The Case for Frontier Markets

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These are very large overlooked economies. So if you take the top 15 countries in the world by population, more than half of them are next-generation emerging markets. Again, countries like Indonesia, the Philippines, Vietnam, they all have populations of over 100 million people, yet asset allocators and equities have allocated less than 1/3 of 1%.

Hello and welcome to the Barron's StreetWise Podcast. I'm Jack Howe, and the voice you just heard, that's Stephen Quatry. He manages the Next Gen Emerging Markets strategy for Morgan Stanley Investment Management. Next-gen emerging markets, as in not yet emerging markets, as in perhaps future emerging markets, as in what you might call frontier markets. In a moment, we'll hear Stephen's view on whether and why investors should get involved. Listening in is our audio producer Jackson. Hi, Jackson.

Hi, Jack.

What is your frontier market exposure in percentage terms across your portfolio?

Yeah, well, I have an ex-US fund, a total international stock fund.

A cheap index fund, I'm guessing. Okay, continue.

Yeah, very, very, very low expense ratio. It's 25% emerging markets and it doesn't make the distinction of which of those are frontier, but I'm seeing some frontier markets here. There's Malaysia, Indonesia, and Turkey, all about, you know, tenths of a percent of that fund.

You know these to be frontier markets? You're assuming that they are?

I didn't want to start a fight here, but yeah, I don't.

Are there listeners in these markets that are now outraged that you have suggested that they are not among the emerging markets?

How do they make the distinction?

I'm looking at a methodology report from Standard Poor's. That's just one of the companies that makes these classifications. They mention economic factors, the rate and variability of real gross domestic product. They mentioned political factors including war, civil disruption and disturbance. There are restrictions on investments imposed by other governments. They have a whole section for investment conditions, settlement procedures, foreign exchange access. Rules on short sales, availability of futures contracts, and so on. There's a long process that includes feedback and consultation. At last count, there are 25 markets that they classify as developed, 23 emerging, 32 frontier, and 9 that they call standalone. If you're wondering what those definitions mean, it says an emerging market shares some characteristics of a developed market but does not meet the full criteria necessary for that classification. For a frontier market, they say that's a developing economy with generally lower market capitalization and liquidity and/or more restrictions than an emerging market. They point out that frontier markets may become emerging markets in the future, or they might have been in the past. And a standalone market, they say that's a developing economy that does not meet the required basic conditions for any market status described above. This classification also applies to markets with significant restrictions or other accessibility issues. And there are yearly watch lists for potential changes. For example, Poland is on the watch list for the 2025 annual review where they'll decide whether to change its classification from emerging market to developed market. For Iceland, they're going to consider whether to change that from a frontier market to an emerging market. Okay, so those are some definitions. Why would an investor put money in frontier markets, I am not the guy to ask. I have described myself in this podcast as a financial nudist. I'm a minimalist. I don't think you need much. I think you need quality stocks and bonds. I think if you're a US investor, for example, and you have US blue chip stocks like an S&P 500 fund, I think you have companies that are doing business all around the world. I think you're probably sufficiently diversified, but I can understand the case for putting money in a developed markets fund. You have some markets out there with lower valuations, possibly better dividend yields. They also have different economic exposure. They're not quite as loaded up with tech as the US market, which hasn't been a great thing over the past decade, but might be better going forward. So I definitely get the appeal of adding some money to a developed markets fund. And I think it's fine to take Jackson's approach, keeping the fees very low, buying a a broad international fund that has mostly developed markets, some emerging markets, and maybe a dash of frontier markets. If I sound like an emerging markets poo-pooer, it's not because I don't believe in the ability of these countries to grow over time and to create wealth, but economic growth is not the same as functional capital markets that can be relied upon for decade after decade for people who are trying to build wealth and pass it down to their heirs. Does that make sense? Let me put it like this. When people say in the US that the average stock market return over time is about 10% a year, that is not some immutable law of finance. That is not the way it has to be. In most of the world, that's not nearly the way it has been. The US is a relatively young country, but its current constitution came into effect in 1789. That is absurdly old for a democracy. We don't have to look to frontier markets or emerging markets to see what political upheaval can do to capital markets. We could just look to Europe in World War II. That's a long time ago, I realize, but if you hope to leave money to your kids that they might be able to one day leave to their kids, you got to think in terms of long time periods. Also, as I have explained on this podcast, I worked for a big brokerage firm 30 years ago when the mutual fund salesman came around and explained to everyone why they had to get money into China. And China has had periods of marvelous economic growth and many people have been lifted out of poverty, but the stock returns over 30 years have stunk. So I'm not someone who has ever felt an urgent call to overweight emerging markets. Now don't scold me about standard deviations of return and correlations and diversification and all of that. I don't really, what's a nice way to say this? I don't super duper care. Only because, only because correlations between assets have a bad habit of changing in a hurry at just the moment when you need them to behave. Diversification can look like diversification until it doesn't. I am more swayed by the argument that some of these emerging markets are large and growthy markets. They have some impressive companies with a lot of potential. Maybe I'm being too dismissive. Maybe I'm missing out. I wouldn't describe it exactly as FOMO, fear of missing out, on frontier markets, but I am open to new ideas. I want to hear the pitch from someone who knows more than I do on the subject. So I reached out recently to Stephen Quatry, who manages the Next Gen Emerging Markets strategy for Morgan Stanley Investment Management. Let's hear some of that conversation now. If I were to go out there and I were to buy an emerging market index, an index fund, and I would say, all right, I need a, I need a smidgen of exposure. The, all the financial advisors say it. So let me buy this index fund and there I'm done. What am I getting? What am I not getting in the indexes?

