GUEST POST WRITTEN BY
Mr. Benard is the COO of Schulze Global Investments, a private equity firm focused on frontier markets.
Hungry for higher returns and put off by sluggish growth and sky-high valuations in traditional emerging markets like Brazil, China and India, savvy investors have begun to sub-allocate a portion of their emerging market allocations towards frontier markets.
Why would Starbucks serve as such a clean proxy for whether a market qualifies as frontier? (AP Photo/Mark Lennihan)
But as frontier markets go mainstream, there is one big problem: Experts cannot agree on what markets qualify as frontier; and the existing frontier indexes are both over- and under-inclusive, thereby failing to provide clear guidance. We have developed our own complex methodology for classifying a market as frontier. In doing so, however, we stumbled upon the realization that our resulting list corresponded almost one for one with what one might call the “Starbucks SBUX -0.2% Test.” Markets with a Starbucks did not make our frontier list. Markets without a Starbucks did.
Why would Starbucks serve as such a clean proxy for whether a market qualifies as frontier? Indeed, why would it do a better job than the indexes themselves? The answers prove highly instructive about the nature of a frontier market and why the frontier presents a compelling investment opportunity.
Let’s start with the major indexes, all of which are based on the IFC’s definition of a frontier market. That definition classifies countries as frontier based on certain characteristics of their public equity markets – factors like total market capitalization and liquidity. This approach naturally leaves out any market that has no stock exchange, meaning almost all of the most exciting frontier markets in Africa, for example – and ends up including markets that happen to have smaller and less active stock exchanges even though the markets themselves are highly developed and would not appear to meet a common sense definition of frontier – like Slovenia and Romania, both mature, full-fledged members of the EU with relatively high per capita GDP that are wholly integrated into the global economy.
So what, conversely, would result in Starbucks, a company with aggressive global ambitions, deciding that a market is not yet ready for Frappuccinos and Venti lattés?
What makes Starbucks’ decisions unique
The company’s primary consideration is the consumer. Starbucks needs to know that there are enough consumers in a market who are willing and able to pay relatively high prices for coffee. And not just enough to support one location, but multiple locations (one location is not enough to justify the headache and expense of putting together a whole new country strategy). It would need to know that there is a sufficiently capable labor force to provide the level of service that its customers would expect. A robust legal framework, including protection of intellectual property, would be important. And Starbucks would need to have comfort that the country’s infrastructure is robust enough to manage its supply chain.
It turns out that the absence of some or all these factors is exactly what makes a market frontier – with all of the accompanying challenges and opportunities that such a market presents.
The challenges are obvious, but the significant opportunities perhaps less so. Frontier markets are often growing at fast rates – around the level of 10% to which investors became accustomed in emerging markets during their boom years – providing a strong baseline for investment returns. On top of that, the absence of robust capital markets in the frontier means that cash is king, resulting in low entry valuations and generally attractive deal terms. There is significant room for the introduction of modern management techniques and other productivity enhancements, allowing an activist investor with a board seat to generate substantial added value.
Frontier markets aren’t like other markets – they’re insulated
Even the challenges themselves can present hidden opportunities. True frontier markets are largely isolated from the world economy, including international capital flows, which means they are not affected as strongly by global downturns. This non-correlation means that frontier markets form an important component of a diversified investment strategy, and helps explain why it is much less useful to have “fake” frontier markets in one’s portfolio – at last not as part of a frontier allocation.
Of course, not all frontier markets are equal; some present far more compelling investment theses than others. Separating the wheat from the chaff is a complicated, multi-faceted process that includes, among other things, analysis of both macro- and microeconomic factors as well as an evaluation of the market’s political prospects.
But here it is again worth looking to Starbucks. An interesting question to ask is which frontier market is likely to have a Starbucks location in the next 5-10 years. Those are the markets that have the potential to jump from frontier to emerging. Invest in them just before that transition occurs.