Zaab Sethna interviewed on the Iraq Stock Exchange

November 20, 2019

Strategy focus: Taking the plunge in frontier markets
Posted By Ludovica Brignola On November 20, 2019 

Emerging markets have been out of favour with investors this year, but their frontier markets counterparts – which take risks in failing or struggling states, often riven by poverty – have been more unpopular still.

Asset flows to frontier markets have hit their lowest levels in recent years, but that has not deterred the small number of fund managers investing in the poorest regions on the planet. Nor have the disappointing returns experienced by several frontier markets managers interviewed by EuroHedge.

 
Frontaura Capital’s Global Frontier fund, a Cayman-based vehicle which invests mainly in public equities listed in Sub-Saharan Africa, South-east Asia and the Middle East, is currently flat for the year after losing 13% in 2018.


Iraq Investment Partners I, a Bermuda-domiciled hedge fund investing solely in the developing country’s public equities, has lost more than 3% this year, after a fall of 8% in 2018.

Worse still, both funds have under-performed the MSCI Frontier Markets Index, which has gained 11% so far this year.

Yet hedge fund managers investing in often troubled economies have more than one reason to feel bullish.

“Asset flows to frontier markets have never been so low. But poverty is rife in these countries, and their middle-class growth is taking place at the highest pace ever observed in history,” says a $1bn-plus manager investing solely in frontier markets, speaking on condition of anonymity.

“The best stocks to follow are the goods mostly tackled by this nascent middle class: consumer staples such as alcohol, cigarettes, shisha and consumer health products such as soap and so-called cosmeceuticals are gold for investors across the frontier region.”

Zaab Sethna, an ex-adviser to the Iraqi government and partner at Northern Gulf Partners – the firm managing Iraqi Investment Partners I – agrees.

“Even though now there is growing turmoil in the country, with demonstrations blowing up in the street and the government under pressure, the ISX [Iraqi stock exchange] offers invaluable opportunities, especially within the consumer, telecom and local banking sectors,” he tells EuroHedge.

Founded in 2008 by Zaab Sethna and Bartle Bull – an ex-portfolio manager at Jupiter Asset Management – the company is betting on the country’s recovery after an eight-year-long war.

The upside potential of its stock-market, which was founded in 2004, is vast, according to the manager.

“Certain stocks in Iraq had a tremendous growth in the past five years, and we think they will continue to do so,” says Sethna.

National telecom firms such as Zain Iraq or AsiaCell are some of the company’s top positions, as phone penetration in the country only stands at 40% as of 2018, a long way from Western levels which hover around 75%, estimates show.

Consumer stocks such as the local Pepsi bottler Baghdad Soft Drinks are also a focal point for the company.

The firm, which has the exclusive licence to sell Pepsi products in Iraq, has grown an unheralded 88% over the past five years.

Banking stocks such as Mansour Bank also appear as major holdings in Zaab’s concentrated portfolio, as the company expects buoyant expansion in the sector, given the rising middle-class’s quickly-evolving financial needs.

Vietnam represents another gold-mine for courageous investors, Tim Raschuk, partner at $110m London-based Frontaura, says.

The Asia-Pacific nation – the largest regional holding of Frontaura – is one of the countries that has reduced poverty the most in the past two decades, according to World Bank data.

A real estate bubble and a gold trading bubble inflamed markets shortly after the 2008 financial crisis, deterring investors.

But low single digits price-earnings multiples, particularly in the country’ industrial stocks, have recently started to lure investors back to the Asian nation.

“The country is experiencing good growth, inflation is coming down significantly and the consumer class is rapidly growing, as a consequence”, Raschuk tells EuroHedge.

Local companies such as Masan Consumer Holdings – a company selling condiments and noodles – and the local automobile assembler, VEAM, represent lucrative opportunities.

United Arab Emirates and its ailing real estate sector are also a boon to money managers, Rashuk says.

“In the Emirates we tend to be value-investors and buy stocks when the rest of the investors are selling: we are keen on real estate stocks at the moment, given how badly the market has scored in the past five to six years.”

Finally, Egypt and Pakistan are two other focal regions for managers tapping developing economies – and they are two major regional holdings at Frontaura.

The Arab world’s most populous nation – which has just completed a IMF economic reform program and is eyeing a new potential IMF deal in the first half of 2020 – has seen its core inflation rate fall to 2.7% in October, the lowest level in nearly a decade, with GDP expected to grow 5.5% in 2019.

Consumer stocks – which took a battering in 2008 recession and in the aftermath of 2011 Arab Spring – have a good chance to correct now, with salaries slowly picking up.

“The Egyptian central bank has also cut interest rates again recently, a factor which will further stimulate investors’ interest towards equity markets that were previously neglected, given the attractive returns that holding government t-bonds offered,” says Raschuk.

Pakistan is also awaiting the IMF’s second tranche of aid – worth of $450m – in December.

According to hedge fund managers investing in the regions, the country has the potential to follow in the footsteps of Egypt by reducing inflation and stabilising its currency.

Despite the high hopes, frontier economies still grapple with political turmoil.

Southern Iraq is facing violent demonstrations, with protesters opposing the country’s alignment with Iran and dire economic state.

In Egypt, protests calling for the end of corruption and a quicker increase in salaries flared up recently – seen by some as an alarm bell for incumbent president Al-Sisi.

In Pakistan, demonstrators are currently blocking major roads and highways calling for the resignation of prime minister Imran Khan.

Frequent terror attacks are also taking their toll on central African nations, and contributing to political instability and high currency fluctuations.

But despite disorders, frontier markets hedge funds expect juicy returns in the years to come.

“Whenever the seemingly infinite US equities bull-run will end, investors will look again for alternative and uncorrelated sources – and regions – of returns,” a frontier-focused manager tells EuroHedge.

While the S&P 500 tumbled in 2008, the Iraqi stock exchange finished the year in the black, a factor to which Sethna alludes to.

“These markets are not liquid and shorting is virtually banned across the whole frontier regions, but these markets have an intrinsic potential that will unfold slowly when the tide will shift in global equity markets,” he says.

According to the managers, low levels of liquidity have forced Ucits out of these markets, whereas AIFs have resisted and will be the prevalent hedge fund model in the near future.

“I’m not going to lie,” adds one manager. “Corporate governance in some of these countries is disastrous. I still remember an episode in which despite our voting rights in one of the companies which we had a majority in, the company’s lawyers prevented us from exercising that right. We were baffled.”

Trade war is also one of the latest concerns for the already-struggling nations, which could now be impacted by growing protectionism, and new rounds of tariffs.

Sethna adds: “The double-digit returns we experienced up to 2013 are still possible in the future, but it’s an environment for very patient investors.”