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By
Michael A. Blank, Managing Director Senior Advisor, Credit
Suisse Private Advisors, Miami, Florida, USA
Emerging markets are not what they used to be. Many countries originally given that tag now boast better economic indicators than some states in the developed world. Investors with a high risk tolerance seeking new horizons might now do well to address the next wave of fast-developing frontier markets, i.e., markets at an earlier stage of development than emerging markets.
In the past five years, after a period of unprecedented growth, emerging markets significantly improved their economic, financial and social profiles. In fact, many markets still classified as "emerging" have now effectively “emerged,” acquiring many features associated with developed markets. One only has to look at key indicators such as economic performance, education and the use of technology in many of these markets to see the progress.
For instance, Korea is still officially viewed as an emerging market, but it has a GDP per capita that is higher than those of European Union members such as Greece or Portugal. Moreover, the average level of higher education exceeds the European average and the ownership of mobile phones and computers per inhabitant is higher than in Germany and Italy, respectively.
The same observation also applies to macroeconomic stability. In recent years, emerging market countries have improved their finances, reduced debt and built significant currency reserves. As a result, traditional emerging market risks of inflation and currency devaluation have been significantly reduced. The majority of these countries arguably now have better balance sheets than most Western countries (see Figure 1).
The macroeconomic improvement in emerging markets has led to an increased convergence of valuations between emerging and developed markets. Indeed, while emerging markets used to trade at a 50% discount five years ago, that valuation gap has now almost closed (Figure 2).1 Furthermore, in regions such as Asia ex Japan, emerging markets are now starting to trade at a premium relative to developed markets.
Figure 2 Source: Datastream, Credit Suisse
The next wave of success stories
The key question for investors now is how to identify the next wave of emerging market success stories – the frontier markets. Typically these countries will display:
• Low levels of income (GDP/capita).
• Early stages of development.
• High economic growth.
• Underdeveloped financial markets, often reflected in low valuations.
• A low domestic consumption base.
These characteristics can be found in several countries that can be best described as frontier markets.
Frontier markets are at a less advanced stage of development than traditional emerging and developed markets, based on indicators such as GDP per capita and consumption patterns. To quantify this, we create a scorecard aimed at defining a universe of frontier markets. We look for underdeveloped countries that have demonstrated sustained growth in recent years and where growth is expected to remain solid in 2008-09. Moreover, this growth needs to be built on a low base (less than USD6000 per capita income). Within our frontier market universe, we then developed a scorecard to assess countries based on the following four development catalysts:
1. Macroeconomic potential: Countries are ranked according to GDP per capita (the lower the figure, the better the potential) together with 5-year GDP/capita growth (high growth scores best, highlighting the start of a period of improved prosperity). Population size (the more inhabitants, the higher the chances for a country to become a leading nation), inflation (the lower the better), and current account as a percentage of GDP (the highest surplus scores best) are also included in the calculation.
2. Human welfare: Factors include life expectancy in years (the higher the better, indicating relatively advanced healthcare), literacy rate and access to education (best access scores well, as we view education as a key to development) and the UN’s "healthcare expenditure score" (a higher expenditure is positive).
3. Political stability: We use the World Bank's "political stability” index (the most stable economy scores best), to which we add the World Bank's "rule of law” index and its "perceived corruption” index (the lower the figure the better).
4. Financial market development: Market capitalisation as a share of GDP (a lower ratio scores best, highlighting underdevelopment of financial institutions), foreign direct investment inflows as a share of GDP (the lower the better, highlighting the lack of penetration in such markets by international investors). To this we add the World Bank's “ease of doing business” index (the easier the better). The last criterion is, of course, the market valuation, measured in terms of EV/EBITDA.
The most attractive frontier markets are countries that rank highest using those criteria. The top ten countries according to our scorecard method are listed in Table 1.
Three examples: Botswana, Kazakhstan and Morocco
The following three countries are examples of countries that we have passed through our screening process: Botswana, one of the oldest democracies in Africa, is the world’s largest diamond exporter, with almost one-quarter of the global market. This enables the country to achieve a massive current-account surplus worth 19% of GDP (2007E). Botswana uses this wealth to make major investments in education and industrial development. As a result, Botswana’s economy is moving from being solely diamond-export focused to greater diversification, with the introduction of call and data-processing centres for instance. The country is already seen as the African model of development.
Kazakhstan is an oil-rich country and second only to China in GDP growth over the past two years. The thirst for natural resources from neighbouring China and other emerging economies has boosted Kazakh coffers and reduced the need to borrow. Public debt as a percentage of GDP is among the lowest of any frontier market at just 12.7%. The Kazakh government is implementing market-friendly reforms and oil wealth is starting to find its way across the population, with disposable incomes growing at a fast pace, and consumption being further boosted by nascent consumer credit.
Morocco is increasingly opening its doors to overseas business. In 2006, Morocco entered a free trade agreement with the USA, which has significantly accelerated the North African state’s economic development. Exports have risen by more than 30% over the past three years. A major infrastructure development plan was also launched the same year to boost competitiveness, this being one of King Mohammed VI’s key targets. As a result, GDP growth recently registered a significant acceleration, and this trend is expected to continue in the near term.
Looking ahead
The global economic landscape has changed significantly over the past few years. Many traditional emerging markets have started to exhibit developed market characteristics. In our view, investors will now focus increasingly on "purer" emerging markets, which means that investment in frontier markets is likely to increase in the medium term.
END NOTE
1. We base our valuation gap on the difference between the 1-year forward price-earnings ratio (P/E) of emerging markets and the 1-year forward P/E of developed markets. The 1-year forward P/E equals the current index price divided by the estimated earnings per share for the coming 12 months.
This article is not investment research and it is not intended to provide a sufficient basis on which to make an investment decision. Emerging market investments are most suited for investors with a high risk tolerance. The material on these pages represents the opinion of Credit Suisse Private Advisors and is not intended to predict or depict the performance of any asset class, investment sector or commodity. The information provided herein including excerpts, abstracts, and other summary material derived from third parties is believed to be reliable but no such warranty is made. Past performance is no guarantee of future results. These views are as of February 2008 and are subject to change based on subsequent developments.
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