Summary
Over the past decade, an increasing number of investors have discovered the potential of investing in the smaller and less developed “frontier markets,” many of which have been developing rapidly into excellent growth opportunities. Although many of the greatest investment opportunities of the next decade will likely emerge from the frontier, these markets are often characterized by limited research coverage and low liquidity. However, investing in frontier markets offers a good deal of potential for investors who hope to increase their exposure to developing nations, including the majority of the African continent.
Once an investor has decided to increase his or her exposure to frontier markets, there are still a relatively limited number of ways they are able to invest. Although there are a number of index and exchange-traded funds which are designed to mimic the performance of stock markets, we believe that active stock selection and portfolio management is a key driver of success in frontier market investment. Index funds are often weighted towards larger markets and more liquid stocks.
We believe that there are a number of overlooked opportunities trading at attractive valuations which a more active approach will help discover. Active management facilitates risk management in a portfolio, while allowing investors to patiently invest in less liquid stocks, identify key investment themes and opportunities, and follow attractive catalysts. To simply invest in an index or exchange traded fund means missing many of the benefits a more active strategy could provide.
Introduction
When you mix two hot investment trends, some investors assume you can cook up a recipe for success.
Trend #1: The world’s frontier markets are being discovered by more institutions and individuals.
Trend #2: For the past decade, a growing number of investors have accepted the benefits of index funds and ETFs.
Putting the two together, wouldn’t it be smart to take your first steps “into the frontier” through index funds? As experienced active managers of investments in Africa, our answer is that it is not.
For reasons we will cover in this report, we believe Africa is one of the least crowded investment spaces on Earth, with wide-open opportunities for finding attractive long-term values. As active managers in Africa, our goal is to take advantage of the continent’s unusual dynamics and the unique characteristics of its 54 separate countries. As we will explain, index funds don’t have this freedom.
As more ETFs and index mutual funds emerge in Africa, we believe they are crowding into the same stocks, for the same reasons. These reasons have more to do with index fund structures and requirements than with Africa’s growth potential over the next decade and the companies that will drive it.
We believe the key to success in many frontier markets, especially Africa, will be a patient long-term horizon combined with local market resources and research and an active management strategy.
How Index Fund Choices Avoid the Frontier
For investors who want to “follow the crowd” into African markets, a few index fund choices have been launched. However, for the most part, they are heavily concentrated in Africa’s only two emerging markets (South Africa and Egypt) and lack broad exposure to frontier markets. For example:
- The S&P Mid-East and Africa BMI Index recently held 138 stocks, with its largest country weightings in South Africa (86%) and Egypt (6%). It is tracked by the SPDR S&P Middle East & Africa ETF (GAF).
- The Dow Jones Africa Titans 50 Index holds 51 stocks, and its largest weightings are South Africa (30%), Egypt (21%), Nigeria (15%) and Morocco (11%). It is tracked by the Van Eck Market Vectors Africa Index ETF (AFK). These two indexed ETFs are capturing investors’ attention and assets – gaining about $250 million in combined AUM since their launches in 2007 and 2008, respectively. However, what are their investors actually getting? The answer is mostly emerging market stocks that meet index and ETF criteria for size, free-float and liquidity. Therefore, the correlation between the above indices and emerging market index is high.The graph below shows the correlation between the MSCI Emerging Market Index and Market Vectors Africa Index ETF (AFK).
These two indexed ETFs are capturing investors’ attention and assets – gaining about $250 million in combined AUM since their launches in 2007 and 2008, respectively. However, what are their investors actually getting? The answer is mostly emerging market stocks that meet index and ETF criteria for size, free-float and liquidity. Therefore, the correlation between the above indices and emerging market index is high.
Like stocks, the price of an ETF changes throughout the day, and determining when to buy and sell will be determined by the bid-ask spread. Most ETFs in frontier markets are illiquid and as a result investors often pay high transaction costs because of the wide spread. These spreads are hidden costs that eat away at potential returns. For African ETFs it is not unusual to see bid ask spread in excess of 5%. For a large investor, the spreads will be higher, as large orders need higher buying prices and lower selling prices to be fulfilled.
In frontier markets, the structure of an ETF requires it to invest in the largest and most liquid stocks, so that authorized participants can effectively price and trade its shares. Thus far, investors have created liquidity only in a few frontier stocks of the best known and most thoroughly researched companies. The vast majority of investors who enter frontier markets through ETFs walk down the same narrow, well-worn path.
This trend was recognized in November of 2010 by one of the world’s most noted “contrarians,” Nouriel Roubini, Professor of Economics and International Business at the Stern School of Business. In a Reuter’s interview, Roubini was quoted as saying: “Fund managers should consider African markets such as Ghana, Kenya, Nigeria and Tanzania rather than chasing crowded emerging market trades elsewhere.”
