Investors need to consider whether they are being adequately compensated for risk in today’s increasingly uncertain global environment, according to investment managers at Allan Gray, who believe that the perceived risk gap between developed and frontier markets may be narrower than many investors assume, with opportunities opening up in unloved areas.

Speaking during a recent episode of the Allan Gray Podcast, Rory Kutisker-Jacobson, co-fund manager of the Allan Gray Frontier Markets Equity Fund, said some investors appear to be more comfortable paying a premium for businesses in markets that feel familiar, despite valuations appearing stretched. “A feeling of discomfort emerges when an unfamiliar name emerges,” he says.

Global portfolios remain heavily concentrated in US assets and the dollar, with companies such as Apple, NVIDIA and Meta continuing to command premium valuations partly because they are well known to investors.

“You need to ask yourself what price you are paying,” emphasised Kutisker-Jacobson, pointing out that political and economic risks – factors that dissuade investors from frontier and emerging markets – have become especially pronounced in many developed markets.

“Much of the world, regardless of geography, faces political and economic risk at present,” he said. “In light of this, you can either have the comfort of a familiar name or the comfort of a good price, but a trade off in investing means you can’t have both.”

He added that smaller emerging and frontier markets are often trading at significant discounts relative to their developed market peers, despite containing quality businesses with strong fundamentals.

“We are seeing rising incidences of supply chain shocks and companies operating with a number of operational risks,” said Varshan Maharaj, co-fund manager of the Allan Gray Frontier Markets Equity Fund. “But many management teams across frontier nations have been operating under these circumstances for decades. In addition, many of the businesses in these markets have strong balance sheets.”

Maharaj echoed Kutisker-Jacobson, saying that in today’s circumstances, the appropriate risk premium for frontier stocks relative to developed markets is lower than most investors perceive. “Many companies across regions including Eastern Europe, Southeast Asia and the Middle East, have decades of experience and established track records.”

“We think the risk is disproportionately mispriced in these markets, which then creates opportunity,” Kutisker-Jacobson said, adding that attempting to eliminate risk entirely is unlikely to generate meaningful returns in today’s world.

“If you take an investment that is completely risk free and eliminate all possible risks, you are probably going to overpay for it, in which case it becomes return free.”

Capitalising on opportunity

Allan Gray recently added 15 nations to its frontier market universe, increasing its investable capacity by approximately 10 times. Over time, this will allow the Fund to offer more diversification to global portfolios as it invests in attractively priced businesses in additional parts of the world.

“Over the long term, we now have much more scope for growth in our Frontier Markets Equity Fund and we are also able to invest in more liquid shares, making it easier to enter and exit businesses,” said Maharaj, adding that liquidity is an important consideration in an uncertain world.

The Fund follows a bottom-up investment approach, identifying quality businesses across geographies rather than allocating capital according to benchmark weightings. Maharaj said this means the portfolio is likely to look materially different from traditional emerging market benchmarks over time.

“About 16% or 17% of the Fund is currently invested in Georgia and a similar amount in Kazakhstan, which are attractive places to invest in currently. This could, however, change in the future, say in five or 10 years,” he said. “By expanding the universe, we are able to take advantage of opportunities wherever they emerge.”

The 15 newly added nations span multiple regions, including Chile, Mexico, the Czech Republic, Greece, Hungary, Poland, Turkey, Indonesia, Malaysia and Thailand, as well as selected Middle Eastern markets. While South Africa is included in the expanded universe, the intention is to limit exposure to South African businesses.

The Fund offers investors exposure to industries that may not be directly investable via their domestic markets, such as exposure to pure-play uranium miner Kazatomprom.

Kutisker-Jacobson said that the markets in the Fund collectively make up roughly 2% of the MSCI World Index, while broader emerging market indices remain heavily dominated by large economies such as China, Brazil, India, Taiwan and Korea; meaning that the Fund is focused on finding opportunities that are often excluded from recognised global benchmarks altogether.

“The more negative the news flow, the weaker the sentiment and the greater the short-term discomfort, the better the opportunity for long-term investors to generate potential outsized returns. When decisions are grounded in deep fundamental research, that reveals the opportunities,” concluded Kutisker-Jacobson.

To listen to this episode of the Allan Gray Podcast, please visit https://www.allangray.co.za/latest-insights/offshore-investing/exploring-the-frontier-why-elevated-risk-offers-enticing-opportunities/.