Frontier markets have performed particularly strongly during 2013 and 2014, significantly outperforming their more liquid and well-known emerging market counterparts.
There have been several reasons for this, among them superior economic growth in some of the relevant countries reflected in strong earnings momentum, the recovery of the Gulf Co-operation Council markets post the Arab Spring, and the fact that some of the Middle East Gulf countries are closely US dollar and US interest rate-linked.
This means they do well in a world where there is concern about tapering as a headwind for emerging markets.
In an increasingly globalised world, where everything tends to correlate with everything else, there is more idiosyncratic country risk to be found in frontier than elsewhere in the world, a fact that helps with portfolio diversification.
Emerging market portfolio managers have increasingly started to include some frontier names in their funds, but aggregate allocations remain low.
Some of the consumer-focused investments in the Gulf are particularly interesting.
Almarai, for example, in Saudi Arabia, runs a dairy and bakery business that has grown strongly, while Alhokair is a clothing retailer that holds the franchise for brands such as Zara and Next in Saudi Arabia.
The company benefited from the increasing entry of women into the workforce and the consequent growth in disposable income for females to deploy on clothing.
Meanwhile, banking stocks have been another profitable area, with Doha Bank in Qatar being a play on investment and infrastructure development in the country, while Commercial International Bank in Egypt has performed strongly as the political situation in the country has stabilised.
Valuations have moved up materially in some of these frontier countries since the beginning of 2013 and are now slightly above historical averages.
While this isn’t necessarily cause for alarm, it means it is more important than ever to look for stock-specific upside that is underpinned by improving fundamentals.
The consumer space as a whole is now valued much more in line with emerging markets, whereas it was on a significant discount 18 months ago.
The banks may continue to do well as US rates start to move up as some of them, particularly in Saudi Arabia, are relatively geared to that dynamic – but this feels increasingly well understood and priced in.
Have valuations moved to a point where frontier no longer looks interesting?
This is not necessarily the case. There is good upside in some Saudi consumer names, as well as the Nigerian oil sector, where the global oil majors are selling stakes to local players who can operate the assets more effectively, as well as taking advantage of significant tax breaks.
Frontier is still exciting, but the stock picking is more important than ever.
Mark Vincent is investment director, global emerging markets at Standard Life Investments
