Stocks & Markets April 13, 2010, 9:25PM EST

Stocks: Investors Explore the Frontier Markets

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A young, productive workforce; a large, growing consumer economy; and lots of foreign direct investment will eventually add up to a "virtuous cycle" that allows large portions of the population to move up the economic scale in Nigeria and similar countries, says Herber. Improving infrastructure and advances made in the legal and regulatory systems are the kinds of development that will drive stock performance and growth across the frontier markets for the next 15 to 20 years, he says.

Herber and Rowader's Africa exposure is roughly 9% of the fund's assets, all of which is via total return swaps with various counterparties. Their biggest Nigerian holding is First Bank of Nigeria (FIRSTBAN:NL), which trades on the Lagos Stock Exchange. The stock is a play on the local economy's health and how fast the bank is able to expand its loan book and raise deposits. Like China and India before it, Nigeria probably needs to accrue many years of continued growth to be able to pull large numbers of people up into the middle class, says Herber. But once that happens, it will further perpetuate economic growth, he adds.

Argentina Opportunities

Herber and Rowader's Middle East exposure, the largest in the fund, isn't in oil companies, which are government-owned and not publicly traded. Instead, they focus on banks, property developers, and telecom providers—all driven by local consumer demand and the strength of the local economies. The most cost-effective way to get exposure to the Middle East markets, they've found, is through a Deutsche Bank (DB) exchange-traded note that delivers the return of the MSCI Gulf Cooperation Council (MSCI GCC) index. Their fund was up 13.88% year-to-date as of Apr. 13.

Third Avenue Management in New York invests in frontier markets through a hedge fund whose value the company won't disclose because of regulatory restrictions. Amit Wadhwaney, the hedge fund's manager, looks for well-capitalized companies with strong corporate governance and trustworthy management that are "neglected, disliked, out of favor, and in turn present opportunities that are similarly depressed." Several are in Argentina, where economic turmoil and concerns about a populist government have weighed on asset prices.

One of Wadhwaney's top picks is IRSA Investments & Representations (IRS), which trades as an American Depositary Receipt on the New York Stock Exchange. As Argentina's largest real estate company, IRSA controls 65% of the country's largest shopping-center operators and has an option to buy its key rival, which controls another 30% of that market.

Besides its shopping-center assets, IRSA own three large hotels—including one at a popular ski resort—office buildings, large land reserves, and a nearly 12% stake in Banco Hipotecario, a traditional mortgage bank. Argentina's mortgage debt as a percentage of people's income is among the lowest in South America, "so theoretically there is room for this to grow," says Wadhwaney. The stock was up 25% year-to-date as of Apr. 12. The stock trades at roughly 14.8 times projected earnings of 80¢ per share for fiscal year 2010, ending in June.

Impact of Global Economy

One of the selling points for frontier markets, says Rowader, is their low correlation to the global economy compared with China and the extent to which the individual companies within the countries are dependent on the local economies. That makes them fairly insulated from global events like weakness in the U.S. banking system or devaluation of the euro, he says.

Chamie at RBC Capital Markets disagrees. The significant pullback in oil and other commodity prices during the financial crisis and global recession had a dramatic impact on economies such as Argentina's and Nigeria's, and weakness in the global economy reduces tourism and money remittances from nationals to countries in Central America and the Caribbean, he says. Some of the Gulf states may have large enough cash reserves to provide protection from global cycles, he says, but overall, frontier economies are more vulnerable than some people would like to think.

Bogoslaw is a reporter for Bloomberg BusinessWeek's Finance channel.