So, you know, for the emerging markets, I think that sometimes there's a lot of opportunities that are sort of left to the wayside. So one example is if you were to invest in such an ETF a few years ago, you would've had 40% of your capital in China. And we know what's happened in the meantime, which is that the market of India has actually gained much more of an index weight due to some of the incredible growth opportunities.

How do you find the opportunities? It's easy for me to just sit here with stock screening software in the US and say, "Okay, what's going on? What's moving? What's cheap? What's this? What's that?" Yeah.

I mean, there's only so much you can do from a stock screen, number one. Number two, when it comes to these These companies in these countries, there's actually just not much data often. So it really does require us to travel quite extensively. We meet with the management teams. We're meeting with their competitors. We're meeting with their customers. We're meeting with government officials just to try and really understand the macroeconomic landscape. And so it's a high degree of due diligence that I think is required for some of these markets.

How would you generalize about the performance of these next-generation emerging markets recently?

Yeah, interestingly, recently I think a lot of people are starting to pay more attention to some of these markets. We recently wrote a paper where we detailed the sort of reform stories that are happening in 5 key markets, which are Argentina, Turkey, Pakistan, Nigeria, and Egypt. And interestingly, over the past 2 years, I think investors are starting to take notice. These markets, I think 3 of them are outperforming the S&P. Argentina's up something like 100%. Pakistan is up, I believe, 60% plus, and Turkey as well. Why is that? Well, I think if you look back at sort of the global environment, it's been quite turbulent. You had COVID, you had the global interest rates, which are quite elevated, and that's really impacted some of these markets. They've had poor policy choices because of that. But, you know, as the saying goes, it's always darkest before the dawn. And some of these countries have used their crises, which they faced, in order to enact a number of reforms. And we're starting to see more orthodox policies, which is starting to impact the economies. And I think investors are starting to take notice. So we are quite excited about some of these next-generation emerging markets. You can still invest in them at historically low valuations. And I'm always astounded by when I travel to certain countries in Asia, maybe it's Vietnam or the Philippines, and I go to a mall and I'm sort of rewound back in time to my youth. I feel like I'm in the late '80s, early '90s, where The mall was the social square. I mean, it is where all of the youth are still going. And it's interesting that you go by a beauty product store, you go by a cafe selling boba tea, and you can really see this middle class starting to rise, starting to demand more aspirational goods. And I'm sort of rewound back in time to what I feel like is the '80s and '90s here, given very few people go to malls in the US these days. I think a big theme in a lot of these markets is it's still informal retail. They're still visiting mom-and-pop shops, or in the case of Vietnam, wet markets to get a lot of their groceries. And so there are certain companies that are setting up shop next to the wet markets in a formal retail format, like a convenience store offering fresh produce, but in a refrigerated space offering meat, but in a refrigerated space offering customer service. You can return things if something isn't up to par. So I think we're seeing this informal to now formal retail start to happen in many of these next-gen emerging markets. Just one last point I'd make is that unlike maybe some of the other markets you mentioned with respect to China and Taiwan, these are not correlated to global equities. A lot of these next-generation emerging markets aren't correlated even to emerging markets, and they're not correlated to each other. So it's an interesting sort of diversification benefit you get as well.

