In the aftermath of the global financial crisis investors are increasingly looking for niche opportunities that offer outsized returns. This drive for new possibilities, along with a realisation that there are no real safe havens, is bringing pre-frontier markets onto their investment radars. MENA Fund Review spoke to Bjorn Englund, founder and CEO of Godvig Capital Management and Eric Swats, head of asset management at Rasmala Investment Bank, about the benefits and dangers of investing in those region's of the Middle East and North Africa perceived to come with added risk.
The Middle EAST and North Africa markets have suffered in recent years along with much of the globe. The financial crisis has shifted perceptions and shaken beliefs. Booms have turned to busts and safe havens have begun to look decidedly shaky.
With this in mind investors have begun to look increasingly to 'niche' markets for performance. Places such as Iraq and Palestine, have provided strong returns for those prepared to invest and interest in them is growing, but still they remain a step too far for the vast majority of investors.
There are a variety of reasons why investors should look at these markets that are perceived to be more dangerous investments. According to Eric Swats, head of asset management at Rasmala Investment Bank, which in partnership with the Palestine Investment Fund launched the Rasmala Palestine Equity Fund last year, they provide better returns, more attractive valuations, higher growth rates in basic industries such as telecoms, banking and real estate as they are still in their early stages of development, and low correlation to regional and international markets.
In addition, "The market is not followed by a large number of fund managers and analysts, which leads to a higher number of undervalued and attractive stocks," he says.
According to Bjorn Englund, founder and CEO of Godvig Capital Management, which manages the Babylon Fund that invests in Iraq, in pre-frontier markets, "The Perception Performance trade tends to be a strong winner, as most investors tend to exaggerate risks excessively once risk levels either become higher than normally experienced, more unpredictable or even knightian - thus hard to evaluate or immeasurable."
Correlations also tend to be lower because the investor base is made up of the local community and thus performance tends to be derived from local events rather than international ones.
"The flow factor is simply much smaller," he says. Thus, the risk-adjusted returns tend to be both higher and less correlated than in an international portfolio.
Palestine proves this point, according to Swats. It was one of the best performing markets in the MENA region in 2011 and over the past three to five years. Palestinian companies have been reporting strong results and those are expected to grow over the coming years - 72 percent of the listed companies posted positive results in the first nine months of 2011.
"The Palestinian economy is not as integrated to the global economy as other MENA countries and most of its growth comes from internal consumption and economic activity, in addition to donors money which kept on flowing, even during the midst of the financial crisis," says Swats.
"In addition Palestine has a relatively large and young population of around four million, one of the most highly educated peoples, and a large diaspora that is spread all around the world."
While the positives of strong company results and market performance are there, it is the risks that most investors concentrate on in pre-frontier markets. Both Iraq and Palestine are fraught with complicated political situations that can spill over into violence, as well as outside interference in internal affairs that is not in the country's best interests.
In Iraq there is a minefield of risks, including physical, political, regulatory, legal, foreign exchange, economic, sovereign, transfer risks, market risk, liquidity, counter-party risks, reputational, and Knightian risks, according to Englund. But they are often exaggerated in the media and the minds of investors, and they are declining, he believes.
"We see the aggregated level of risk falling over time, as we experience a strong economy and new reforms are decided upon and eventually implemented, though slowly. The security risks remain high, but have come down radically in a few years time," he says.
In Iraq, Swats believes political risk, which is the major concern for investors, will probably ease in 2012 on the back of the Palestinian UN statehood bid and reconciliation between Fatah and Hamas.
"Also, more Palestinian firms and businessmen are promoting and spreading awareness about the country and the market, and as investors become more familiar with the market risk, levels should fall," he adds.
Investors in these risky regions come from a wide range. In Rasmala's Palestine fund they include local institutions, individuals, and internationals. In Godvig Capital's Iraqi Babylon Fund, the core is comprised of institutions such as pension funds and funds of funds, with high net worth individuals taking an increasingly larger role.
"All our investors see Iraq as being in a transformation phase from a socialistic dictatorship towards some degree of democracy and market economy," says Englund.
"All believe this route will economically play out very successfully, while some also want to help out in this transformation via investing into the region. Still others see a minor investment into Iraq already now as a cheap and easy way open up contact nets that set up the stage for much larger investments and opportunities further down the road when risks have become lower.
"And lastly, I do believe a few use their investments into Iraq for spicing up their portfolio with something a bit more fun and interesting than the normal lot."
Despite the growing interest in pre-frontier markets, attracting investors remains an uphill task. Many have an exaggerated negative impression of the risks formed largely by newspaper headlines. Knocking on doors can be a fruitless task, according to Englund. Godvig Capital relies more on word of mouth and even then it is a matter on convincing potential investors that the risks are worth the reward. There is often a long time between interest and subscription and at institutions a tendency to listen to the most cautious voices around the decision table, which can lead to a wait and see attitude.
Perceptions are changing slowly as more investors dip there toes into these markets and regulatory changes, such as improved trading and settlement, well-known trading infrastructure and publication of trading data electronically, make the process more transparent. International mergers and IPOs of companies within interesting industries, such as the telecom or banking sectors, are also factors in growing investor confidence as well as greater recognition of the strong performance and low correlations pre-frontier markets can offer.
