Macro challenges test frontier markets
JF Asset Management portfolio manager Rajendra Nair says oil prices, food inflation and risk appetite are the key concerns for frontier markets.
Rajendra Nair is an investment manager and an India country specialist with JF Asset ManagementÆs Pacific Regional Group in Hong Kong. Together with Mayur Nallamala and David Smith, Nair co-manages the $32 million JF Asia New Frontiers fund.
The fund invests both in frontier market-listed companies and those listed elsewhere but benefiting in some way from those markets. As of June, the fund's top country allocations were to Kazakhstan, the Philippines, Australia, Pakistan, Sri Lanka, United Kingdom, and Canada. Financials, materials, and energy were the fund's top three sector exposures. The top three stock holdings were energy firm Kazmunaigaz, Halyk Savings Bank, and materials firm KazakhGold Group û all three of which are listed in Kazakhstan.
Nair shares with AsianInvestor his views about frontier markets and why it makes sense to be an early mover in those markets.
You launched the JF Asia New Frontiers fund towards the end of 2007. Have your expectations been met?
Nair: It has only been eight months since launch. It has been kind of a mixed bag in terms of our experience. To some extent, some of the characteristics have played out in the sense that they are not as correlated with the other mainstream markets as some of the other emerging markets are. The overall macro environment clearly has been a challenge. While they are less correlated, it is not as if they are completely correlated to what has happened to the rest of the world. To that extent, it has been a learning experience in terms of the challenges these markets face.
Within the frontier markets, the macro environment has been more challenging for some more than the others. Having said that, we have consistently maintained that frontier markets are for investors with a higher risk appetite and with a longer-term time horizon. Those two aspects have not really changed.
On balance, if you look at what has happened, the fund has probably outperformed a lot of the other mainstream funds. ItÆs too short a period to draw any conclusions.
When you say that frontier markets are for investors with a longer-term horizon, how many years are you referring to?
One to three years. From an investorÆs standpoint, the opportunities in these markets are longer term. And if you really want to capitalise on those opportunities, you have to take those opportunities now. Markets move pretty quickly.
When do you expect these frontier markets funds to pay off?
ItÆs difficult to quantify and the last few months have shown that. ItÆs fair to say that returns from markets that have gone from frontier-like status to mainstream bigger emerging markets today have generated strong returns. I would not hesitate to think that those returns can be expected with the current set of frontier markets over the long-term.
For example, a market like India has gone from being a small and very under-explored market to being one of the larger emerging markets with a reasonable degree of foreign investments. Vietnam is also an example. It has emerged but is has had difficulties in the past months. It has gone through those days when it went up a lot, and now it has come down. All these markets have all these cycles over long periods of time.
What we are hoping is that some of these frontier markets will become bigger emerging markets in five to 10 years and the idea is to try and explore the opportunities because some of these markets may not be understood by investors. What we are trying to do is be ahead of the curve.
Vietnam used to make up around 5% of your portfolio. It is no longer among your top holdings market-wise. Have you taken losses in that market?
As far Vietnam is concerned, we know that clearly the market has had its challenges and those challenges are very much related to the common problem in Asia, which is inflation. Asset allocation for us is a function of what we think top-down, and those views will change over time. In hindsight, you can look at the market and pass judgement on it.
Have frontier markets maintained their æfrontierÆ status?
Many of them, yes. Overall, foreign investments in markets like Bangladesh, Pakistan and even places like Kazakhstan are still small.
Do investors chase the same stocks in these frontier markets?
One of the challenges of investing in frontier markets is the opportunity set in each market is very limited. The capital markets are not very developed, certainly not as much as emerging markets. The number of investors looking at these markets is not that many. Are we looking at the same stocks? Yes.
How do you gain exposure to Kazakhstan, Sri Lanka and Bangladesh?
Sri Lanka and Bangladesh allow direct foreign investment. Kazakhstan also. But from our standpoint thatÆs not the only way. In the case of Kazakhstan, a lot of large companies are listed in London. Another way is, from our standpoint, trying to identify companies that have businesses or assets in frontier markets regardless of where they are listed in frontier markets. As long as they have investments and businesses in frontier markets, we will consider them.
What are the challenges you face in investing in frontier markets?
This year has been all about macro, not so much micro. Oil prices, food inflation, risk appetite. ThatÆs all macro. ThatÆs clearly a challenge. ThatÆs the number one challenge common to all the markets in the world today û the macro-environment.
With regard to the frontier market itself, the specific challenge is what it has always been that the capital markets are not very well developed so the investment universe is very small. But when you think about it, they are frontier markets precisely because of those challenges. So those challenges are also the opportunities.
