May 16, 2017 / 10:36 PM / 3 months ago

Frontier stock markets draw fresh look as U.S. shares get frothy

NEW YORK (Reuters) - Fidelity Investments portfolio manager Adam Kutas, a frontier markets specialist since a trip to Hungary more than three decades ago, has scored big on shares of Olympic Industries OLIS.DH, a Bangladeshi cookie maker, up some 620 percent since 2012 for his Frontier Emerging Markets Fund.

Driehaus Capital's Frontier Markets Fund has reaped gains on BRAC Bank BRAC.DH, a Bangladesh-based retail and small business lender that has risen 271 percent over the same time.

These investors say the ready availability of easy-to-understand and cheap stocks like banks and retailers is a main attraction of frontier, an asset class less established than emerging markets (EM) like Brazil, Turkey and India, that can have political instability and potential poor liquidity.

"It's very similar to emerging markets 15 years ago," said Chad Cleaver, lead portfolio manager at Driehaus Frontier Markets Strategy. "These are basic industries that happen to be heavily underpenetrated."

After years of sub-par returns, frontier markets started 2017 strong and are getting fresh looks as U.S. valuations look steep and emerging markets have been on an explosive run.

The S&P 500 index .SPX trades at a heady 21.35 price-to-earnings ratio, compared with the MSCI International Frontier Market Price Index's .dMI7400000PUS 13 P/E.

Fund managers say while they don't buy with a particular P/E in mind, frontier's ratios are generally some of the cheapest in global equity markets.

Lawrence Speidell, chief investment officer (CIO) of Frontier Market Asset Management, says most of the securities he owns trade at 10 times earnings or less.

Frontier stocks and bourses can offer triple-digit returns for investors who make the right call, such as Pakistan's Karachi SE 100 index .KSE up threefold over the past five years. But the segment has underperformed badly as an asset class over the longer term.

From 2010 to 2016, the MSCI frontier market index posted a negative average annual return of 2.4 percent, dragged lower by bourses like Nigeria's NSE index .NGSEINDEX, off more than 38 percent from its 2014 peak to the start of 2017.

For a graphic, click: tmsnrt.rs/2qsv7ar

'STICKING OUR NECKS OUT'

Such a track record helps explain why many mainstream investors steer clear.

"We find them to be very, very (underdeveloped). We have issues of liquidity and I think the emerging markets in general provide enough fertile ground without really sticking our necks out," said Leonardo Vila, a Federated Investors senior portfolio manager who specializes in global small- and mid-cap equities.

"The risk/reward for those frontier exposures may not help me sleep at night."

So far this year, MSCI's frontier market index is up 10.3 percent, beating the S&P 500's 6.8 percent rise, which may account for revived investor interest.

Since the second quarter of 2016, net inflows for actively managed frontier market equity funds have totaled $267.7 million, while EM managed equity funds have had outflows of $4.84 billion, according to eVestment data. Also, $438 billion have left actively managed non-EM equity funds.

Many frontier market portfolio managers are true-believer active stock pickers, which may be a tough sell as the wider fund industry has gravitated toward lower-cost index funds and exchange-traded funds.

For U.S.-based frontier stock funds, some $1.8 billion are invested in actively managed funds, while $668 million sit in passively managed index funds, according to Morningstar Inc.

Despite occasional gems like Olympic, the Bangladeshi cookie maker, active frontier investors have struggled to beat the benchmark, with just one in 13 funds outperforming the iShares MSCI Frontier 100 ETF (FM) so far this year.

According to Morningstar data, 43 percent of actively managed frontier funds have beaten the MSCI frontier ETF over a three-year horizon.

EM active managers have fared better, with 37 percent beating the EM ETF year to date, and nearly 62 percent outpacing it over a three-year period.

While acknowledging frontier investments are not for the faint of heart, proponents like Speidell, Frontier Market Asset Management's co-founder and CIO, say the asset class is like "a fine bourbon" and provides a chance to break from the pack.

"The poorer you are, the faster you grow, and this is what’s intriguing to me about going to the places where there aren’t a lot of analysts, where companies don’t have their stories down pat to present in slick PowerPoint presentations," Speidell said.

Speidell's fund has done well enough to command a reported 20 percent performance fee on top of a 1 percent management fee.

The growing uncertainty in developed markets created by events like Brexit and Donald Trump's upset election has prodded investors to seek securities that won't sink if U.S. or European stocks take a dive.

Frontier market equities have moved much more independently of U.S. equities than have EM stocks. MSCI's frontier index shows a 42 percent correlation to the S&P 500, compared with 91 percent for MSCI's emerging markets index, according to Reuters data.

Fidelity's Kutas has even invested 5 percent of his mother's retirement account in frontier assets.

Frontier investors say the best is yet to come as capital markets in little-known countries develop and their populations begin to flex their financial muscles. That will only add to gains for banks, retailers and consumer staples stocks for years, or even decades, to come.

"The very long-term thesis is that as you get less civil wars and more peace, you get better managed governments," said Leigh Innes, lead portfolio specialist for T Rowe Price's frontier markets strategy. "These are ... countries that tend to be at an earlier stage of development and are getting that early stability."

Additional reporting by Trevor Hunnicutt; Editing by Christian Plumb and Jeffrey Benkoe

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