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Frontier Markets: A new Generation of Investment Opportunities
Daniel Broby, Chief Executive Officer, Danfonds, Denmark

Investors are increasingly looking for uncorrelated assets and strategies. They want to understand the concept and want to get into it before the crowd. The net result of this trend is a rise in popularity of ‘exotic’ funds. This is occurring even as many ‘conventional’ approaches to alpha generation are losing appeal. Funds focused on frontier markets, namely those investing in the Middle East, North Africa, Sub Saharan Africa and the former CIS are the next big thing. A raft of new funds have been or are being launched. That said, the market is hardly saturated. According to the HFN database, 90% of these funds have less than USD 50m under management and there is no fund larger than USD 500m that is open for investment. All these new funds are banking on frontier markets riding a wave of economic growth. This has certainly been the recent experience. According to the latest report from the OECD, Africa has experienced economic growth for four consecutive years. In 2007, the continent registered GDP growth 5.7 per cent (a per capita increase of 3.7 per cent). Indications are that this growth will continue to accelerate in 2008 and remain buoyant in 2009. This economic growth is ‘piggybacking’ on something that Adam

Smith considered important: namely resources. With the advent of ‘peak oil’ and the ‘commodity super-cycle’, the economics of development suddenly and dramatically turned around. The high oil price kicked in, in a big way. The commodity story, however, dose not stop at oil. Ghana, for example, is the world's second largest cocoa exporter and Africa's second biggest gold producer. Such commodities are also booming. Ghana, as a result, is enjoying its strongest growth in four decades. Even Tanzania, one of the ‘Least Developed Countries’, with a published per capita GDP of $210, is benefiting from the strong gold price. Tanzania's GDP growth rate is currently 4.9%, and has averaged 3.5% for the past four decades. Take Malawi as well. Apart from the adoption of Madonna's baby, the country is not exactly on most people’s radar screen. Why not? Because most people don't even know where it is. Well they should. Since 2005, inflation has fallen from around 30% to 7%. GDP is growing at around 6%. Sure, they have poor telephone infrastructure, but that spells opportunity. The different nature of the various frontier markets means that they are not correlated much with either themselves or developed markets. Although these markets are uncorre-

Daniel Broby enjoying a safari break during an organised investor trip

lated, Caveat Emptor! The universe is comprised of so called ‘failed states’. Their immature capital markets are often corrupt, illiquid and dangerous; certainly not the place for the faint-hearted (investors used to say the same things about the BRIC countries - before their economic transformation). There is another force for change, namely globalisation. This phenomenon is creating a social, political and economic renaissance within the world’s poorest countries. Economic historians will tell you that the wealth generated from the resulting industrialisation and its ‘multiplier effect’ will dramatically be captured by the entrepreneurial companies that are either in the right place at the right time or that just ‘get it’ . Stephen Jennings, the CEO of Renaissance Capital, having already made himself a billionaire out of such

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trends in Russia, calls this ‘the second once in a lifetime opportunity’. He cautions, however, that just ‘getting it’ is not enough. The winners in frontier markets have to be dynamic and entrepreneurial. Globalisation in itself is not enough. Clearly there has to be a catalyst. Cynics claim that the strong growth seen in the GDP of these countries was driven by a prolonged period of low global real interest rates and the resultant carry trade. In effect, they argue that the frontier markets are simply a beta play on global liquidity. They are partially correct, but the base case is deeper than that and the more informed analysis focuses on the writing off of debt of these countries by the Paris club, a leap in technology and the aforementioned commodity boom.

Most frontier economies now have a new generation of Western-educated political and business leaders. They want a different future
It is very clear that the oil price is super-heating economies like Nigeria and Angola. Although this is good for investors, a cautionary note on the impact of high oil prices is provided in a report by Moody's which argues that ‘even the ratings of affluent, oilexporting sovereigns could be affected over the longer term’. The interesting thing about the growth of frontier markets is, however, that even counties without oil are booming. Zambia, for example, which has abundant land, sunshine, water and labour - but no oil - has an economy is growing at 5.3%. Change, like such extraordinary growth, is a generational thing. Most frontier economies now have a new

