Searching for the Next Hot Emerging Markets

NEW YORK ( TheStreet) -- During the past decade, emerging markets stock funds soared, returning 15.7% annually, according to Morningstar. It was a notable performance in an era when most stocks delivered uninspiring results. Can emerging markets repeat their strong showing in the next 10 years? Probably not. The problem is that the stocks have become too rich to deliver outsized results.

A decade ago, stocks in Asia and Latin America sold at modest prices. Few investors were enthusiastic about emerging markets because they had suffered from a series of financial collapses in the 1990s. As the emerging economies recovered, the stocks rallied, rising sharply from depressed levels.

These days emerging markets have become market darlings, boasting healthy balance sheets and ebullient stock markets. In the past year, investors have poured into emerging markets ETFs, putting $11.4 billion into iShares MSCI Emerging Markets ( EEM) and $7.2 billion in Vanguard FTSE Emerging Markets ( VWO), according to IndexUniverse.com.

But there is an area of global markets that has received little attention: the countries known as frontier markets. While the emerging markets ETFs focus on established countries, such as Brazil and India, the frontier markets ETFs include shakier economies. Guggenheim Frontier Markets ETF ( FRN) has assets in Kuwait, Pakistan and Kenya.

Like emerging markets stocks, the frontier exchanges were crushed during the financial crisis. But since then, the established emerging markets have rebounded, and the frontier stocks have struggled. As a result, frontier stocks are now relatively cheap, says Christian Deseglise, Managing director of HSBC Global Asset Management. He says that frontier markets trade for 10.2 times earnings, compared to 11.5 for emerging markets.

Deseglise argues that frontier markets will outperform in future years. He recommends stocks in such countries as Qatar and Nigeria. "In the next five years, the earnings growth will be much faster in the frontier markets than in the established emerging markets," he says.

The IMF predicts that in the next two years many frontier countries will report growth rates of more than 4%. Countries that should exceed 6% include Qatar, Bangladesh, and Vietnam. The growth is accelerating as frontier economies experience the kind of massive modernization that swept countries such as China and Mexico a few years ago. While hundreds of millions of people in the established emerging markets now enjoy middle-class comforts, consumers in frontier markets have only recently gained access to cell phones and bank credit.

Frontier stock markets could achieve strong growth for years, says Raman Subramanian, executive director of index research for MSCI. Subramanian says that in 1988, the emerging markets accounted for only 0.8% of the total global stock market value. But by 2011, the figure had climbed to 12.3%.

Today the frontier markets account for 0.4% of total global markets. "As the frontier markets become more integrated in global capital markets, we could see the same kind of growth that the emerging markets experienced," he says.

Until the frontier markets become more seasoned, investors should tread carefully. But there is a clear case for adding a small dose of frontier markets to a portfolio that includes a stake in emerging markets. Besides offering growth, the frontier economies can provide some diversification because markets in Vietnam and Pakistan don't necessarily move in lockstep with Brazil.

While most frontier companies are still small, portfolio managers argue that some champion businesses are beginning to emerge. Deseglise says that he is finding more companies with high returns on equity and the resources to pay reliable dividends. He says that the frontier markets provide an attractive dividend yield of 4.5%, compared to 2.2% for the S&P 500. According to HSBC, the average frontier stock now has a return on equity of 12.1%, close to the figure for the emerging markets.

Like the markets they track, the frontier ETFs are not seasoned. The Guggenheim frontier fund started in 2008. So far it has delivered decent results, returning 7.7% annually during the past three years, compared to 7.0% for the average emerging markets fund. But the frontier ETF comes with clear risks. The portfolio has 42% of assets in a single country, Chile. The country accounts for a big weighting because it has a relatively developed market and strong growth.

A competing ETF is iShares MSCI Frontier 100 ( FM) began operating in September. The iShares fund also has some concentrated stakes, keeping 29% of assets in Kuwait.

The top-performing choice in the past year was Wasatch Frontier Emerging Small Countries ( WAFMX), an actively managed mutual fund that returned a blistering 38.7%. While the frontier benchmarks have big stakes in financials, Wasatch portfolio Laura Geritz has been emphasizing consumer staples. Holdings include Nestle Nigeria and East African Breweries of Kenya.

"The consumer companies have been showing strong growth," Geritz says. "When consumers begin to get some money, the first thing they do is buy staples."

Geritz is particularly keen on Sub-Saharan Africa. She has 18% of assets in Nigeria. Boasting big reserves of oil and other commodities, the country is evolving rapidly, she says. The IMF forecasts that the country will grow 7% annually during the next two years.

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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