These four markets made 70.9%, and they’re not done yet

In the business capitals of Asia, a particular type of restaurant specialises in bland food.

The restaurants are for the visiting business people and investors, you see. A lot of foreign investors aren’t interested in the real Asia. They’d rather not stray far from an air conditioning unit. Those types fly business class on Singapore Airlines. They travel in sleek black town-cars. And they eat at swanky Asian restaurants with English menus and bland curries.

But there is another way to do it. The second option involves going to the last white spots on the investment map.

It means you arrive on a low-cost carrier and stay in a hotel that could perhaps use a fresh coat of paint. The companies you visit are located in nondescript buildings where a manager often takes you through the accounting department before handing out a photocopied presentation. Later on, you eat at restaurants with baffling menus but exciting food.

It’s a much more authentic way to learn about the company and the market.

To invest in frontier markets, you need to do that legwork. It’s definitely not for investors who have got used to their cushy offices in Canary Wharf. But for the adventurous investor who is willing to explore uncharted territory, frontier markets offer some of the most exciting opportunities.

Asian frontier markets

The benchmark for Asian frontier market investing is the MSCI Frontier Market (FM) Asia Index. It consists of large and mid-cap stocks across four Asian markets: Pakistan (45.1%), Vietnam (27.3%), Sri Lanka (14.2%) and Bangladesh (13.4%).

The index is made up of 30 stocks. It covers about 85% of the free-float adjusted market capitalisation in each market, with the following sector breakdown: financials (34.2%), energy (22.6%), materials (11.4%), industrials (10.0%), consumer staples (9.0%), health care (5.0%), telecommunication services (4.0%) and utilities (3.0%).

But the most interesting thing is that the MSCI FM Asia index has offered a total return of 70.9% since its inception in May 2009. That’s well ahead of MSCI Frontier Markets at 26.9% and MSCI AC World at 58.9%.

Valuation for the index looks appealing given a dividend yield of 4.4%, historical price to earnings (p/e) of 12.8 times and a price to book value of 2.4 times.

Why I’m predicting big things for frontier markets

So what should we expect from here? Well, I think frontier markets are nowhere near finished.

Warren Buffett’s favourite way to value a country’s market is the market value of all publicly traded securities as a percentage of GNP.

He says “if the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200% – as it did in 1999 and a part of 2000 – you are playing with fire.”

Currently the market cap to GDP (that’s domestic growth, which is very different to national growth, which takes into account earnings from overseas) for the US and UK stand at 112% and 140%, respectively.

For MSCI FM Asia, the leading markets Pakistan and Vietnam ratios are a mere 21% and 30%, respectively. That makes them the lowest in the region.

I see three reasons for optimism.

First, there will be a convergence of asset prices as local and foreign investors explore these markets in greater depth. And entrepreneurs from neighbouring countries will play a pivotal role.

Second, the inclusion of new markets will increase the size and breadth of investment possibilities. There are a number of other frontier markets that are yet to be represented in the MSCI FM Asia Index.

For instance, I expect countries like Cambodia (one listed company), Laos (two listed companies) and Mongolia (around 400 listed companies) to be included. And beyond that list, Myanmar is planning to set up a stock exchange by 2015.

Third, there will be structural changes. These countries are changing at the ground level, and changing fast. Growing free trade regimes, such as the Asean Free-Trade Agreement (Afta), which is being implemented at the end of 2015, will speed up this process.

Get ready to party

Frontier markets aren’t easy to reach. That’s unavoidable.

So if you fancy an armchair strategy such as an exchange-traded fund (ETF) you’re out of luck – there are none available as far as I know.

The other option is to buy specific stocks. This is easier said than done, because research coverage is thin. And brokers back in the UK don’t usually sell them.

A third and preferred option is to hand it over to an expert. By that I mean specialist asset management firms. These firms will have people on the ground, and have developed an extensive network of local contacts.

They come in various permutations, from groups of markets to specific countries. And they are often run by people who have gained first-hand experience in other emerging Asian markets.

I know at least a handful of people scaling up their operations on this front, paving the way for the theme to go mainstream over the next three years. And remember, these markets are small, so a small amount of capital could be enough to set them off.