There is no single 'best time' to invest in pre-frontier markets, according to Englund. In general he says he is happy to "jump on the bandwagon," investing small amounts initially before increasing this once political improvements that will lead to sustained economic progress materialise.
"Once we see some real effect in the economy we invest the remaining capital. Quite often the stock market effect tends to lag the macro effect with many quarters," he says.
The approach to investing in these markets differs from more developed regions, according to both Swats and Englund. A more rigorous due diligence process is needed, which involves meeting management and understanding the views of stakeholders, as more companies in Palestine are family firms, says Swats.
"Having people on the ground adds a lot of value, as it puts us in a better position to take advantage of any opportunity, and gives a deeper understanding of the market and its dynamics," he adds.
According to Englund, as risk is often based on volatile political events, it is important to remain diversified across assets, sectors, industries and stock picks and to rebalance often.
"Further, as information often tends to be either wrong, late or even non-existent, expecting deeper levels of research than normally is not always possible," he adds.
"Thus the extra attention to a disciplined approach, based in modern portfolio theory, with good diversification and to focus on performance per risk unit takes center stage."
While the outlook for much of the MENA region was shaken by the global financial crisis and the Arab Spring, both Iraq and Palestine escaped relatively unscathed. These markets both revolve largely around local events. The biggest impact has been to cause some investors to hold off from investing or to redeem assets due to issues in other parts of their portfolios.
In Palestine, most companies serve the local markets and have no direct links to the Arab world so they felt no impact from the Arab Spring, according to Swats. The largest effect on the fund was a drop in investor sentiment for the whole region.
In 2012, he believes the Palestinian story will continue to improve, with the economy expected to grow around seven percent and inflation to stay around three percent.
"We expect a growth rate of around 20 percent in companies' profits on average and lower perceived risk due to fewer uncertainties. Most of the growth will be in the real estate and services sectors," he says.
Prospects could improve further if peace talks improve, and on the completion of reconciliation between Fatah and Hamas. The reconstruction of Gaza could also prove a catalyst to rising economic prospects and greater investment opportunities. On the other hand there remains a potential for escalation in the conflict with Israel.
In Iraq, Englund believes the best opportunities of 2012 will be in the hotel, banking and telecom sectors from a risk-reward perspective.
Growing risk of political escalation between the country's various ethnic groups, as reconciliation talks have largely failed, and in the wake of the US troop pull-out, could threaten stability, he says. Iran's attempts to increase its influence could add to this threat.
"The possibilities of a political stalemate, with an inept government that might stall the reform progress altogether, has risen," he says. "Possibly, we could see the country go down a path towards a much looser federation than today, or even division over time. From a long-term investment consideration this might not be bad though. Many countries in the past that have loosened up, with each region taking at least a larger economic role in its own regional affairs, have ultimately become very successful.
"Another more clear positive catalyst is the upcoming IPOs into the ISX of new companies within the telecom sector (telecom is not yet represented on the ISX). This could attract larger and more of the international institutions to finally decide to take their first steps investing into the ISX," he says.
WHAT TO INVEST IN
Palestine:
Telecoms and real estate are two strong investment opportunities in Palestine, according to Eric Swats.
The telecoms sector has a lot of room for growth as penetration rates are currently around 67 percent (the lowest in the Middle East and North Africa region), the population is young, highly educated and growing at around three percent, and there are only two players in the market.
The real estate sector is not as volatile as other areas and "usually holds strong during downturns," says Swats. In addition, there are around $500m worth of real estate projects planned over the next five years.
The Palestinian government has initiated an affordable housing plan, which aims to construct 15,000 homes in the West Bank by 2013, including the new city of Rawabi and the Palestinian Investment Fund led al Jinan and al Reehan developments.
This should prove a boost to the construction sector, which is already a significant contributor to GDP, growing from 6.9 percent in 2006 to 9.2 percent in 2010. As of 2010 it employs 13.2 percent of the work force.
Its growing importance as part of the economy is evident in the fact that 2,015 building licenses were issued in the Palestinian Territory in Q2 2011, a significant increase of 14.7 percent compared with Q2, according to Swats. Most new licenses were for the West Bank (1,942) with only 58 in Gaza and 15 in East Jerusalem. Importantly, the number of new dwellings (2,972) grew by 48.2 percent compared with the second quarter of 2010 and by 8.2 percent compared with the previous quarter.
Real estate sector growth is also driven by a lack of alternative investments in Palestine, with a relatively small equity market and no bonds market, as well as by a lack of investment sophistication to seek more complicated investments instruments.
Iraq:
Godvig Capital diversifies its Iraq investments over almost all available sectors, but is weighted towards banking for size, liquidity, merger and valuation reasons, according to Bjorn Englund. In total 75 percent of ISX Mcap is made up of banking stocks as are eight of the ten bluest blue chips, he adds.
"The banking sector tends to be the spider in the net and a front runner, after land and real estate, in an improving market economy," he says.
"Banks are also more transparent than many other sectors. International banks need a foothold and a banking license in Iraq."
© MENA Fund Review 2012
