FRONTIER MARKETS: An ‘undiscovered and many times misunderstood market’

Iraq-marketIraq and Palestine are among the world’s most troubled regions, and yet frontier fund managers insist there are big returns for brave investors, writes George Mitton.

Mention Iraq and most people think of car bombs, armed insurgents and US marines patrolling the streets. They might not think of busy food markets and a coalition government that has been fairly stable since 2006. Still fewer would imagine a fund that invests in the country’s stock market could return more than 25% in a year.

Now move a few hundred miles west to the Palestinian territories. Judging from the news, you would expect militants wielding AK-47s and ruined buildings destroyed by Israeli shelling. Another part of the reality, though, is a construction boom, a growing financial sector and stock market dividends well above the regional average. A place, says one fund manager, where investors can hope to make 15% a year or more.

Welcome to the Middle East’s frontier markets. These regions are deemed treacherous by many investors and yet offer tremendous growth potential. Frontier fund managers are on a mission to prove that the opportunities outweigh the risks.

For Henrik Kahm, who manages the Bermuda-based FMG Iraq fund in Sweden, the basis of Iraq’s growth is simple: oil. The country has the world’s third largest proven oil reserves and yet in 2009 it was only the twelfth biggest producer. But this is changing. The government has signed big oil contracts with a string of companies and could soon be producing up to twelve million barrels a day, on a par with the world’s biggest producer, Saudi Arabia.

Kahm is investing in industries that will support the oil firms, such as banks, hotels and companies building roads, petrol stations and power lines to carry the influx of trucks and workers. Kahm invests in these firms through the Iraqi Stock Exchange, which contains nearly 100 listed companies with a total market cap of more than $4 billion (€2.9 billion). The fund returned 25% in the year after its launch in May 2010.

Kahm believes Iraq is considerably more stable than many people realise. It has a coalition government that includes Sunni and Shia groups, which have already had years to negotiate with each other.

“It’s not like Egypt, which has six months to put together a number of parties that must compete for governing the country,” he says, referring to the recent ousting of Egypt’s dictator of 30 years, Hosni Mubarak. “Iraq has had a good six years to do this.”

Security is still a grave concern, though. In late August, gunmen attacked a police station 50 miles west of Baghdad, the capital. And a car bomb exploded outside a police checkpoint near Fallujah, also in the west, killing nine in total. Such attacks are common in an area which has seen fierce fighting between troops from the United States and Sunni militants since 2004.

Rarer, and more troubling, was a suicide bombing near a mosque in Basra, in the south, a city that has seen increased foreign investment in recent years. The attack killed four and injured 50.

Kahm says it may get worse when the US troops pull out at the end of the year, when there may be “a short uptick in casualties”. But he insists that the death rate will continue its decline. In the meantime, he hopes to continue making money for the fund’s investors, who include expats in his native Sweden, which has provided a home for many Iraqi refugees.

Solutions are known
Muhammad Shabbir, co-head of Mena equities at Rasmala Investment Bank, believes Palestine also offers a compelling opportunity. The stock market is smaller than Iraq’s, with some 40 listed companies and a combined market cap of about $3 billion. Unlike Iraq, it has no oil wealth. But the country has a thriving demand-driven economy and the International Monetary Fund is predicting growth of 10% a year until 2014.

Palestine is attractive because it is uncorrelated to other world markets. It is a largely landlocked country with growing banking and telecoms industries, as well as a huge appetite for construction. “There is a lot of pent-up demand for infrastructure, housing,” says Shabbir.

This means demand in the self-contained Palestinian economy remains resilient even during a global crisis. Another attractive point is that average dividend yields on the Al-Quds Index exceed 5% while the surrounding region attains about 3.5%. Shabbir says the Rasmala Palestine Equity fund attracts the kind of investors seeking annual returns of 15% or more.

Of course, there is continued friction with Israel. Palestinians are resentful about Jewish settlements in the West Bank, restrictive town planning rules that prevent Palestinian towns from expanding, and continued violence in the Gaza Strip (see box).

But Shabbir believes the Palestinian people have grown used to adapting to their conditions. “Palestine has had big problems, but beyond those it is OK,” he says. “The issues are known and the solutions are also known.”

Fragile peace
Mark Mobius, chairman of emerging markets at Franklin Templeton Investments, is also bullish about Palestine, which he calls an “undiscovered and many times a misunderstood market”. Thanks to the government’s “solid track record” in reforms and institution building in recent years, as well as a period of relative stability and economic growth, the country has been the best-performing market in the region this year.

If there is progress on a peace deal with Israel the opportunities would be huge. An important step would be international recognition by the United Nations which, Mobius says, “would be a game changer”.

There are drawbacks for investors, though. A problem Iraq and Palestine share is that their stock markets contain a relatively small number of companies, meaning there can be a lack of liquidity when trading equities.

Mobius warns that there is less transparency in the Palestinian market than elsewhere in the region. He also describes the economy as “fragile” because it is highly dependent on donor budget support and foreign aid. Similar risks apply to Iraq.

Then there is the legacy of war. Although Palestine has made great strides in the past few years, gross domestic product (GDP) in the West Bank is still about 10% less than its 1999 level, while GDP in Gaza is about 40% less.

These are the economic wounds of the conflict, but there are human costs, too. The Israeli human rights group, B’Tselem, says

Israeli security forces have killed more than 6,000 Palestinians since September 2000. In the same period, Palestinians have killed more than 1,000 Israelis.

It goes without saying that Iraq has also suffered appallingly in the past decade, with survey results ranging from 100,000 to a million deaths as a result of the conflict.

This damage takes time to heal, and there is clearly much to do. Though fund managers like Henrik Kahm are optimistic about Iraq, security fears still mean many foreign employees are reluctant to live and work there. International aid agencies have complained about corruption, insufficient funding and poor co-ordination in the country’s reconstruction efforts.

However, to focus on the negatives only gives half the story. Bad press makes news, but the slow return to normality and growth is the trend that should attract pioneer investors.

©2011 funds global

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