Investing in Frontier Emerging Markets

The streets of Lima, Peru, are lined with slot machine parlors and stoplight vendors. Vans bulge with passengers as their drivers run red lights and the vehicles spew exhaust. Stray dogs, beggars, and nursing mothers mill about. But James Harmon only sees the cranes dotting the skyline.

Harmon is a frontier investor, and he's disposed to spot opportunities hiding amid chaos. Today he's touring a new pasta-making factory in a nondescript hangar tucked behind high walls and a double security gate. He's excited about the prospects for Alicorp, a $1.3 billion food manufacturer and a standout in Harmon's $200 million Caravel Fund, which is up 26 percent this year and 221 percent in the six years since it launched. "They're now churning out 10 times the noodles in half the time," Harmon, 74, yells over the roar of brand-new Italian machinery. He's wearing a hard hat with his suit, and errant bits of macaroni bounce off his freshly shined shoes.

In the span of two decades, Peru has graduated from near-failed-state status to a stable democracy with an investment-grade credit rating and some of the most consistent economic growth in the world. Its unlikely comeback is just one case study in the booming frontier, the extreme edge of emerging-market investing: Pakistan. Ghana. Egypt. Bahrain. Lebanon. Cypress. Kenya. In 2005, Goldman Sachs (GS), having already coined the term "BRIC" to refer to Brazil, Russia, India, and China, introduced the "Next 11" (N-11), positing that Bangladesh, Egypt, Indonesia, Iran, Korea, Mexico, Nigeria, Pakistan, the Philippines, Turkey, and Vietnam were poised to rival the G-7 in economic influence in the 21st century. "The astute investor is now zeroing in on the next wave of developing nations—the late bloomers, the ones that have been flying under the radar screen," says Jerry Haar, an associate dean of the business school at Florida International University in Miami. The great equalizers, Haar says, are newfound macroeconomic stability, microeconomic reform, and consumer growth led by a rapidly expanding middle class—especially the lower middle class. It's a major reason why the International Monetary Fund expects emerging and frontier markets to grow at nearly three times the average rate of the developed world. "The bottom of the pyramid," says Haar, "is discovering banks, credit cards, and the many joys of capitalism."

Harmon realizes that most people don't see what he sees in Lima. And he's grateful that the majority of American investors react to enterprises like Alicorp with a mixture of apathy and arrogance. " 'So you figured out how to mass produce a low-margin staple,' " he says, mimicking a U.S. fund manager speaking up at a meeting for prospective investors. " 'Why should I care?' " It's precisely this perception gap that Harmon's fund lives to exploit.

In September, a group of Goldman Sachs strategists led by Timothy Moe predicted that the next 20 years will see the total equity capitalization of emerging markets soar from $14 trillion today—about the same value as all listed American companies—to $80 trillion, a change that will prompt a land grab for assets across the developing world. Failed economies will become frontier ones before graduating to emerging markets status, while established emerging markets such as South Korea and Brazil come to be seen as fully developed. Wal-Mart (WMT) just demonstrated its confidence in global economic maturity by offering $4.6 billion to buy Massmart, a South African retailer with supermarkets in Botswana, Uganda, Zambia, and eight other sub-Saharan countries. BlackRock (BLK), the world's largest asset manager, will soon be launching a frontier investment trust, while HSBC (HBC) readies an exchange-traded fund that focuses on the Middle East and North Africa.

"In the developing world, there's been a tipping point where you realized you could make more as a shareholder than by stealing from a firm," Harmon says, dusting the flour off his shoes. "That genie is out of the bottle, and it's never going back in."

In 1980 in Peru, a guerilla movement called the Shining Path launched a national terror campaign marked by executions, kidnappings, and bombings. "We were the Cambodia of Latin America," says Fritz Du Bois Freund, a local newspaper columnist, over breakfast on the waterfront strip of Miraflores. Katiana Guzman MacNabb, Harmon's Peruvian-born senior portfolio manager, recalls a childhood of armed guerillas stopping the buses she rode with her mother, sometimes roughing up passengers and throwing them into the back seats of their cars within full view of everyone. "It was such a reign of terror," she says. "You just wanted to stay at home."

The army and paramilitaries finally clamped down on the violence in the early 1990s. Now, when the 40-year-old Guzman McNabb is back in Peru, her daily routine consists of visiting new department stores and company CFOs with her laptop and spreadsheets in hand. Apartment buildings are rising from the ground, along with mega shopping malls and new hotels. The economy can't seem to cool off.