Africa and Middle Eastern Hedge Fund asset flow

generation of Western-educated political and business leaders. They want a different future. They understand why it is important to develop capital markets, institutions and the ownership framework. Mo Ibrahim, one of Africa’s richest men, says this “new breed of African leader is all trying to do the right thing in and out of (political) office." Despite the new leaders, it will come as no surprise to hear that frontier markets are risky. In financial markets, risk is measured in terms of volatility or standard deviation. By that measure alone, these markets are risky. In June, the Nigerian stock exchange rose 7.6% one week and corrected 9.6% the next. Risk is something that has to be treated differently in frontier markets. Like doing business in Zimbabwe – that has it risks. Lonzim Plc, is one listed company that understands that. It will be able to fly its assets out if anything goes wrong! It is building a fleet of Fly540-branded freight and passenger services operating out of Harare.

The risk related to conflicts and coups are less prevalent than they used to be. That said, some disputes have the potential to turn into bigger problems. For example, tensions have increased in the Niger Delta following a series of attacks on oil pipelines by the Movement for the Emancipation of the Niger Delta. Conflicts do not, however, necessarily close down the markets. The Iraqi stock exchange still trades! That said, hours are limited to two-and-ahalf hours, three days a week. In addition to conflicts, corruption is a common factor in frontier markets. Corruption increases the cost of doing business and addressing it is certainly a priority. The answer to the question of what investors can do about corruption is not simple. In the private sector, direct questions on corruption are often difficult to raise. Such issues, therefore, are best raised in an indirect fashion. This avoids implicating the respondent of wrongdoing and facilitates dialogue and a constructive debate. It is worth noting that reliable quantitative data on the determinants and conse-

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Being poor does not mean capitalism is absent

quences of corruption at firm level are not always easy to obtain. Finding investments can sometimes be hard, particularly in the public markets. Take Mozambique, for example, only seventeen companies are currently listed on the exchange. These include the local brewery, Cervejas de Moçambique, the local bank, Banco Internacional de Moçambique, and the local cement company, Cimentos de Moçambique. Not exactly much choice, but all are respectable investments.

The Geography of frontier markets

This economic growth is ‘piggybacking’ on something that Adam Smith considered important: namely resources
A number of recent IPOs are widening and deepening the choice in frontier markets. Safaricom, one of the biggest floatations, had a first day premium in excess of 50%. Kenya's biggest stock market flotation was clearly a success. Foreign investors were required to pay 10% more than the price offered to Kenyans but even so the sale was oversubscribed by more than 500%! The success of Safaricom highlights that one of the most investable frontier themes is telecommunications. New providers have sprung up as far afield as Afghanistan. Interestingly, Senegal,

which only has ten million people, is one of the most attractive telecoms markets in Africa. Dakar is already a communications hub for West Africa and it has the potential to build itself into a regional gateway. The best way to get exposure is through Sonatel, listed in Cote d'Ivoire. All this development requires infrastructure. This represents another opportunity. Unfortunately, many infrastructure projects are government or quasi government but that still leaves a big opportunity in cement producers and ancillary services. Cement requires an investment in excess of $400 million to set up a plant. It may be a while before domestic supply equals demand in almost every frontier market. Land and real estate are also big investment themes in frontier markets. The world's population is expected to top nine billion by the middle of the century. This will put pressure on a range of resources, including land, water and oil, as well as food supply. In Ukraine, agricultural land costs just 10% of the same quality land in Western Europe. It’s not just agriculture or housing. Also in Ukraine, real estate consultants estimate that office supply will not equal demand until 2010-2011. Office rent rates grew 40 per cent in 2006 and 35 per cent in 2007.

In most frontier countries the yield curve is not filled out. It is therefore difficult to price risk, difficult to borrow long term, and hard to manage public finances. This is changing. There is a revolution in

The new access to capital is one of the biggest factors that gives investors confidence that the growth multiplier will continue to work in frontier markets
the provision of financial services. The new access to capital is one of the biggest factors that gives investors confidence that the growth multiplier will continue to work in frontier markets. The underleveraged consumer is deploying his buoyant cash flow, thereby creating a virtuous circle. This is a process called industrialisation and all developed countries witnessed their strongest periods of wealth creation when they in turn went through the same process. ■

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