If liquidity dries up, that will have an impact on the way we manage the portfolio and therefore that will have an impact on returns.
What are the main risks?
Lack of liquidity, the small investment universe, and the capital markets that are not well developed.
How are you managing those risks?
There are risks where we can do something about, and there are risks where we canÆt do anything. Managing liquidity risks, for example. What we can do is perhaps focus much more on preventing single stock level concentration. The idea is to be cognizant of stock risks, diversify the portfolio more, try and manage and diversify risk at the country level.
There are other things that we cannot do anything about. For example, currency. In many cases, you cannot hedge currency risk exposure because your currency derivatives products are either not available or too small.
What is your maximum allocation to a single stock?
We have no cast iron rules. This is a dynamic variable. We try and maintain a level of diversification that we are comfortable with in terms of liquidity in the markets and our own risk management matrix.
What is your overall outlook for frontier markets?
In the near-term, the outlook has become very fuzzy. We donÆt spend too much time worrying about whatÆs going to happen in the next one to three months. The near-term challenges are there. As long as crude oil prices remain high, food inflation remains a challenge, these markets will be affected by those issues.
Having said that, it is important for investors to realise that these markets have fallen off quite a bit. In many ways, they have already responded to what is happening.
ItÆs a question of what will be the catalysts that will bring about a turnaround. These catalysts are global macro factors: inflationary pressures easing off, which in turn will mean interest rates will come off, which will mean sentiment will improve.
What do you think of current valuations?
If you think in term of multiples such as price-to-book or price/earnings six months ago, they were trading at a discount to the more mainstream emerging markets. Therefore one could argue that they were cheaper, but I donÆt necessarily agree with that. While they were optically cheaper, they deserved to be trading at those multiples because of specific issues and challenges they face. That was six months ago.
Fast forward six months. Many of the markets have fallen a lot. The discounts are not as wide compared with the mainstream emerging markets because they too have fallen. First, in relative terms the discount is not as wide. Second, looking at multiples is only one side of the story. The other side is what is happening to fundamentals itself. There, itÆs a mixed bag.
The thing about frontier markets is its very difficult to generalise. For example, you have a market like Kazakhstan that is resource-oriented. ItÆs driven by what happens to oil prices, commodities prices, and what happens to gold. If you look at it optically, Kazakhstan looks more expensive than other frontier markets but it is actually positively affected by what is happening in terms of higher oil and commodities prices.
For an in-depth review of frontier markets, see the July 2008 issue of AsianInvestor magazine.
The fund invests both in frontier market-listed companies and those listed elsewhere but benefiting in some way from those markets. As of June, the fund's top country allocations were to Kazakhstan, the Philippines, Australia, Pakistan, Sri Lanka, United Kingdom, and Canada. Financials, materials, and energy were the fund's top three sector exposures. The top three stock holdings were energy firm Kazmunaigaz, Halyk Savings Bank, and materials firm KazakhGold Group û all three of which are listed in Kazakhstan.
Nair shares with AsianInvestor his views about frontier markets and why it makes sense to be an early mover in those markets.
You launched the JF Asia New Frontiers fund towards the end of 2007. Have your expectations been met?
Nair: It has only been eight months since launch. It has been kind of a mixed bag in terms of our experience. To some extent, some of the characteristics have played out in the sense that they are not as correlated with the other mainstream markets as some of the other emerging markets are. The overall macro environment clearly has been a challenge. While they are less correlated, it is not as if they are completely correlated to what has happened to the rest of the world. To that extent, it has been a learning experience in terms of the challenges these markets face.
Within the frontier markets, the macro environment has been more challenging for some more than the others. Having said that, we have consistently maintained that frontier markets are for investors with a higher risk appetite and with a longer-term time horizon. Those two aspects have not really changed.
On balance, if you look at what has happened, the fund has probably outperformed a lot of the other mainstream funds. ItÆs too short a period to draw any conclusions.
When you say that frontier markets are for investors with a longer-term horizon, how many years are you referring to?
One to three years. From an investorÆs standpoint, the opportunities in these markets are longer term. And if you really want to capitalise on those opportunities, you have to take those opportunities now. Markets move pretty quickly.
When do you expect these frontier markets funds to pay off?
ItÆs difficult to quantify and the last few months have shown that. ItÆs fair to say that returns from markets that have gone from frontier-like status to mainstream bigger emerging markets today have generated strong returns. I would not hesitate to think that those returns can be expected with the current set of frontier markets over the long-term.
