Strategy Note /

7 reasons to consider investing in small EM and Frontier

  • (1) Macroeconomic silver linings in the crisis, (2) Macro benefits of a changing world, (3) Structural growth endures,

  • (4) Taboo reforms revisited, (5) Disruptive wars unlikely, (6) Cheap value, (7) Idiosyncratic stock markets.

  • Caveats: allocation should be multi-year (not daily liquidity) and off-the-shelf benchmark indices are of little use

7 reasons to consider investing in small EM and Frontier
Hasnain Malik
Hasnain Malik

Strategy & Head of Equity Research

Tellimer Research
14 April 2020
Published byTellimer Research

I do not run money for a living. Instead I try to process data and come up with ideas to provoke and help those who do. I realise that sometimes my ideas can be so unremittingly bleak that I might be provocative but unhelpful. This may be one of those times. 

So, to be helpful, I will try to put myself in the position of one of my institutional clients. If I had to reassure an existing investor or asset allocator in a small Emerging and Frontier market public equity fund or attract a new one, this is the letter I would write to them. To keep it brief I have not included supporting data and charts or links to relevant previously published research, but, where I have them, these are available on request.

The context is that the institutional funds under management in this asset class have more than halved in the past five years (while assets in EM active and passive public equity and private equity have grown) and many now regard small EM and FM countries as among the most vulnerable in an era of Covid-19, oil price collapse, US-China trade war, and the resultant contraction in global risk appetite.

In the hypothetical "letter" to investors and asset allocators below, some arguments are new and adapted for the current environment and others are long-standing ones that many will be familiar with (but are worth a reminder given the pall of gloom over the asset class currently). The new potential positive drivers for small EM and FM, particularly relative to developed and large EM, are the following:

  • High loss of life but relative economic resilience to Covid-19;
  • Appetite for previously taboo structural reforms;
  • Sovereign external debt relief;
  • A new search for yield;
  • Positive spillover from the US-China cold war;
  • US Dollar weakness; 
  • End of the share buyback boost for US earnings growth.

To be clear, there is no change in my previously published views either on the short or long term investment case issues in small EM and FM, which are significantly more tempered (particularly on what I label "Economic and Covid-19 Darwinism" below) and more nuanced than the enthusiasm expressed in this empathetic exercise. 

Dear investor or asset allocator, 

You should allocate fresh capital to an active small emerging and frontier markets (small EM-FM) strategy because the prospects for relative outperformance, in US Dollar terms, on a three- to five-year view are bright. The case rests on the macroeconomic, political and stock market-specific factors listed below.

(1) Short-term macroeconomics: silver linings from the crisis

(a) Economic and Covid-19 Darwinism – Poverty resulting from social distancing, and the resulting economic sudden-stop, may be a greater cause of death in poorer parts of small EM-FM than the Covid-19 outbreak that social distancing is intended to combat. This may moderate social distancing policies in much of small EM-FM. While the loss of life, in absolute terms, may be very high, the proportionate damage to the economy in poorer parts of small EM-FM may be less than in developed and more advanced emerging markets. Furthermore, the generally young demographic bias of most countries in small EM-FM should mitigate the overall fatality rate.

(b) External debt relief – The global nature of Covid-19 may create a consensus behind debt assistance for small EM-FM countries; ie richer bilateral creditor countries and the community of private debt investors may see it in their aggregate interest to allow debt forbearance and, potentially, relief. The IMF is already pushing along these lines.

(c) Renewed search for yield – The return with a vengeance of very loose monetary policy in developed markets likely sparks a renewed search for yield, which, in those countries in small EM-FM with credible economic policy frameworks, should benefit Eurobonds, at least, and, perhaps, local currency assets too.

(2) Long-term global macroeconomics: benefits of a changing world

(a) Dollar weakness repercussions – The US Dollar will ultimately weaken and this will alleviate stress on all EM-FM FX rates. This weakness will occur either because the global crisis and the search for safety in the global reserve currency recedes, or low growth and productivity in the US keeps US interest rates very low, or the US Dollar will gradually see its dominance among global reserve currencies challenged.

(b) China growth spillover – China will ultimately recover: many in small EM-FM supply commodities to China (eg Argentina soybean, Chile, Peru, Zambia copper, Colombia, Kazakhstan, Nigeria, Saudi and other GCC hydrocarbons, Indonesia, Malaysia palm oil, Zimbabwe diamonds and tobacco) and/or are recipients of outbound Chinese capital (eg Bangladesh, Kenya, Malaysia, Oman, Pakistan, Philippines, Sri Lanka).

(c) US-China cold war benefits – Relocation of manufacturing and purchasing away from China to other low-cost locations started with the US-China trade war and will accelerate with what we expect to be a coming US-China cold war. There will be beneficiaries in small EM-FM, eg Bangladesh, Egypt, Morocco, Pakistan, and Vietnam.