I want to lay my prejudices at your feet. I have many of them, and I feel like I'm the person who needs to be talked into this. So this will be a good test of the case. Like, I'm the person— first of all, I'm an American. When I open the global business magazines, I read the US part eagerly, and then I read the parts about Europe, and I'm engaged in that. I start to get to some of the smaller markets, and I'm reading them dutifully. I hang in there, but there's so many exciting things that seem to be going on in the US economy, including these, you know, technology companies and artificial intelligence and so on. And then I say— so I say to myself, the performance here in the US has been great. Why would I need to be somewhere else? Diversification. Okay. But also when I look at the long-term returns here in the US, we take it for granted. If you're doing financial planning, people say, well, the stock market has historically returned, I don't know, whatever it is, 10% a year or something like this. And then I think to myself, that's not a law of finance. That's not like an immutable concept when you're investing. That's because this place has held it together for a while, right? We haven't had a civil war in like 160 years, or I might be a little off on that math. And we've had the same constitution, well, the foundation of the constitution is for 250 years. And that's not nearly the case with some of these markets. You think to yourself, Is this place still going to be the same place in 20 or 30 years? So those are my prejudices. What would I, as a long-term saver, not trying to do anything fancy, what do I gain from being in not just emerging markets, but these next generation emerging markets? What do I get?

A few things. I think first of all, I don't think anyone's going to make the case that you should sell all of your US equities and invest them into these countries. But I do think there is a place in global equity portfolios for these countries. And I think there's a few points I'd like to make. Number one, while the perception is that they can be much more volatile from a political and economic perspective, it turns out the companies that operate in these countries are used to a higher degree of volatility. They have learned to adapt. They raise their prices. They have very strong business models. And so an interesting statistic that I like to point out is that since 2011, right, since the boom of, you know, the FAANG stocks in the US, The markets of Pakistan and Argentina have actually grown earnings in dollar terms faster than the S&P. A country like Turkey, which some associate with high degrees of volatility, they've grown their earnings in dollar terms faster than India over the same period. And so I think the perception doesn't always meet the reality when it comes to companies' ability to generate earnings. So that would be the first point. And I think secondly, if you look at the frontier market in general, it is no riskier than the rest of the world once you strip out the US. So if you look at the frontier index volatility over the past 5 years, it's essentially the same as MSCI World ex-US. So I think the volatility argument is also interesting. And then I'd just say one last thing, which is that these are very large overlooked economies. So if you take the top 15 countries in the world by population, more than half of them are next-generation emerging markets. Again, countries like Indonesia, the Philippines, Vietnam, they all have populations of over 100 million people, yet asset allocators and equities have allocated less than 1/3 of 1% to these massive countries that are going through a transformation. So I think, you know, there is room for these countries in a global equity portfolio due to their strong earnings growth, due to their low correlations, and frankly, I think due to some really interesting growth themes that we've invested in.

That's interesting. Large overlooked economies and the earnings growth has been good. What about the currency? What about inflation? Like we had a bout here in the US with double-digit inflation, the first that most people can remember. And it was, you know, thankfully fairly short-lived, but people are still feeling the pinch about it. But sometimes investors here, they read about these other economies where inflation just really spirals outta control. In a portfolio like this, is that something that you have to manage on the portfolio level? Is it something where the markets you're investing in have done a good job of containing inflation? Is it something where the companies that you're investing in do business around the world so they're fairly insulated? Where does the protection come from for inflation?

