COVID-19: Is there long-term value in frontier markets?

COVID-19: Is there long-term value in frontier markets?

Rory Kutisker-Jacobson  - 23 April 2020

At the time of publication, roughly one-third of the world’s population is living under lockdown regulations as a result of the COVID-19 pandemic. In many countries, industries outside of those deemed to be essential services have been forced to close, and revenues have gone to zero overnight. Amid the extreme market volatility, new investment ideas have arisen. Rory Kutisker-Jacobson discusses some of the long-term opportunities in the frontier universe.

Markets have been quick to react, with asset prices falling sharply across the globe. There has been almost nowhere to hide. Assets historically considered safe havens have fallen in price. At the other end of the spectrum, assets perceived to be riskier, as many frontier markets are, have seen even more aggressive selling. To the end of March 2020, the MSCI Frontier Emerging Market (FEM) Index was down 31.6% in US dollars. Many individual markets were down more: The MSCI Colombia Index fell 49.7%, for example. We do not know the length or depth of the coming recession. Nor do we know the time it will take for the coronavirus crisis to pass. Nobody does.

We do know that in the short term the news flow is likely to get worse:

  • Confirmed cases will continue to increase
  • There will be significant business closures and job losses as a result of prolonged shutdowns
  • Supply chains will be disrupted
  • Healthcare systems will be temporarily overwhelmed in many countries 

We also know that this time shall pass. This is not the first crisis or pandemic that humanity has been faced with, nor is it the last. We never celebrate events that bring on global disruption, particularly one that is going to bring with it such significant loss of human life. However, it is with events like those prevailing today, when fear and uncertainty are elevated and sentiment is low, that emotional selling becomes prevalent and bargain opportunities arise for the long-term investor.

The banking sector offers some promising opportunities

Global banking shares have collapsed as investors price in extreme bad debt scenarios. The banking shares in the FEM Index are no exception, with some falling as much as 50% in the last month alone. There does, however, appear to have been blanket selling, with little to no consideration for the relative quality or safety of one bank over another. Banking shares account for approximately 45% of the Index overall. Within that universe, many banks have come into this crisis well placed to weather a prolonged downturn: They are well capitalised, use less leverage than developed market banks, have not been aggressive in extending credit and have high profitability buffers. They were already depressed coming into this crisis and are now priced for extreme distress. By way of example, Halyk Bank, the largest bank in Kazakhstan, trades on just 3.6x historic earnings, despite having an average return on equity (ROE) of 23.9% over the last five years and Tier 1 capital of 20.6%. Similarly, TBC, the largest bank in Georgia, trades on less than 3x historic earnings and has had an average ROE of 21.1% over the last five years. It too is well capitalised with Tier 1 capital of 14.6%. As a comparison, JP Morgan Chase, the largest bank in the USA, has Tier 1 capital of 12.4%. Some of the banks in Nigeria are even cheaper, trading on less than 2x historic earnings. Earnings for these banks can come under considerable pressure and the valuations will still be attractive.

Seeking value in the broader frontier universe

A number of high quality, well-capitalised businesses in the frontier universe were already undervalued before the recent collapse. Many had net cash on the balance sheet and have defensive earnings streams which are unlikely to be materially impacted by COVID-19. One example is Eastern Tobacco, the monopoly cigarette producer in Egypt. At the end of March, Eastern had fallen 20% in US dollars for the year, despite cigarette sales being expected to go largely unaffected. Eastern now trades on just 7.5x earnings to June 2020 and is in a net cash position. The new management team seems to be more shareholder focused: They recently announced a share buyback to capitalise on the depressed share price which should further enhance investor returns over this time period.

Across the frontier universe there is now a wide range of similar opportunities available. No doubt the short-term news will get worse, and earnings in the next 12 months for most businesses will be down materially. However, we don’t buy stakes in these businesses based on earnings over the next 12 months, but rather the next 20 years.

In conclusion, we are faced with significant uncertainty in the current environment. This uncertainty has created compelling opportunities for the long-term investor to buy great businesses at bargain bin prices. We don’t know if frontier assets will get cheaper, but we do know that they are currently trading at extremely attractive prices relative to history. For those with a long-term horizon, who are willing to stomach mark-to-market volatility in the short term, now should prove an extremely fruitful time to be allocating capital. As a result, we are extremely excited about the long-term prospects of the opportunities we are finding within the African and broader frontier universe.

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