Investing in frontier-market stocks can lead to success, but investors need to realize that these are riskier than even emerging markets

Frontier markets are developing countries, but with economies considered still too small to be classified as emerging markets.

While risky, the best of frontier-market stocks can offer sound prospects for growth and good fundamental value.

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Understand frontier market stocks more deeply so you can make better picks

Many frontier countries have sizable populations with favourable demographics, including a rising middle class as well as low penetration of basic goods and services. As well, rapid urbanization, coupled with low labour costs, are making frontier countries increasingly attractive destinations for foreign-direct investment in manufacturing.

Vietnam, Kuwait, Morocco, Romania and Bangladesh are examples. What’s more, frontier market stocks generally offer substantially lower valuations, such as p/e ratios, compared to those for stocks traded on exchanges in emerging and developed markets.

At the same time, though, frontier markets are among the riskiest markets in which to invest. Risks in these markets include political and social instability, and restrictions on foreign investors. Volatile currencies, lower levels of liquidity, and poorly regulated markets are also risk factors.

The iShares MSCI Frontier 100 ETF (symbol FM on New York) is an example of a prominent frontier market ETF that aims to benefit from those stocks and their markets. This ETF invests in the top 100 companies that are located in frontier markets. Its companies are the largest and most liquid of the publicly listed frontier market firms.

Morgan Stanley Capital International (MSCI) uses a classification framework to distinguish between developed, emerging and frontier markets. Key elements of this framework include the following: the country’s level of economic development, market accessibility (including openness to foreign investment), market operational framework (trading, settlement, custody), strength and consistency of regulations, rights of foreign investors, accounting standards, availability of company information, and the size and liquidity offered by a market.

Emerging markets are less risky than frontier markets, but more aggressive than developed markets

Emerging markets are countries or geographic regions with economies that are for the most part growing rapidly. They are less risky than frontier markets, but are still more aggressive than developed markets.

These emerging economies include those of India, Brazil, Mexico, Russia, Malaysia, Thailand, Indonesia, the Philippines, Poland and Turkey.

Like frontier markets, buying stocks of companies based in emerging markets is risky because many are still in the early stages of establishing the rule of law in which property rights are respected. Corporate governance is in its infancy and control of corruption is sporadic. The legal and political climate can change quickly in countries that do not have a tradition of the rule of law. When changes occur, you can bet that foreign investors will suffer more than well-connected locals.

Because of this, they are typically only suitable as aggressive investments.

However, we think that most conservative investors could hold as much as, say, 10% of their portfolios in foreign stocks (apart from the U.S.)—and emerging markets could make up part of that component. And the best way to invest in stocks in emerging markets is through ETFs.

BONUS: Aggressive investments carry higher risks

Some investors like to get into fast-growing aggressive investment picks at what they describe as “the ground floor.” They think the best way to profit in stocks is to buy them when they are just barely starting out on a growth phase that can last for years if not decades. Ideally, they want to buy the future top performers when they are still near or close to the penny stock range and have yet to be discovered by the broad mass of investors.

These investors rarely find what they’re looking for. That’s because there’s a large random element in investing, especially at the ground floor. Many promising junior stocks fail to thrive as businesses for one or more of any number of reasons.

To borrow from the opening lines of Tolstoy’s Anna Karenina, successful stocks tend to have a lot in common, whereas unsuccessful stocks tend to suffer from their own unique sets of risks and faults.

Promising concepts rarely translate into investment success

Sometimes stocks with intriguing business concepts just don’t go anywhere. They generate a number of encouraging news releases, but these releases turn out to be a series of exaggerations and broken promises.

Promising stocks may start out with a brilliant idea or a plan to get involved in a high-profile or fast-growing business area. They may enjoy an initial burst of sales or even earnings. But many just can’t keep up the momentum. They never reach the critical mass they need to achieve consistent profitability.

This is more common in junior techs, because they compete with well-established, well-financed senior techs with big research budgets. The seniors have an enormous advantage in well-trained staff, sales networks, media contacts and all sorts of other business assets that can take years, if not decades, to develop.

Use our three-part Successful Investor philosophy to build a sound overall portfolio

1. Invest mainly in well-established, mostly dividend-paying companies;
2. Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; the Consumer sector; Finance; Utilities);
3. Downplay or avoid stocks in the broker/media limelight.

Volatility, illiquidity, and a lack of transparency scare some conservative investors away from frontier markets. What keeps you away or invites you into investing into these markets?

Do frontier market stocks make sense for conservative investors and do you think they have a place in a conservative portfolio?