(d) Leap-frogging traditional bottlenecks via new technology – Mobile telecom network and smartphone technology have already enabled many small EM-FM countries to bypass the traditional bottleneck of poor fixed line telecom infrastructure and build services for communication, media, and finance far quicker than seen in larger EM countries two decades ago, not to mention more quickly than seen even in some developed countries. Technologies such as aeroponics, batteries, blockchain, distributed power generation, drones, and 3D printing may achieve similarly expansive frog leaps in agriculture, electrification, legal contracts and title deed registration, manufacturing and transport.

(e) Less earnings growth from share buybacks in developed markets – Listed US companies have been the largest buyers (via share buybacks and M&A) of US equities since 2007 (ETFs were second at about half the quantity of US companies). The largest 20 listed companies accounted for almost a third of all corporate purchases. Technology, industrial and consumer discretionary were among the sectors where the boost to earnings per share growth from share buybacks was felt the most. Companies with a high ratio of share buybacks to market capitalisation outperformed the S&P 500 index between 2008 and the start of 2020.

(3) Long-term structural growth drivers: factors that have not changed

(a) Demographic dividend – Long-term growth is driven by the growth in human capital, physical capital and improvements in productivity. Most countries in small EM-FM benefit from faster population growth rates and more youthful demographic bias than most developed and larger emerging markets. Education and healthcare levels are also generally improving in most of small EM-FM. All of this should support faster growth, assuming political systems provide adequate representation of that youthful demographic and economic growth supports the absorption of a sufficient proportion of the growing labour force. 

(b) Improving ease of doing business – From better protection of property rights to reduction in bureaucratic barriers to doing business in the private sector, most countries in small EM-FM are improving. Instances of the imposition of ad hoc regulation and taxation, eg Bangladesh, Tanzania, Zimbabwe, are the exceptions, rather than the rule.

(c) Under-penetration of established goods and services and low base of infrastructure – The penetration of modern consumer, banking, insurance, retail, transport, healthcare, and entertainment goods and services are generally much lower in small EM-FM than in developed and large emerging markets. The marginal impact of infrastructure (utilities, road, rail, airport, port) upgrades is much greater in most small EM-FM than in developed or large EM. 

(d) High urban density and increasing urbanisation – Extremely high urban density in many parts of small EM-FM is an obstacle to social distancing policies in response to Covid-19, but in more normal times is a great boost for network-based businesses (potentially driving far greater economies of scale than in more sparsely populated countries). Furthermore, the rate of growth of urban populations, which generally adopt modern goods and services quicker than rural populations, is generally higher in small EM-FM than in developed and large EM.

(4) Better governance (self-help and improvement): taboo reforms revisited in the crisis

(a) Taboo reforms revisited – The oil price collapse (and long-term constraint imposed by US shale and the encroachment on the use of fossil-fuel based energy by alternative technology) will force long-overdue structural reforms (transparency of economic data, subsidy removal, consolidation of government-related enterprises, leveling of the playing field for the private sector) in the oil exporters as the vested interests which have stood in their way historically use their political power to pursue them (in recognition that the old rentier model is no longer viable). This is already underway, to differing degrees, in Qatar, Saudi, and the UAE. Economic hardship which predates the current crisis has already seen structural reform (subsidies, tax, FX regime) taken on, to differing degrees, in Argentina, Colombia, Egypt, Georgia, Ghana, Morocco, Kazakhstan, Pakistan, Philippines. The current crisis likely renews, out of necessity, the political will for this reform.

(b) Orthodox economic policy – Governments in small EM-FM have, in general, become better (more orthodox) managers of the economy. This is reinforced by IMF programs in many of these countries, eg Argentina, Egypt, Jordan, Morocco, Pakistan, Sri Lanka, Tunisia, Ukraine.

(c) Manufacturing exports – The shift to a manufacturing export model (with steady growth and FX rate benefits) has been achieved in Bangladesh, Morocco, Vietnam, and, in doing so, replicates some of the success a generation earlier in the Asian tigers of Indonesia, Malaysia, Philippines, and Thailand.

(d) Intra-regional trade – Trade flows between small EM-FM countries and the US or China is generally much higher than their trade with countries closer to home. Geopolitical rivalries have historically inhibited intra-regional trade but the vagaries of US foreign policy, an unwillingness to rely too much on China, the gradual maturity of regional trade organisations (eg COMESA, AfCFTA, RCEP, TPP), and the less common occurrence of major wars (see point 18 below) should drive a pick-up.

(5) Long-term (geo)politics: fewer disruptive successions and wars

(a) Political transition and succession – Across small EM-FM, while deficiencies in the quality of governance and the provision of social justice remain, political transitions have been successfully managed (if not always fairly, at least in an orderly manner), establishing precedents which reduce future risk in both monarchies via succession, eg Saudi and the GCC, and republics via elections, eg Argentina, Bangladesh, Colombia, Kenya, Malaysia, Nigeria, Pakistan, Peru, Sri Lanka. Even in veneer-deep democracies, eg Egypt and Thailand, recent elections (more akin to political coronations) have passed without major disruption. 

