Investing in Frontier Markets
Frontier Markets: More than Emerging?
The world's most dynamic economies aren't quite at the edge of the earth, but these frontier markets are terra incognita for most investors. Here's why you can't stay away completely.
Defined loosely by international bodies like the World Bank, frontier markets are high-risk, low-income countries. This stands in contrast to more commonly discussed emerging markets, defined as low-to-middle income economies (on a per-person basis).
The total population of the countries in these two brackets of the world's money hierarchy makes up about 90% of humanity, but their economic punch is well below their weight, with less than a third of international wealth.
Frontier markets are identified by a few major marks:
high difficulty of access for outside investors
high presence of risk factors (political and economic)
the potential for both whopping returns and crushing declines
Why Invest in Frontier Markets at All?
Like any migrant taking off for greater prosperity in a foreign land, moving yourself or your money to the outback of the global economy can be imposing.
In some cases, it's flat-out impossible.
Consider online brokerage service E-Trade, which announced in August 2007 the ability for account holders to trade shares in Canada, Hong Kong, France, Germany, and Japan. This platform is separate from the American Depositary Receipts that trade on U.S. exchanges under agreements sponsored by domestic banks. For example, with ADRs a stake in a German company like semiconductor maker Infineon Technologies AG (NYSE:IFX) can be bought just as easily as Big Blue blue chip IBM (NYSE:IBM).
But even within the European Union, some of Germany's neighbors are much more difficult to access, either through direct purchasing or ADR investing.
The Czech Republic, Slovakia, Estonia, Latvia, and other countries that acceded to the European Union in 2004, and which I myself have visited with the goal of bringing home juicy stock picks, are less easy to tap unless you have an institution on your side.
Nevertheless, the siren's song of triple-digit returns in places like Kazakhstan and Jordan exists, and Standard & Poor's debuted new metrics in the second half of 2007 to capture the performance of frontier markets, with a 30-stock Select Frontier Index and a broader Extended Frontier 150 Index.
Unfortunately, the top country in both S&P frontier indices is Pakistan, where the assassination of Benazir Bhutto and a resurgent Taliban (combined with the absence of a Wall Street Santa Claus rally) the Karachi Stock Exchange lost 9.9% off the KSE-100 benchmark's value in just one week at the end of 2007.
With a continent-leading seven Kenyan companies also included in the Extended Frontier club, that country's political turmoil is also hitting the S&P's African all-stars hard.
Shaky national current account balances (essentially, the national version of your bank and credit statements), energy-driven inflation, and corruption all play a big role in frontier economy investing as well.
Heck, these factors carry over to the richest nation in the world, the United States!
New Frontiers in 2008
What I urge for investors on Wall Street is the same as what I urge for those who play the tickers on Estonia's Tallinn exchange: a portfolio open to international growth opportunities but hedged against some major downtrends that are in motion.
The first stop on your way to frontier market investment shouldn't be Slovenia's bustling Ljubljana Stock Exchange (just behind China's Shanghai and Shenzhen for world-leading year-on-year gains from November 2006!).
Look at the companies already in your portfolio, and see how they're building on the foundations of economic health in long-neglected countries like Estonia. There, just across the Baltic Sea from Finland, my research junket in 2006 took me to the offices of many Estonian high-tech and biomed startups, many of whom had received major inflows of money from established Scandinavian firms like Finland's Nokia Corporation (NYSE:NOK).
Unfortunately, I couldn't recommend these startups or even bigger Estonian companies that trade on the Nordic OMX family of exchanges. But I could recommend Finland's Metso Oyj (formerly an NYSE ADR, now listed only in Helsinki) and Norway's StatoilHydro ASA (NYSE:STO), both of which yielded nearly 40% returns in just around half a year.
Through my travels in a country with lower "investibility," I discovered these more accessible stocks and turned them into a profitable reality.
You should look out for downturns, and consider some short plays like the FTSE/Xinhua UltraShort China 25 Index (AMEX:FXP). This doubles the inverse of the FXI FTSE/Xinhua China 25 index, making a heavy bet on a downturn in the recently brilliant Chinese stock exchanges.
Perhaps most importantly, we are in the middle of a major worldwide process of stock market consolidation. The 24-hour trading day is now a reality not just for giants like Goldman Sachs with offices from Shanghai to Santiago, but also for ADR holders and ETF investors.
Ironically, it's been with the help of frontier market money from Dubai in the United Arab Emirates (the #2 investment destination for S&P's frontier funds), that U.S.-based Nasdaq is set to take over the Scandinavian and Baltic exchange operator OMX, which I mentioned above. With over $5 billion in cash, the Persian Gulf petrocrats are moving some money north, only for Nasdaq to reward them with a cash and share exchange that brings a Middle East-Scandinavia-New York triangle of stock exchange power into being.
The Gulf states and their sovereign wealth funds are now turning the tables on traditional concepts of frontier markets as backwards, making up for lost time counting petrodollars and turning homegrown bourses like the Dubai International Financial Exchange (DIFX) into real market forces.
The IPO of port operator DP World in late November on the DIFX was the Middle East's largest ever, with over 300 million shares trading for a market cap of nearly $5 billion. Even though they've got the loot to buy an entire European exchange system, Dubai traders want DP World to stay right at home.
With each acquisition and agreement between and among international exchanges, we all get closer to total worldwide market access.
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