While BRIC (Brazil, Russia, India, and China) countries have dominated headlines and are still an important source of growth for the world, the next generation of opportunities for growth and stock picking are in the frontier1 and smaller emerging markets (FEM). We believe that FEM countries may be in the early innings of a rapid transformation. Within these markets, we see this growth trajectory being fueled by economies benefiting from growing populations with young demographics, improving education and labor skills, urbanization, and rising consumption. However, these countries continue to be overlooked by many investors, as these capital markets tend to be smaller and in earlier stages of growth than larger emerging market (EM) counterparts. While some reservations are understandable, we believe this next generation of growth can be harnessed, especially with prudent active management.
30 Countries comprising the MSCI Select Emerging and Frontier Markets Index2
Source: MSCI Select Emerging and Frontier Markets Index as of June
The case for a FEM investment lies in their long growth trajectories and development of those capital markets. Countries in the emerging and frontier markets generally grow faster than developed or global peers driven by continuing progress in literacy, growth in the middle class, consumption, technology, and positive structural reforms.
In theory, all markets were, at one time or another, frontier markets before graduating to emerging and developed market status. By most definitions, China qualified as a frontier market in the 1980s, yet the country now stands with a market capitalization second only to the United States.
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Global GDP Growth Projections (%)
Source: IMF, June 2020
Shifting Dynamics Make the Case for Investing in Frontier Emerging Markets
Human Capital Advantages - A key demographic advantage of the FEM countries is the significant proportion of youth in their growing populations. This represents a large pool of potential future workers who could contribute to their local economies.
Rise in Middle Class and the Power of Consumption - With a young, growing work force, the “consuming class” has become a major economic force in FEM.
Contribution to GDP Growth by Expenditure Component, 2018
Source: United Nations, Global Economic Situation Prospects 2019.
Technology Leapfrogging - While the developed markets have had a clear time advantage on the earlier build-outs of their technological infrastructures through advances such as high-speed fiber and the presence of wireless towers, the appetite for internet adoption has grown steadily in the FEM countries. Technological leap-frogging affords considerable efficiency gains and offers developing nations a fast track into the globalized economy. The trajectory of technology adoption is an important factor for future economic growth. Digital transformation was already underway prior to the COVID-19 pandemic, but the economic crisis has accelerated the adoption, as digital connectivity is critical to societal resilience and business continuity.
Positive Reform Tailwinds - Positive structural reform, improving political stability, and the growing ease of doing business are also prominent strengths among select FEM countries. A focus on economic improvements attracts the foreign investment necessary to unlock the potential of these countries. Further, market dislocations are more frequent in FEM regions, but these represent an opportunity to capitalize on high quality, fundamentally sound businesses at attractive valuations.
FEM Market Inefficiencies - In our evaluation of smaller FEM opportunities, we consider each market’s “equitization ratio,” defined as a country’s total stock market capitalization divided by its gross domestic product. The equitization ratio measures whether a country’s economic activity has been fully reflected in its stock market (a level of 100%) or has unrecognized potential (less than 100%).
Given the level of due diligence required to effectively assess individual emerging and frontier company risks and the potential impact of macroeconomic issues, we believe that an active approach is best positioned to generate alpha in these smaller markets. An in-depth familiarity with each country, local economies, geopolitical issues, and market dynamics provides active managers with an advantage to gain exposure to frontier markets. Global expertise married with local presence through networks of contacts built up over decades of combined experience may offer competitive advantages within these markets.
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1 The term “frontier market” was first introduced in 1992 by the International Finance Corporation (IFC) of the World Bank to denote and create indices for markets that have lower market capitalizations and/or less liquidity than emerging markets.
2 The MSCI Select Emerging and Frontier Markets Access Index is based on the MSCI Emerging and Frontier Markets Index, its parent index. The Index aims to represent the performance of 200 securities from select countries within the MSCI Emerging and Frontier Markets Index, specifically 150 securities from Emerging Markets and 50 securities from Frontier Markets. The Index screens securities classified in the Emerging Markets to target companies with high economic exposure to the Emerging and Frontier Markets excluding Brazil, Russia, India, China, Korea and Taiwan.
TimesSquare Capital Management LLC is a fundamental research-oriented equity investment management firm specializing in growth equity strategies. Our strategies cover U.S., non-U.S., and global equities. We use a well-established, team approach to growth investing that has been in place since the mid-1980s. Our goal is to build diversified portfolios of growth stocks that generate competitive risk-adjusted returns.
The views expressed are the views of TimesSquare Capital Management, LLC only through the period ended March 2020 and are subject to change based on market and other conditions. It should not be assumed that any of the securities discussed were or will prove to be profitable. The opinions expressed may differ from those with different investment philosophies. The information we provide does not constitute investment advice and it should not be relied on as such. It should not be considered an offer or solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. We encourage you to consult your tax or financial advisor. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. TimesSquare has no obligation to update, modify or amend any material in the event that any matter stated herein, or any opinion or analysis set forth herein changes or subsequently becomes inaccurate. There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information.