In an April 2010 briefing, the global consulting firm Towers Watson evaluated 14 countries included in the FTSE Frontier 50 Index, which tracks the 50 most liquid stocks from an eligible universe of 23 frontier markets. Almost half (47.3%) of the index weight was in two Middle Eastern countries (Qatar and Jordan). Africa was represented by only an 18.6% combined weight allocated to just three countries – Nigeria (11.7%), Kenya (4.2%) and Mauritius (2.7%).
Towers Watson concluded: (1) “Many indices do not represent frontier markets particularly well”; and (2) “Frontier markets therefore seem more informationally inefficient, with any insight on a stock more likely to be unique and so more profitable.”
Although these comments are useful, we believe they only scratch the surface of differences between index funds and active managers in frontier markets. To help investors understand choices, Nile Capital Management has identified five Key Differentiators between passive and actively managed frontier funds. We believe Africa is an attractive region for identifying overlooked opportunities, and also for demonstrating how these Key Differentiators add value to globally diversified portfolios.
Five Key Differentiators
Undiscovered Stocks Trading at Attractive Valuations
Active managers increase their potential to outperform indexes when they can gain an edge in acquiring information. Although Africa is now developing modern communications infrastructure and methods, useful original investment research remains scarce. Large investment management firms won’t commit research resources to Africa until they have enough AUM to justify costs. This creates opportunities for firms such as Nile Capital Management who travel extensively across the continent, visiting companies and cultivating personal contacts and research resources.
We pay close attention to the quality of a company’s balance sheet and financial strength and in particular its management team. Because Africa’s national economic cycles tend to be short and dynamic, we look for managers who understand their local markets, can maneuver in difficult times, and have the ability to communicate with overseas investors. At times, we can identify capable management teams and attractive companies even in distressed markets.
For example, Zimbabwe has become a symbol of hyperinflation, resulting from government currency manipulation in 2007 and 2008. The Zimbabwe Stock Exchange remains tiny, with just 65 listed securities.
Yet, our “on the ground” research in Zimbabwe identified a company whose management team has consistently navigated through challenging times. This company, Innscor Africa Ltd., has developed an efficient vertical integration of the nation’s food chain – from farms to snack foods. Although the company’s revenues declined when the local currency collapsed in 2008, its resourceful managers have doubled sales (measured in dollars) over the past two years, and the company has become an even more dominant part of Zimbabwe’s consumer economy. To fully appreciate the strengths and achievements of a company such as Innscor Africa, local market knowledge and resources are essential.
Risk Management
In most markets around the globe, active managers tend to outperform indices during stock market downturns. The reason is intuitive: active managers have more flexibility to adjust to recessions and market sell-offs. Index funds are “flat-footed” and can’t easily respond to scenarios involving rising risk levels.
We believe this difference is magnified in the frontier markets of Africa because: (1) economic and market cycles tend to be shorter than in developed or emerging markets; and (2) cycles are not highly correlated among the diverse markets of Africa. When risks are rising in one African market, they may be falling in others; and (3) low liquidity levels can make entering and exiting positions challenging, as liquidity rises sharply when sentiment is strong, but disappears equally quickly as the mood sours, often causing stocks to trade below fundamental value, which creates opportunities for skilled active managers.
As risk factors become more complex, the value of risk-conscious active management increases. Our risk-assessment process begins with a comprehensive quantitative macro-economic ranking of all 54 national markets in Africa. Our model helps to evaluate all important risk factors of frontier markets including political, regulatory, structural, inflation and transparency risks.
Sovereign credit ratings, which can be useful in evaluating risks of developed or emerging markets, have limited value in fast-changing frontier markets. Our model drills down into risk factors that are highly correlated to frontier market risks, such as debt-to-GDP ratios and changes in currency reserves.
For example, over the past few years, Nigeria ranked high in our model’s output because the country has taken advantage of its oil resources to pay down debt and increase currency reserves, which we consider a proxy for national revenues in Africa. However, more recently the country reserves have declined because it is spending more money on infrastructure and a restructuring of its banking system. As active managers, we can make timely shifts in our exposure to Nigeria. By nature, ETFs are not nimble enough to adjust portfolios for such dynamic macro-economic changes.
Patience
Investors have the best opportunity to succeed in frontier markets when they have a long-term focus and are patient. The proof of that statement is the long-term performance in markets such as China and India, which would have been classified as “frontier” 20 years ago.
By definition, ETFs and other index funds put a premium on holding liquid stocks, and they are willing to pay a “liquidity premium” to own them. ETF components must be able to meet a demand for immediate liquidity, if it arises, because share turnover tends to be high and liquidity drives investment flows.
