HSBC Global Asset Management is bullish on frontier markets over emerging markets as they offer more compelling valuations and are more uncorrelated, less volatile and still relatively under-researched.
The investment rationale for both frontier and emerging markets is similarly based around a need for infrastructure and a consumption story driven by large, young and increasingly wealthy populations and booming commodities production.
But the asset manager says that one key differentiator is that frontier equities are now trading on average at a 15% discount on a price-to-earnings (P/E) basis to traditional emerging markets, which rallied 27% in the second half of last year but have since moved into correction territory.
“We expect to see that discount continue to narrow because these markets started to outperform traditional emerging markets in the last couple of months,” says Andrea Nannini, frontier markets fund manager at HSBC Global Asset Management based in London.
Frontier markets outperformed emerging markets by 6-7% in 2010, he notes, and expresses his belief that this year will be a similar story.
The chief concern when it comes to frontier countries is geopolitical instability in the Middle East and North Africa. But Nannini says: “In most frontier markets there is always political risk associated with investments, which is mostly known and priced-in by the market.”
With more than 25 frontier markets globally, he points to the low correlation between them, which equates to diversified risk on an overall portfolio basis.
“The correlation among different frontier markets, spread out in five continents, can be very low or even negative sometimes,” notes Nannini.
He outlines market data from January 2005 to December 2010 showing that frontier markets have recorded lower volatility of returns to both emerging and global markets – a little over 10% versus over 20% for EM and a touch lower for GM at the end of last year.
Presently, HSBC’s favourite frontier is Nigeria, Africa’s third largest economy, which is expected to become its largest by 2020 driven by strong economic growth from a low base. “The valuation of the banking sector is very attractive, with a price-to-book ratio at 1 to 1.5 times and return on equity of 10-20%,” he highlights.
“Consumer names such as food producers and retailers and the infrastructure sector including cement producers are also attractive, supported by growing consumer purchasing power and heavy infrastructure spending.”
Nevertheless, most Asian frontiers are missing off HSBC’s recommended list. “Markets like Bangladesh and Sri Lanka have priced in the growth story more than they should,” he says. “Vietnam has to deal with a high current account deficit and high inflation and the government’s tightening measures do not create a good environment for equities.”
On the present consolidation phase among emerging markets, Nick Timberlake, the firm’s global head of emerging market equities, believes the risk of high inflation has largely been priced-in and is bullish about Russia and certain sectors in China on valuation grounds.
Among HSBC’s global investment funds, Bric Equity gives more weight (38%) to Russia than any other single market, based on rising oil prices and valuations.
“The market is traded at a P/E ratio of 6.9 times today, at a 25% discount to a historical average of 9 times and more than a 30% discount to the whole emerging market asset class at 11 times,” notes Timberlake.
With reference to China equities, he reckons the next move is to buy rather than sell and sees value in the financial sector and some airline and industrial companies. “These sectors are nearly as attractive today as they were after the global financial crisis in late 2008,” he notes.
China has raised banks’ reserve requirement ratios eight times by a total of four percentage points since January 2009, with an initial drop in bank share prices followed by outperformance, “which gives me confidence that much of the bad news has been priced-in,” says Timberlake.
“You can buy Chinese banks between 1.3 to 1.5 times book value today which are generating returns in high teens and low twenties, which is very attractive risk-award.”
However, Timberlake points out that unorthodox administrative measures used in every sector in China to benefit society at large rather than company shareholders has handicapped the overall market.
“These [government] policies are designed to create steady growth and lift the employment and overall wealth of society, but companies have to pay the price by earning less, which could be one of the reasons that the Chinese market has performed poorly despite high GDP growth.”
Among Bric markets, Brazil is least favoured by HSBC. “The way the Brazilian government kills inflation is rate hikes, which has induced carry trade between the real and other currencies into the market, pushing the currency up and adding pressure to its export sector,” he adds.