Stars align on the final Frontier
We embrace fundamental and technical analysis (and macro, and anything else that helps build out the picture for that matter!) at Topdown Charts. Thus to us, it is exciting when an asset class sees strong technicals begin to emerge alongside cheap valuations. That is presently the case for Frontier markets (FM).
Let’s start by defining FM. Many investors are familiar with the international developed market and even emerging market [EM] equities. FM is like the emerging of the emerging.
If that sounds risky, it is. The country makeup is from uneasy markets like Kuwait, Vietnam and Morocco. In total, there are 28 FM countries across the mid and large cap spectrum which the index covers. There are 93 total holdings in MSCI FM, covering 85% of possible market cap in those countries.
We track the MSCI Frontier Market index. It has performed poorly for a number of years – not surprising given how bad EM stocks have been since 2011. The MSCI FM index is decidedly negative since its heyday at the 2007 peak. Despite 13 years of dead money, Frontier markets sport a 6.8% CAGR since the May 2002 inception due to explosive growth from 2002 to 2007. It's also offered a very interesting trading range for more active investors.
The composition of FM is perhaps what many investors find dubious. Half of the space is Financials. Communications make up 14% followed up with an 11% weighting in Real Estate. So, much of the poor performance during this secular bear market is attributed to the general sector weighting. Financials along with energy have, of course, struggled mightily during this market cycle. Interestingly, that composition has tended to deliver returns with a lower correlation to the rest of the world (compared to EM). And while FM is risky, the data shows it’s no more volatile than EM.
We expect FM to perform very well in the coming 5-10 years. Despite featuring slightly lower nominal growth versus EM, FM has a higher dividend yield, and comparable expected valuation reversion (and a slightly lower forex discount). But why now? What makes the niche equity arena special after year and years of downright awful returns?
March 2020 brought about a washout type of event from a technical point of view. Consider it a healthy (and painful for those who were long) reset. Several technical measures reached extreme levels. Since the March lows though, the 200-day moving average country breadth and 52-week new highs minus new lows have turned positive – these are bullish technical signals.
From a valuation point of view, which really drives intermediate to long-term expected returns, FM’s trailing PE ratio nearly matched the 2008-2009 low during the March capitulation. The forward PE is modestly higher versus history than the trailing, however. But the price to book, price to cash earnings and enterprise value to EBITDA ratios are all at or very near all-time lows in the brief history of the index.
We were bullish on FM back in early April when we saw these factors materializing. Just last week we reiterated our bullish stance, helped in part due to sharply improving technicals.
While we expect impressive returns, frontier markets are a niche and volatile space. It is a miniscule piece of global market cap. From an asset allocation perspective, it is important for investors to be aware of the active bet you are making with a sizable investment.
Here’s the point – March 2020 brought about a healthy reset during a very unhealthy market environment. FM was just about on life-support. Since the March low, however, the niche equity arena has rallied and technicals have managed to turn positive. We expect strong returns out of this sub-asset class due to a variety of return factors.
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