So essentially I'd say two things. Number one is we are very focused on the sort of top-down macroeconomic analysis of all the countries we invest in. It is a crucial part of our investment process. So there's a number of countries that we have avoided up until very recently because we were quite concerned about the valuation of the currencies and what we viewed as an impending depreciation. And that's what actually happened in countries such as Egypt and Nigeria and Pakistan. However, it's important to remember that once currencies do depreciate, and in these cases, Currencies have fallen between 50% and 90% in the case of Argentina, then it starts to get interesting. So then you start to say, has the adjustment been large enough for me to find some value at the company level? So that's number one. Number two is, as you sort of said earlier, companies are somewhat used to operating in these environments. And what we do is look for business models that are either earning dollars or are tied to a depreciating currency. Maybe they're an exporter and maybe they have some both that protects their, their margins over time. So it is an important prospect. You cannot invest in, in these countries without taking a look at inflation and currency analysis.

Thank you, Stephen. Let's take a quick break and we'll be back with more on investing in frontier markets.

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Get the facts at meta.me/risk. Welcome back, Jackson. I like Steven's point about the retailers competing against the wet markets. That sounds like I think if you're, you know, if you're some version of a, of an overseas Costco and you're going up against the wet market, you can do pretty well. But that's coming from my standpoint as an American who my main hearing of the phrase wet market has been in connection with COVID and, you know, all sorts of big wet market needs to hire a crisis brand manager. But we should explain. I mean, if people don't know what a wet market is, it's a really common thing all around the world. And it— and I think the wet part just means like perishable stuff. Like there are, you know, dry markets where they would sell like household goods and textiles and that sort of thing. And the wet market means they're bringing some fresh produce or meats and different things through.

We just call those farmers markets here. And they're there. Doing quite well. There's a farmer's market near my house that's ridiculously expensive, and you'll often see C-list, maybe even some B-list celebrities there.

Name one. We might not want to say, but name them. We'll bleep it out if we have to. I've, uh, and you're saying B or C-list for him? He's A-list all the way.

You know who played basketball with him?

Really?

Yeah, on Saturday mornings.

He's a huge star.

He'll just show up. Yeah, he's huge.

You know who I played basketball with is Joe Stewart. Oh no. Back when he was big on TV, because I had some friends who worked at Comedy Central and they had a weekly basketball game for the people who worked there. And I used to— they just told me to show up and just say you're Jack from accounting.

That's what I did.

Oh, that's awesome.

Let's get back to what we were talking about. It wasn't just celebrity basketball. Or why wet markets need a rebranding, possibly to farmers markets. Before that, we were talking about frontier market events.

Frontier markets.

Yeah. And I want to get right back to my conversation with Stephen Quatry at Morgan Stanley Investment Management. Can you tell me about something that you like right now? Something you're very enthused about? You mentioned a handful of, of individual countries earlier. If you're able to talk about individual companies in your portfolio, I, I'd love to hear about some. If you're not able to. Maybe you can tell me about your one or two favorite markets right now.

For one example, currently, we're looking and have invested pretty extensively throughout the continent of Africa. And there's a number of Pan-African telecom operators that are really leveraged to strong demographic trends, secular growth in data usage, and uniquely mobile money. These mobile money businesses are growing upwards of 30% a year. One such company just did over $120 billion in transactions, earning them about $1 billion in revenue. These are high-margin businesses that earn 45% EBITDA margins and they have a moat. They have this distribution. It's usually a duopoly, maybe a 3-player market that allows them to earn high returns on invested capital. Ian Formigle: And most importantly, some of them trade at EV-to-EBITDA multiples of about 4 times.

So when you say EV/EBITDA 4 times, enterprise value to the acronym for the adjusted earnings before interest, taxes, depreciation, amortization. But 4 times, how would that compare with like, what's a typical number that you might see here in the US just for folks to get a sense?

Yeah, that's a good question. Typically telco operators can vary, but I think something around 10 to even 12 times is something more normal we're used to seeing. Essentially what I'm saying is that in 4 years, The EBITDA this company generates is essentially what you're paying for the business. So in 4 years, your EBITDA will recoup the entire value of the business.

I cut you off. Go ahead with what you were saying.

Yeah. I think one other interesting theme that we're just seeing throughout these countries is that many of them have underinvested in healthcare. This isn't anything new, but we think that this is a large growth area with long tailwinds for growth. One such opportunity I could mention is in the country of Indonesia. Indonesia, interestingly, has the world's largest universal healthcare scheme. There's over 280 million people, 95% of which are enrolled in universal healthcare. So we've invested in a private hospital operator that is the largest private hospital operator. They cater to the middle class. And they earn very high returns on invested capital of 20% plus, a very clean balance sheet and a strong management team. And so there's appealing economics of this industry. We think the growth tailwinds will last. One statistic I can quote you is that Indonesia has 1.4 hospital beds per 1,000 people. In developed markets, you get to much higher numbers, anywhere between 5, 10, even 15 beds. I think in some other countries, it could be even much higher. And so we think that this will need to change and grow over time. So we're pretty excited about this, this sector in Indonesia as well.

