Brave investors should head for the frontier

Emerging markets have had a tough time of late, but long-term investors can't afford to ignore them, says David C Stevenson.

September is not shaping up to be a great month for investors in emerging-market equities. Markets have got it into their collective heads that countries such as Indonesia and India are vulnerable to runs on their currencies. Meanwhile, China is facing its own Minsky moment' (named after US economist Hyman Minsky), where rampant credit creation results in an asset price collapse. As a fun exercise, just go to Google and tap in "China and Minsky moment" you'll see a long list of articles predicting trouble at the top' for its Communist leadership.

Back in the real world occupied by long-term investors, I'd suggest that this market fear which has been largely driven by talk of the US Federal Reserve tapering' (withdrawing quantitative easing gradually) is interesting, but slightly beside the point. If we look at any sensible long-term measure of either risk or of long-term equity-based fundamental value, emerging markets and Asia in particular look attractive.

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Crucially, if you talk to most investors then they'll venture a strong (and usually negative) view on emerging markets. Yet their actual portfolio exposure is usually very, very low, if not non-existent. In my experience, investors are far more likely to have an investment in Japan, for example, than in, say, Malaysia or Thailand.

Yet both of these latter countries are underpinned by remarkably sound macro-economics and have almost no chance of a demographically inspired economic meltdown over the next 30 years. (Whereas I believe that could be a very real problem for Japan just watch the bond yield of Japanese debt start rising as we hit the middle part of this century.)

As as far as I'm concerned, it would be foolish in the extreme for investors to ignore the entire emerging or developing world over the long term. However, investors need to build exposure intelligently, using certain themes and ideas. Simply buying any old emerging-market fund might not be the smart way forward over the short term, as they are likely to have a tough fourth quarter for this year, at least. In my last article a fortnight ago, I suggested a few fund-based ideas (they are listed under this week's tips in the summary box below). This time, we'll focus on three final suggestions.

The sub-Saharan frontier

As we're about to see, there are plenty of excellent funds available that track Asia's markets. But for me, the most interesting region within the broad emerging markets / frontier sector is also the least accessible namely, Africa, and in particular what's known as sub-Saharan Africa, excluding South Africa (SSA ex-SA, for acronym fans!). We're talking about markets such as Nigeria, Kenya, Ghana and beyond.

I'd be very cautious about South Africa itself, which is I think going to have a very tough time indeed over the next year. Ditto for North African markets, such as Egypt (which is looking deeply, deeply unattractive) and Tunisia (which is more attractive, but is also facing massive political change). The really interesting countries are in the vast middle of the continent, virtually all of which are what we call frontier markets.

In these countries, growth in profits is remarkable and equity valuations are very sensible. To gauge this opportunity, it's worth using the research coming out of Constant Capital, which works with UK-based analyst Christopher Hartland-Peel. This small boutique tracks the leading 30 equities by market capitalisation, listed on the sub-Saharan exchanges. These leading African firms (dominated by banks, consumer-goods companies, and the odd cement manufacturer) have seen their market value rise by 28% over the year to date, and by 59% over the last 12 months.

Yet even after these increases, many of these firms still look attractive. Of the 30, 16 still boast returns on equity of more than 25%. Eight trade at single-digit price/earnings (p/e) ratios (many at the very low end). Seven offer a dividend yield of more than 5%. Six of them trade at below one and a half times book value. Just to ram the point home, the research looks at recent trading numbers and finds that, for 28 of the 30 companies in their index, earnings are up by 28% so far, with profit margins rising pretty much across the board.

The bad news is that in reality most of the exchange-traded funds (ETFs) and actively managed funds that invest in Africa boast big, dangerous weightings towards either South African or Egyptian stocks. I'd run a mile from these funds, which unfortunately leaves you with almost no choice at all! In a future article, I'll return to this subject, but for now retail investors can really only invest in the London-listed Africa Opportunity Fund (LSE: AOF), or a US ETF tracking the Nigerian equity market, Global X Nigeria Index (NYSE: NGE).

Where to invest in Asia

Returning to the much more familiar terrain of Asia, there's a truly vast range of choices. Last time, I mentioned a focus on Asian consumers via the Samarang Asian Prosperity Fund, which has sadly now closed to new investors (although hopefully those of you who read about it a fortnight ago had a chance to get in). But there is an interesting alternative that I plan to invest in; namely, the Asian Total Return Investment Company (LSE: ATR).

This used to be the Henderson Asian Growth investment trust, but was taken over a few months back by Schroders managers Robin Parbrook and Lee King Fuei. I quite liked the manager behind the old Henderson fund, but the board of directors thought that performance was lagging and shifted to this team, which has been behind a phenomenally successful fund of the same name.

That fund has been going since 2007, and over that period has delivered a total return of 153% versus 36% for its benchmark index (the MSCI Asia Pacific ex-Japan), with lower volatility (fewer ups and downs) to boot. The trust currently yields 1.7%, trades at a small discount, and has an annual fee of 0.65% of gross assets, plus a performance fee of 10% on any trust gains over 7% a year, with total fees capped at 2% a year.

What's behind those impressive return numbers? At its simplest, this fund aims to provide an absolute return (ie, it won't lose money) through all markets, which should be a good strategy if those currency crises break out, or China has its Minsky moment.

In practical terms, the fund managers start off with their 50 best conviction stock picks (many based around the Asian consumer the me, with companies in the portfolio such as conglomerate Jardine Matheson, Thai retailer Siam Makro, and building materials provider Home Product Centre) and then hedge away any national market risks using derivatives.

Utility and infrastructure

For my final idea, we return to the broader emerging-markets space, but with a specific focus on utility and infrastructure companies. The fund is called Utilico Emerging Markets (LSE: UEM) and currently trades on a discount of around 7%. The focus of this fund is fairly obvious its specialist team invest in stock market-quoted vehicles that dominate in everything from ports and airports, through to power utilities. This is classic, defensive, income-orientated stuff (the yield is 3.3%).

On a full total-return basis, including that growing dividend, this is now the best-performing emerging-market generalist fund over the last one, three and five years. According to a recent analysis by Westhouse, "over the last three years on a full total return basis, the net asset value (NAV) on UEM has grown by 34.1%. This is more than three times greater than the emerging-market generalist peer group, and compares with a shallow 5.9% for Templeton Emerging Markets (LSE: TEM), its largest peer'."

Another added bonus is that you are investing in real assets that tend to see their income grow as inflation rises. The fund was launched in 2005 and is managed by Charles Gillings and his team of analysts out of Bermuda. As you'd imagine, its list of holdings is very dividend- and cash-flow-focused, with certain sectors dominating. By my reckoning, investments in ports account for 22% of the portfolio; waste and water 18%; gas 11%; and electricity 8%.

At a country level, China/Hong Kong is the biggest investment on 28.4%. Brazil follows on 21.7% of fund assets, then Malaysia on 14%; the Philippines on 10%; and Thailand on 9%. The biggest holdings include ports operators International Container Services (9%) and Ocean Wilson Holdings (5%), and airports operator Malaysia Airport Holdings (7.7%). I think this is a great, defensive bet for investors looking for emerging-market exposure, but without too much volatility.

My emerging-market tips