Adam Kutas | Portfolio Manager
Every year over the end-year holidays, I gather up a mix of research, try to avoid my computer screens and think about an outlook for the next year. Usually the stock markets over the holidays are quiet providing some room for deeper thought. This year was different, though. At the end of 2018, volatility spiked as the markets finally priced-in most of the higher business cost of capital. As well, oil and other commodity prices collapsed sharply given fears of an oversupply by producers, but also weak demand given a growing consensus of recession for many major markets. For many market participants, these movements lent themselves to a generally bearish outlook for 2019.
Yet what may have been missed by some market commentators is this volatility was generally confined to the developed markets, primarily the US. Emerging and frontier markets were relatively stable from their lows reached mid-year. Frontier markets performed quite well in 2016-17 so it’s not much of a surprise to see a re-setting of expectations and a shake-out of marginal investors. In my view, these lows were likely a cyclical downturn in a broader structurally positive outlook for these asset classes. This constructive outlook is based on a blend of bottom-up company fundamentals, investor sentiment and equity valuations as well as a broader, positive outlook for the macro backdrop for the structural winners (such as Vietnam, Bangladesh and Cambodia), but also commodity-oriented, frontier countries (like Colombia, Nigeria and Saudi Arabia).
To start, let’s look at investment returns for 2018. As seen in Chart 1, the MSCI Frontier EM Index was down almost 15% in USD terms last year which hurts any portfolio. Yet this performance is inline relative to other international equity asset classes such as developed and emerging markets. The only market that performed better was the S&P 500 Index which was down almost 5%. Within frontier markets, as seen in Chart 2, the main driver of the weakness was the macro-driven decline in Argentine equities. Conversely, Kuwaiti stocks performed quite well as the market priced-in a potential upgrade to “EM status” by MSCI.
So, after that decline, how do fundamentals look going forward? Well, as seen in Chart 3, returns on equity (one measure of profitability) continue to trend-up globally, with FEM companies posting broadly around 13-14% which is above their EM and DM counterparts excluding the US. From an earnings growth perspective, as seen in Chart 4, frontier companies are expected to grow around 11% in 2019 while the bottom line could grow 17%. These growth figures are above both EM and DM which is generally in line with history as frontier countries are earlier in their economic development and hence should grow faster (similar to small cap companies versus large blue-chip corporates).
Chart 4: Revenue and Earnings Growth Expectations
|Revenue %||EPS growth (%)|
So, we have companies that are growing at a low double-digit pace and at a profitable level. But what price are we paying for this growth? As seen in Chart 5, using price-to-book valuation measures as our proxy for prices, frontier equities compare quite well. They are a bit more expensive than broader EM and developed markets, though much cheaper than the US. Though the valuation premium is only around 10%, the higher price to book measure for frontier equities is driven by the higher-priced stocks in the Philippines and Kuwait markets (both of which the fund is underweight). But when one merges the growth outlook and prices paid, frontier equities compare quite favourably, as one is paying a decent price for better growth, and investor sentiment is on the beaten down side after a tough 2018.
So, in conclusion, though the headlines continue to unsettle most investors, stock pickers digging in commodity-based markets should find decent growth for attractive prices, especially relative to most richly-priced developed markets.
Thanks for reading
Adam Kutas, CFA