When we identify an African stock that appears deeply undervalued, it’s rarely being followed by international investors. The investor base tends to be local, and we also know that local investors in these markets often need to sell stocks to raise cash. This dynamic, which does not exist in developed markets, can make undiscovered and undervalued frontier stocks even more of a bargain.
An active manager can take advantage of falling prices and low liquidity to enter attractive stocks strategically, and then hold them patiently until catalysts emerge. Index funds lack this flexibility.
Theme Identification
All over the world, investment managers attempt to identify and participate in themes. In the U.S., Europe and Asia, attractive themes tend to be well known and crowded. In Africa, they are relatively undiscovered and wide open.
One theme we are continuously pursuing at Nile Capital is the emergence of Africa’s consumer markets. Although the consumer sector tends to have smaller companies and less liquid stocks than the natural resources sector, we believe it represents attractive valuation and holds long-term return potential. As Africa’s standards of living rise and rural populations move into cities, demand will follow for many basic consumer goods -- including food, shelter, clothing and home appliances. We have identified companies with strong consumer franchises in several top-ranked African markets, and we currently are allocating about 30% of portfolio weight to this theme.
Another current theme we have identified is China Demand. To build new factories, high-rise office buildings and high-speed train systems, China requires vast amounts of raw materials that Africa can supply, such as iron ore. In recent years, China has launched an aggressive campaign of acquiring or investing directly in overseas mines, especially in Africa. This is helping to attract global attention and investment capital to Africa’s most productive iron ore mining companies.
In pursuing this theme, we also have selected companies that are deeply involved in extractive industries, even though they are not listed on local exchanges. Most index funds don’t have this freedom.
Conviction and Catalysts
Active managers are pursuing a variety of investment styles in frontier markets, including value, growth, and momentum. At Nile Capital, we believe in maximizing our competitive edge with a high-conviction, concentrated portfolio of stocks with attractive valuations and long-term potential. We also focus on identifying near-term catalysts that can trigger: 1) increased research coverage and international interest; 2) a more favorable competitive position; and/or 3) earnings improvement. Because frontier markets are dynamic, catalysts often emerge quickly and fly “under the radar” of large investment firms. Local research and informational resources are essential to capture catalyst-driven changes.
An awareness of infrastructure and consumer market developments in frontier markets can also help to spot timely opportunities. For example, 70% of South Africa’s GDP is driven by consumer consumption, and yet the country has a relatively low-skilled labor force, high unemployment and lack of adequate low-income housing. Supplies of electricity in South Africa are very limited and rising steeply in cost – by a projected 30% per year, on average, from 2010 through 2012. On the surface, this catalyst does not appear favorable for the country or its mining companies, which consume large amounts of electricity.
However, we also are seeing major commitments to upgrade the electrical infrastructure in South Africa and other growing economies, especially Nigeria. Several large-scale public-private development projects are underway or being planned, and they will generate power using fuels that Africa has in abundance including sunshine (solar), wind and natural gas. General Electric, the world’s largest electricity-generator, has supplied more than 100 gas turbines to Nigeria and is invested in major infrastructure projects in South Africa.
Since about 20-30% of total cost structure in these countries goes for electricity, increased generation capacity has the potential to greatly reduce industrial companies’ fixed costs and drive profitability. This example shows how in-depth research and hands-on management can find a silver-lined catalyst in what may appear to be an African cloud.
Conclusions
Clearly, ETFs are changing the way many investors view opportunities and participate in niche markets. They have created more convenient access to markets such as oil and gold, and they can be simple choices for adding exposure to emerging markets such as India and China.
In frontier markets, however, ETFs and other index funds may not be as good as they appear. They can be heavily concentrated in a few of the most liquid markets and stocks, including those best known to international investors, and they create “crowd momentum” that drives stock prices beyond intrinsic value. They also lack the flexibility to strategically phase into emerging opportunities or identify off-the-beaten-track themes and catalysts.
Decades ago, today’s developed stock markets once had many of the same wide-open characteristics that frontier markets offer today. In those times, great active managers such as Peter Lynch honed techniques to leverage competitive advantages in high-conviction portfolios. As developed markets then grew more mature and competitive, and as Fair Disclosure rules dulled managers’ information edge, high levels of Alpha became harder to sustain year after year.
Africa is still risky and somewhat volatile, and is comprised of 54 distinctly different countries that have different economic cycles, growth drivers, and market dynamics. However, its stock markets have much in common with post-World War II America or Asia in the early 1990s. There is no Regulation FD in African markets and probably won’t be for many years – in part because so few analysts are paying attention, and so little information about the continent is flowing among big investment firms.
We believe that investors will have the best chance to succeed in Africa when they have long-term commitment and expectations, diversify among countries and securities, and take advantage of experienced professional management with access to local resources and research.
Nile Capital Management - We Know Africa: From Cairo to Capetown
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