NEW YORK ( TheStreet) -- After Dubai said a state-controlled company would have to reschedule debt, stocks around the world shuddered. In recent days, most stock markets have recovered, but the incident served to highlight the risks and opportunities in countries known as frontier markets. Those are the smaller and less-developed countries in the emerging markets. While most emerging-markets mutual funds are dominated by major countries, such as Brazil and China, the MSCI Frontier Markets Index includes such economies as the United Arab Emirates, Sri Lanka and Ukraine. A growing number of mutual funds have been focusing on frontier markets. What attracts investors is the chance to make early bets on economies that seem poised to grow. "The frontier markets look very similar to the way the major emerging markets appeared 10 years ago," says Donald Elefson, manager of Harding Loevner Frontier Emerging Markets ( HLFMX). A decade ago, it took guts to invest in an emerging-markets mutual fund. At the time, Russia was struggling to recover from a full-blown financial crisis, while Brazil labored to control roaring inflation. Since then, many emerging markets have put their financial houses in order and welcomed foreign investors. The resulting boom has made emerging markets one of the best-performing investment categories. During the past 10 years, diversified emerging-markets mutual funds have returned 10.9% annually, compared with a decline of 0.9% for the S&P 500 Index of the biggest U.S. companies, according to Morningstar. Can frontier stocks repeat the success of major emerging markets? That's hard to know, but some signs are promising. At a time when forecasters are predicting sluggish growth for 2010 in the developed world, economists expect to see growth rates of more than 5% in many frontier countries, including Qatar, Nigeria and Vietnam.
Industries that have boomed in major emerging economies are now spreading to smaller nations. Chinese manufacturers have begun operating plants in Vietnam, where wages are among the lowest in the world. Indian companies that operate call centers are opening units in Kenya, a country with English speakers and newly opened broadband connections. Make no mistake, frontier markets remain risky. Many countries suffer from corruption and a lack of transparency in financial markets. To fully benefit from globalization, frontier markets will have to improve their infrastructure. Still, this could be an opportune time to make a first investment in frontier markets. About half the weighting in the MSCI Frontier Index is in Mideast countries, such as Kuwait, Qatar and Oman. While those economies remain relatively healthy, the stocks are being held back by fears about debt problems in Dubai. With issues in the Gulf weighing on some markets, the MSCI Frontier Index has returned 8% this year, compared with a return of 65% for diversified emerging-markets funds. "In the frontier markets, you can get cheaper valuations and strong growth," says Paul Herber, manager of Accessor Frontier Markets ( FRONX). To try frontier markets, consider Harding Loevner Frontier Emerging Markets, which has returned 40% this year. Manager Donald Elefson looks for solid companies with competitive advantages. His holdings include telecommunications and beverage companies, businesses with steady revenue and secure niches. Elefson avoids leveraged companies. That caused him to underweight Dubai, enabling the fund to dodge much of the trouble in Middle Eastern markets.
A favorite holding is Safaricom, a dominant cellular-service provider in Kenya. Elefson expects the company to grow for years. "Millions of people in Africa are eager to buy prepaid cards and have phone service for the first time in their lives," he says. Another Kenyan holding is Equity Bank, which has 4 million accounts, about half of all accounts in the country. The bank has grown rapidly by providing microfinance, making small loans to tiny businesses. Value investors may prefer Templeton Frontier Markets ( TFMAX). Manager Mark Mobius favors unloved companies with solid cash flow. The portfolio has a price-to-earnings ratio of 10, well below average among emerging-markets funds. A holding is East African Breweries, a Kenyan company that sells alcoholic beverages throughout East Africa. Another is MTN Group, a South African company that operates Africa's largest cellular network. To bet on a revival of Middle East markets, try Accessor Frontier Markets. The fund matches the country weightings of the MSCI benchmark, and about 60% of its assets are in the Middle East. Big positions are in Kuwait, UAE, Qatar and Oman.