of Pépin’s favourites. Profits rose 19% in 2012, while its loan book grew by 18%.
Tallink Group AS (TAL: TAL1T)
P/E: 11.9 | Yield: 0.00% 1-year total return (C$): 58.5%
This Estonian-based shipping company runs ferries between Baltic and Scandinavian countries. It’s recently updated its fleet, says Brudenell.
