Asia’s frontier markets lucrative but size a worry

By Kevin Plumberg, Asia Asset Allocation Correspondent

HONG KONG (BestGrowthStock) – Two years ago during the last bull market, Teera Chanpongsang, a fund manager at Fidelity International, hit the streets of Bangladesh, Pakistan and Vietnam, hoping to find opportunities in frontier markets.

He went back to his office in London and told a client keen to invest in Vietnam that he didn’t find any good deals.

Another bull market arrived earlier this year in the fastest growing region in the world, but this time too Chanpongsang could not found any bargains on a frontier stock for his $78 million portfolio of emerging Asian equities. Vietnam and Sri Lanka figured in his search again.

“At this point I don’t see any opportunities in frontiers, I see more opportunities in core emerging Asia,” said Chanpongsang, who counts India, China and Indonesia as the countries with the biggest representation in his fund.

Razor-thin liquidity, lack of research about the region’s frontiers and high valuations will keep investors like Chanpongsang slow to shift from the region’s fast-growing emerging markets to the frontiers.

However, frontier markets’ low correlations with emerging markets will make them attractive buys at the right price, especially given the surge in volatility on fears Europe’s sovereign debt crisis is worsening.

Four of the five top performing Asian stock markets so far this year are frontiers. Sri Lankan stocks are up more than 20 percent in 2010 on relatively low volatility, and the other top gainers are Bangladesh, Pakistan and Vietnam.

Indonesia is the only core emerging market among the five top risers.

To some extent, there is some disagreement on which Asian countries should be considered frontier, but the pool includes Pakistan, Sri Lanka, Vietnam and Bangladesh. Depending on what benchmark they use, fund managers often also include securities from the Philippines and Kazakhstan.

The countries each have their own political and economic risks and actually have little in common except for one thing: their economic influence is small. The combined gross domestic product of Bangladesh, Pakistan, Sri Lanka, Vietnam and Kazakhstan is about the same as Indonesia, or 3.4 percent of Asia’s total gross domestic product.

To provide a sense of scale, South Korea is 6 percent of Asia’s combined GDP and China is 30 percent.

HIGH GROWTH

Last year, the end of Sri Lanka’s civil war after a quarter century led retail investors and some foreigners to bet on robust recovery, sending Colombo’s benchmark index up 125 percent.

Also, the compound annual growth rate seen for the next five years for Vietnam and Bangladesh is similar to emerging market titans China and India.

What is making foreign investors reluctant to dive in though is simply how small the markets themselves are.

For example, in five years, average daily trading volume has doubled in Sri Lanka to $5.2 million, World Federation of Exchanges data showed. Yet, that is still less than 6 percent of the daily average in the Philippines.

Sri Lanka’s market capitalization is only 0.06 percent of Asia-Pacific excluding Japan.

Patrick Ho, head of Asian ex-Japan equities with BNP Paribas Investment Partners in Hong Kong, is looking for ways to add Vietnamese stocks to his portfolios because of client interest.

However, a dearth of market research in English and strict trading rules make it difficult. For example, Vietnam requires foreign investors to use a single domestic counterparty to trade. That makes leakage of information a problem, if others in the market try to front-run your trade.

“When you generate alpha and you want to get out, your sell order may be known to the whole market. That’s a big issue for us when we want to make a high-conviction trade,” said Ho, who oversees around $9 billion in assets.

He said he may end up hiring a local fund manager in Vietnam or buying some participation notes, which are sold by brokerage firms and effectively allow foreigners to gain exposure to domestic stocks without the regulatory hurdles.

LOW CORRELATION; HIGH PRICE

Vietnam’s low correlations with other markets in the region make it particularly attractive to BNP’s Ho.

On a 90-day rolling basis, correlations between benchmark indexes in Pakistan, Sri Lanka and Vietnam and the MSCI Emerging Asia index were 0.1 or lower. By contrast, the correlation between Hong Kong stocks and the MSCI index is 0.9.

Another factor making frontier market assets tricky is that hedging instruments are not often available.

To reduce risks, Rajendra Nair, who manages a $20.7 million Asian frontier fund for JPMorgan Asset Management, includes stocks from companies listed in Australia, Canada and Hong Kong that have significant exposure to frontier markets.

However, Andrea Nannini, who oversees a frontier fund for Halbis, a part of HSBC Global Asset Management, in London does not like to cut risks in this way because it could limit potential upside in returns.

For Nannini, price is key.

“Asian frontier markets look very cheap relative to the bigger Asian emerging markets like India and China but compared to other frontier markets like Africa and Middle East, Asia is a little expensive,” said Nannini, who oversees some $150 million in assets.

More than half of Nannini’s HSBC New Frontiers Fund is made up of stocks from the Middle East and Africa. Asia has the smallest representation and makes up about 11 percent.

Equities in Sri Lanka are trading at 2.1 times book value, the same as emerging market star Brazil, Thomson Reuters Starmine data showed. Bangladesh is trading at 3.6 times, more expensive than China and India.

Nannini believes Pakistan, unlike its Asia peers, is trading cheaply and offers a good opportunity to diversify.

“Over time frontier markets will become more integrated with global markets but that’s a process that will take many, many years,” he said.

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(Additional reporting by Parvathy Ullatil and Vikram Subhedar; Editing by Raju Gopalakrishnan)

Asia’s frontier markets lucrative but size a worry