(b) Major wars less likely – Very large scale inter-state wars (eg US-China, US-Russia, US-Iran, US-North Korea, Israel-Iran, India-Pakistan, Turkey-Iran, Russia-Turkey, China-Vietnam, Algeria-Morocco, Egypt-Ethiopia, Colombia-Venezuela) are less likely precisely because of less decisive intervention by the US, technology changes, the availability of non-state proxies, and war via economic rather than military tools. All this makes it much more difficult (longer and costlier) for those with conventionally more powerful military forces to win a war.

(6) Valuation check: cheapest relative to history and alternatives

(a) Historically widest valuation discount to developed and large EM – The valuation discount of small EM-FM is near its cheapest relative to developed and large EM since the Global Financial Crisis.

(b) Underperforming pre-crisis, unlike 2008 – Prior to the current crisis, as opposed to the period before the Global Financial Crisis, small EM-FM has been under-performing developed and large EM.

(c) Strategic buyers – Private equity (where assets under management for small EM-FM regions, eg Africa, have grown in recent years), strategic corporate buyers (local, regional, multinational, Chinese) or local sovereigns increasingly stand ready to swoop on distressed public equity valuations and trading liquidity in small EM-FM. Recent local and cross-border M&A has demonstrated, in general, that protection of minority rights in the target company is in place in most parts of small EM-FM.

(7) Stock market idiosyncrasies: loyal locals replace flighty foreigners, overseas listings, active versus passive

(a) Flighty foreigners have disappeared – Most of the "hot" foreign money has disappeared from small EM-FM. Within mainstream EM, investor liquidity (traded value) has migrated to the largest seven markets in the index (and through the current crisis, this migration has become more acutely focused on China and the technology portion of Korea-Taiwan). Furthermore, the funds under management in the dedicated FM equity asset class has roughly halved in the past five years and is less than one percentage point of the EM equity asset class. 

(b) Local liquidity the trigger – As local bond yields come down (in line with local policy interest rates), local investors (institutional and private high net worth) are likely to reconsider the weight they give local equities in their portfolios. The relatively strong balance sheets and high dividend payouts (in reflection, to be fair, of relatively mature growth) of the strongest listed corporates with well-established franchises, should provide an attractive investment destination. Furthermore, the ability of high-net-worth individuals to transfer their excess capital into developed market safe havens is increasingly tougher in a world with more stringent anti-money laundering regulation.

(c) Overseas listings – A substantial number of companies providing exposure to small EM-FM are now listed on developed market stock exchanges. This reduces the costs of trading and mitigates the worst-case scenario of local capital controls (trapped capital). 

(d) The last refuge for an active strategy in public equities (versus passive) – Passive funds outweigh actively managed funds in developed markets and are growing faster than active in EM. A long list of factors suggest that actively managed strategies should outperform passive in small EM-FM: (i) large swings in the country weights in indices such as MSCI FEM and MSCI FM (usually when a country is upgraded to EM) which drive disproportionate flows in and out of the stocks in those countries well in advance of the day those changes take effect, (ii) the loss of otherwise attractive investment cases at the stock level when that stock is removed from the index (eg as part of a country upgrade to EM), (iii) the high representation in indices of relatively mature companies or state-owned enterprises (which often do not have the most compelling investment cases), (iv) the extreme diversity of the investable universe (multiple geographies, languages, FX regimes, regulatory structures), (v) high all-in trading costs (including commission, FX conversion, custodian, structured product access charges), and (vi) generally low trading liquidity (which inhibits the ability to easily trade in and out of stocks).

* Post-script

(1) What is a small EM-FM anyway? I define this as any country which sits outside the big seven which account for 85% of MSCI EM: China 41%, Taiwan 12%, S Korea 12%, India 7.7%, Brazil 5.1%, South Africa 3.7%, Russia 3.5%. This leaves over 20 countries that are represented in MSCI EM, each with a weight of less than 3%, as well as almost 15 countries in MSCI FM.

(2) I am asking for a multi-year commitment: Consider my fund on the same time-frame that you would consider a private equity fund. Please do not invest in my fund with the expectation that you can redeem on a daily, monthly, or quarterly basis. The liquidity of the markets I look at does not support this. Not only will your redemptions likely occur at the very moments I would suggest investing more but, more importantly, the inevitably very low liquidity of some my positions will force me to sell some of my most robust and hardest to rebuild positions (eg in stocks at foreign ownership limit in Vietnam).

(3) Please do not compare my performance to standard benchmarks provided by the likes MSCI of FTSE, most of which are not fit for this purpose because they have excessive country concentration and are based off an assessment biased to stock market development, rather than economic development: EM Small Cap is dominated over 50% by China, Taiwan, Korea (like MSCI EM), MSCI FEM is over 50% Philippines, Kuwait, and Peru, and MSCI FM is over 50% Kuwait and Vietnam.