Investing Opportunities in Emerging and Frontier Markets

As I look back on my experiences exploring and investing in emerging and frontier markets, I realize they came about for one reason—the search for growth. Each time I have traveled, I have grown in my investment wisdom and appreciation for the strong position of the United States. I do expect to continue exploring and seeking those new frontiers for investing for growth.

In this sector, growth and return on invested capital is high. Many say the higher returns relative to the higher level of risks are not worth it. I believe these returns are exceptional and should be utilized in a diversified international and domestic portfolio.

Emerging markets are economies that are still not considered fully developed. India, Brazil and China are in this camp. Frontier economies are similar in nature, but are less developed and still working to establish financial markets that are liquid and effective. Examples would include Nigeria, Kenya, Kuwait and Morocco—all have generally lower per-capita gross domestic products than emerging market countries and less developed financial and legal systems.

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Here are some reasons emerging and frontier markets have higher returns than developed economies.

Higher economic growth rates: Generally, emerging and frontier markets grow at twice the rate of developed economies.

Governments are relatively small: Compared with those of developed economies, smaller governments may impose lower levels of tax on citizens and companies.

Lower costs of labor and materials: This often means a company can have higher gross and net margins.

Lower infrastructure costs: There are many costs that developed economies place on companies in the form of payroll taxes, unemployment taxes or other infrastructure costs—all of which raise costs for companies. Countries that have not yet developed these overhead costs will generally (all other things being equal) have a more profitable corporate sector. It has been my experience that companies in countries such as China and India can have higher profit margins because their tax and overhead obligations are smaller.

Of course, emerging and frontier investment spaces are not without risks. Here are just a few to watch out for:

Currency risk: This is probably the number one risk. Many emerging economies have much higher levels of inflation, making their currencies potentially vulnerable to steady regular depreciation.

Some managers suggest that you should hedge out this currency risk and thus attempt to achieve higher real returns. Of course, this comes at a cost and is easier said than done. Over longer periods of time, currency depreciation and appreciation will be less of a factor, unless you have a rogue country, such as Argentina or Venezuela, which recklessly manages their finances, resulting in radical regular depreciation of their currency.

Political risk: Whenever a new government comes into power, carefully consider the risks associated with the new leadership. Some leaders have very different approaches to foreign investors, which can mean new investing risks. The placing of tariffs or taxes on goods sold overseas can give foreign companies a distinct disadvantage and local companies a distinct advantage.

Security and liquidity risk: Some countries have very well-managed and trustworthy securities markets. Others have unique risks and often place your capital in possible harm's way. Most U.S. brokers have reliable relationships with local custodians and broker-dealers who work diligently to protect clients' funds. The smaller the country, the larger the risk that such reliability is absent.

I was in Vietnam about six years ago and learned that their equivalent over-the-counter market for smaller companies still maintained and managed a physical delivery dealer market. This means the only way to sell or buy shares is to show up in person. This type of exchange allows for many new and different kinds of risk, ranging from fraudulent certificates to just plain old robbery.

Environmental risks: Many extraneous factors, including power outages and health-care issues, pose different types of risk. Natural disasters, such as hurricanes, floods or volcanic eruptions, also present issues in many of these emerging or frontier markets.

The best way to invest in emerging and frontier markets is to invest in the products and services required by the emerging middle class of these countries. The middle class in such economies is often defined as having a per capita income between $6,000 and $10,000 per year in U.S. dollars (in the United States, "middle class" incomes are defined as being four to five times higher than this level).

In my opinion, the areas of opportunity are in the following countries.

India is great, young knowledge economy, ready to emerge.

Nigeria offers steady growth with a solid record; it's the best-kept secret of Africa.

Kenya is the youngest, second-fastest grower in Africa with good resources.

Russia may be the most unloved country in the world by investors, so stocks are dirt cheap.

When investing in emerging and frontier markets, be sure to be mindful of both the opportunities and the risks. Also, be prepared to hold these stocks for three to five years—or even longer.

Rob Lutts is president and chief investment officer of Cabot Wealth Management and the author of The Great Game of Business: Investing to Win.