Illustration: Oliver Munday
By Scott Cendrowski
May 23, 2013

The Magaba market in northern Zimbabwe is a hive of activity during the week. Zimbabweans can find almost anything under the low-slung tents blanketing a mile-wide square. The buyer’s paradise offers everything from Mazoe Orange Crush juice drinks to sheet metal to clothes to plumbing equipment. And as hedge fund manager Larry Speidell likes to note when he visits, none of this activity is recorded as part of the country’s official GDP, which grew 5% last year. “We call it ‘walking around GDP,’ ” he says.

Speidell is an investor in so-called frontier markets, a term that dates back to the early 1990s, when an arm of the World Bank drew a distinction between the mainstream emerging markets and other far-flung economies where markets were illiquid, infrastructure was almost nonexistent, and economic development was in its very early stages. Today these economies across Africa, Southeast Asia, and South America present the same challenges for investors that BRIC countries (Brazil, Russia, India, and China) did more than a decade ago. They also offer the same potential for explosive growth and stock returns.

Frontier markets today commonly offer high-single-digit or even double-digit GDP growth. Public debt levels are a small fraction of those in developed economies. And the demographics are undeniably compelling: Of the world’s 15- to 34-year-olds, a group that spends more freely than older folks and propels economies forward with new purchases of big-ticket goods, roughly 40% live in frontier-market countries.

Against this rosy backdrop, investors have been whiplashed over the past decade. Frontier stocks screamed ahead in the five-year period of 2003 through 2007, rising 370%, vs. 67% for the S&P 500, before crashing by more than 60% in the financial crisis — even worse than emerging markets. But unlike U.S. equities, which have recently hit record highs, frontier stocks remain well below their previous heights.

That underperformance is attracting value-conscious investors. “We’re contrarians,” says Jason Hsu, chief investment officer of Research Affiliates, a quantitative-research shop in Newport Beach, Calif. “What’s been the most popular asset class over the past few years? U.S. stocks. What has been the least popular? Emerging markets and frontier markets.” According to Research Affiliates, frontier- market stocks trade at a trailing price/earnings ratio of 14, compared with a P/E of 17 for U.S. stocks.

Speidell invests in 35 countries and says sub-Saharan Africa offers some of the best values. He warns against picking just a few individual stocks in frontier territory, because financial disclosure remains weak and companies face all kinds of problems, from unstable governments to pervasive counterfeiting. In his 70-stock portfolio, he owns Unilever Ghana, a local subsidiary of the consumer goods giant; Nigerian bank Guaranty Trust, which is quickly expanding financial services in the country; Florida Ice and Farm, a Costa Rican brewer; and Panamanian food retailer Grupo Melo.

Marko Dimitrijević, a hedge fund manager who runs $400 million in frontier assets at Everest Capital, says the current opportunity in frontier markets reminds him of emerging markets in the early 1990s. “When we look at the market capitalization of frontier markets today,” says Dimitrijević, “it’s quite similar to the market cap of what was then emerging markets.” Everest recently analyzed the exposure of U.S. investors to frontier stocks and found that they make up less than 0.1% of total U.S. mutual fund assets, even though the economies represent 15% of global GDP. “U.S. investors are still way underweight,” says Dimitrijević.

Dimitrijević’s investing is focused on a few themes, including the rise of retail banking across nearly every early-stage economy and the huge untapped natural resources available in Africa. He says bank deposits will grow with rising incomes and loan servicing will increase as consumers buy motorcycles, appliances, cars, and eventually homes. Brazil’s banks went through the same cycle 15 years ago. There were more new oil- and gas-field discoveries in sub-Saharan Africa last year than in the rest of the world combined, he says, yet drillers in Kenya and Mozambique aren’t on most investors’ radar.

Investing in frontier markets presents challenges for the average investor. The stocks are rarely traded on U.S. exchanges. And it’s difficult for U.S. investors to buy local shares because of the dearth of brokerages taking overseas orders in those markets. So retail investors have to choose from a handful of frontier-market mutual funds or exchange-traded funds. None of the options is perfect. Frontier mutual funds typically carry high fees, and indexes tracked by ETFs often have outsize holdings of stocks in relatively mature Persian Gulf countries. Among mutual funds, Harding Loevner Frontier Emerging Markets has a steep 2.25% expense ratio but has outperformed its benchmark index by 10 percentage points over the past year. Another option is the iShares MSCI Frontier 100, an index ETF that offers fairly broad exposure to frontier stocks and charges a reasonable 0.79% in expenses. That’s not too high a price to pay for a piece of some of the world’s fastest-growing markets.

This story is from the June 10, 2013 issue of Fortune.

You May Like