Those are some of your favorite markets or regions right now. For somebody who's a typical U.S. investor, they've got their 60/40 mix or whatever for the stock portion of their portfolio. Maybe they have their U.S. stock fund and they have an international stock fund. But if they like what you're saying, they need to have this sliver in emerging markets. Should they separate the emerging markets from the next generation or frontier countries? And what kind of an allocation, what kind of a percentage do you think is appropriate here for their stock funds?

I think the first thing I'd say is when it comes to investing in emerging markets, we are big believers that active management is crucial. That allows you to make sure that you have hired someone who is focused not just on a passive ETF, but that instead is meeting with management teams, is aware of interesting trends and growth opportunities instead of just putting a lot of your capital towards a country which maybe has not as great fundamentals.

To your point, let me just emphasize, because there's people out there who've held an S&P 500 fund, they're saying, "Wait, what are you talking about? I'm doing great in my S&P 500 fund." Well, that's the US. And here, those tech stocks have done wonderfully well. But in some of these emerging markets, if you do a market cap weighting on the stocks, you can get very skewed ratings. Like there might be one giant company that dominates the economy, that sort of thing. And as we talked about earlier, if you have a fund with all the different countries, you might be all loaded up in one country and it may or may not be the country you're looking for. So active management is a way to get, to your point, like a more balanced portfolio targeted on the markets you want.

That's right. And I would add that our team has been on a relative basis positive on India for quite some time. And I think that view's been borne out. And if you had invested just in, say, an ETF, you actually would've had a much lower allocation to India, much higher allocation to China. So I think, again, as you alluded to, it's important to have an active approach when it comes to investing in emerging markets, simply because there is a huge country element that needs to be taken into account.

[Speaker:TREY_LOCKERBIE] There was a long time, I can remember investment salesmen decades ago, 30 years ago, coming around to the Wirehouses and selling their China fund and very soon after it selling their India fund. And there was a long period where there was a lot of promise in India, certainly a large population, some demographic tailwinds and things like that. It didn't play out in the investment funds. Are we now firmly in the period where you think that these things are going to begin to materialize for long-term investors with exposure to India?

Well, it's a good question, Jack. I myself am not an India expert. Our broader emerging market team focuses on India, So I wouldn't feel super comfortable answering it, but I do think that it's clear that the world has woken up to the potential of not just India, but many of these markets in emerging markets that do have strong growth fundamentals, that do have great demographic trends, that have really interesting themes. And while I don't cover India, I think there's a market such as Indonesia that has very similar characteristics, right? It's incredibly large. We're talking 280 million people. It's a country which has had a president who has done a number of really interesting economic reforms. The country has digitized at an amazingly rapid pace, and you can invest in some really interesting consumer opportunities. I think one interesting stat I will also mention is of the next-generation emerging markets that I focus on, they are going to be adding about 150 million new consumers to the labor force over the next decade. So in a world where China is going to lose about 40 or 50 million workers over the next decade. The euro area is losing 40 million workers. These countries are adding essentially the equivalent of a Mexico in a decade. And that actually means, you know, more people means more demand for goods and services, the aspirational consumer and the rise of the middle class. And so I think, I think the market will over time slowly start to, to wake up to, to this idea and hopefully start to allocate more capital to these really important markets.

Thank you, Steven. And thank all of you for listening. Jackson Cantrell is our producer. Jackson, how good was you know who as a basketball player when you played with him?

Pretty scrappy. Maybe could do some cardio training.

Oh no. Well, the fella that I mentioned that I played with, he fouled me like I was on fire and he was trying to put me out. You can subscribe to the podcast on Apple Podcasts, Spotify, wherever you listen. If you listen on Apple, you can write us a review. If you have a question you'd like answered on the podcast, you could tape it on the voice memo app on your phone. You can email it to jack.hough@barons.com. See you next week.

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