For example, a market like India has gone from being a small and very under-explored market to being one of the larger emerging markets with a reasonable degree of foreign investments. Vietnam is also an example. It has emerged but is has had difficulties in the past months. It has gone through those days when it went up a lot, and now it has come down. All these markets have all these cycles over long periods of time.
What we are hoping is that some of these frontier markets will become bigger emerging markets in five to 10 years and the idea is to try and explore the opportunities because some of these markets may not be understood by investors. What we are trying to do is be ahead of the curve.
Vietnam used to make up around 5% of your portfolio. It is no longer among your top holdings market-wise. Have you taken losses in that market?
As far Vietnam is concerned, we know that clearly the market has had its challenges and those challenges are very much related to the common problem in Asia, which is inflation. Asset allocation for us is a function of what we think top-down, and those views will change over time. In hindsight, you can look at the market and pass judgement on it.
Have frontier markets maintained their æfrontierÆ status?
Many of them, yes. Overall, foreign investments in markets like Bangladesh, Pakistan and even places like Kazakhstan are still small.
Do investors chase the same stocks in these frontier markets?
One of the challenges of investing in frontier markets is the opportunity set in each market is very limited. The capital markets are not very developed, certainly not as much as emerging markets. The number of investors looking at these markets is not that many. Are we looking at the same stocks? Yes.
How do you gain exposure to Kazakhstan, Sri Lanka and Bangladesh?
Sri Lanka and Bangladesh allow direct foreign investment. Kazakhstan also. But from our standpoint thatÆs not the only way. In the case of Kazakhstan, a lot of large companies are listed in London. Another way is, from our standpoint, trying to identify companies that have businesses or assets in frontier markets regardless of where they are listed in frontier markets. As long as they have investments and businesses in frontier markets, we will consider them.
What are the challenges you face in investing in frontier markets?
This year has been all about macro, not so much micro. Oil prices, food inflation, risk appetite. ThatÆs all macro. ThatÆs clearly a challenge. ThatÆs the number one challenge common to all the markets in the world today û the macro-environment.
With regard to the frontier market itself, the specific challenge is what it has always been that the capital markets are not very well developed so the investment universe is very small. But when you think about it, they are frontier markets precisely because of those challenges. So those challenges are also the opportunities.
If liquidity dries up, that will have an impact on the way we manage the portfolio and therefore that will have an impact on returns.
What are the main risks?
Lack of liquidity, the small investment universe, and the capital markets that are not well developed.
How are you managing those risks?
There are risks where we can do something about, and there are risks where we canÆt do anything. Managing liquidity risks, for example. What we can do is perhaps focus much more on preventing single stock level concentration. The idea is to be cognizant of stock risks, diversify the portfolio more, try and manage and diversify risk at the country level.
There are other things that we cannot do anything about. For example, currency. In many cases, you cannot hedge currency risk exposure because your currency derivatives products are either not available or too small.
What is your maximum allocation to a single stock?
We have no cast iron rules. This is a dynamic variable. We try and maintain a level of diversification that we are comfortable with in terms of liquidity in the markets and our own risk management matrix.
What is your overall outlook for frontier markets?
In the near-term, the outlook has become very fuzzy. We donÆt spend too much time worrying about whatÆs going to happen in the next one to three months. The near-term challenges are there. As long as crude oil prices remain high, food inflation remains a challenge, these markets will be affected by those issues.
Having said that, it is important for investors to realise that these markets have fallen off quite a bit. In many ways, they have already responded to what is happening.
ItÆs a question of what will be the catalysts that will bring about a turnaround. These catalysts are global macro factors: inflationary pressures easing off, which in turn will mean interest rates will come off, which will mean sentiment will improve.
What do you think of current valuations?
If you think in term of multiples such as price-to-book or price/earnings six months ago, they were trading at a discount to the more mainstream emerging markets. Therefore one could argue that they were cheaper, but I donÆt necessarily agree with that. While they were optically cheaper, they deserved to be trading at those multiples because of specific issues and challenges they face. That was six months ago.
Fast forward six months. Many of the markets have fallen a lot. The discounts are not as wide compared with the mainstream emerging markets because they too have fallen. First, in relative terms the discount is not as wide. Second, looking at multiples is only one side of the story. The other side is what is happening to fundamentals itself. There, itÆs a mixed bag.
The thing about frontier markets is its very difficult to generalise. For example, you have a market like Kazakhstan that is resource-oriented. ItÆs driven by what happens to oil prices, commodities prices, and what happens to gold. If you look at it optically, Kazakhstan looks more expensive than other frontier markets but it is actually positively affected by what is happening in terms of higher oil and commodities prices.
For an in-depth review of frontier markets, see the July 2008 issue of AsianInvestor magazine.
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