Surrounded by the smog and cacophony of Paseo de la República, Lima's main commercial thoroughfare, Harmon and Guzman are berating themselves for not scooping up shares in Graña y Montero, Peru's largest construction and engineering firm. They've just put on steel-tipped boots to tour the company's signature commercial project: the Westin Libertador, a luxury hotel-condominium due to open in Lima's financial district next year. Graña y Montero's stock collapsed when a Peruvian pension fund had to liquidate its long-held position in February 2009, but it has since more than tripled. "I'm not paying this much," says Harmon. "We'll get a good construction stock cheap somewhere else, maybe Egypt."

Harmon grew up in Mamaroneck, N.Y., and studied at Brown University and Wharton business school. Between 1986 and 1996, he was chairman and chief executive of Schroder Wertheim & Co., a boutique investment bank that was later acquired by Citigroup (C). He and his wife of 53 years, Jane, a Tony-award winning producer, became fixtures on the Broadway theater circuit.

The road to Lima began in Washington in 1997, when President Bill Clinton named Harmon, a longtime Democratic fund-raiser, chairman of the Export-Import Bank, a government agency that finances foreign purchases of U.S. exports. Harmon says he had never heard of Ex-Im. He had also barely traveled abroad.

As it turned out, Asia was in economic turmoil. Russia and Latin America would soon follow. Amid frenzied efforts to help developing economies continue to purchase American goods, Harmon practically lived in hotels and on airplanes. He learned a few things about developing populations in the process: That they resented the "Third World" label and hated it when the IMF swooped in and imposed draconian measures in return for aid. "'They're going to snap back,' I remember thinking to myself," Harmon recalls, referring to Asia. What ensued in most emerging markets was a decade of fiscal restraint, in contrast to the credit binge in the U.S. and Western Europe.

By the time Harmon's tour at the Ex-Im Bank ended in 2001, the vast majority of its loan assistance was going to private companies—a turnabout from the government-run clientele it chiefly dealt with in 1997. Harmon launched Caravel in the autumn of 2004. The fund's client pool consists of wealthy individual investors, families, and institutions.

In an investment universe that can include everything from Zambian beef cooperatives to Vietnamese dairy farms, Harmon quickly learned that local expertise is critical. He and his 12-person team have visited 60 countries in search of investments. The process begins with a list of 6,500 publicly listed securities in both frontier and lower-tier emerging markets. Because frontier equities are often thinly traded and have miniscule market values, an otherwise routine $1 million buy order can take weeks to fill and can send a stock price surging. Accordingly, Caravel whittles its initial list down to 600 to 700 securities that can be bought and sold in big blocks without rocking the market. "We can get out of our entire portfolio in 45 days," Harmon says.

Caravel has more money invested in the Philippines than in any other country. In 1998, when Harmon ran the Export-Import Bank, the Philippines was so weakened by the Asian financial crisis that the government was unable to pay its bills. Today, corruption and cronyism still run rampant. An al Qaeda splinter group terrorizes tourists, and the capital, Manila, suffers from a shortage of potable water. Metropolitan Manila, which consists of 16 cities with a total of 20 million people, is the world's densest municipality.

Despite these seemingly intractable challenges, the Philippines boasts high consumer confidence and a well-capitalized banking system. Harmon, on the recommendation of deputy portfolio manager Caglar Somek, invested 7 percent of his fund in the Manila-based casino operator Alliance Global, which caters to the growing class of Filipinos with extra money to blow on gambling. Caravel has another 6 percent of its assets in Bangladesh, and has also been putting money to work in Egypt by investing in Telecom Egypt.

Developing markets have been boosted by the rise of China and its imports of food and raw materials. The Philippines, Bangladesh, and Peru are particularly dependent on China to fuel their rocketing growth, though Mark Mobius, the executive chairman of Templeton Asset Management in Singapore, isn't especially concerned. "Frontier markets," he says, "are in many cases now in their takeoff stage, where self-sustaining development is taking place as a result of high consumer spending in the home markets."

Frontier investing can be rewarding but perilous. Caravel lost half its value in the crash of 2008, when investors around the world were liquidating just about anything in their portfolios that they could. Newly developed economies also pose a heightened risk of economic and political relapse. Moreover, economists debate the question of the relative benefits of foreigners buying stocks in poor countries rather than investing in roads and dams. "Ideally, if you're looking to help people in developing economies, you want long-term capital," says Stephany Griffith-Jones, a Columbia University economist who specializes in capital flows to developing markets. Harmon, for his part, says that his investments are not only lasting but that they also bring his voice into local corporate governance. "If companies and governments want my continued investment," he says, "they have to show me they're listening." The upshot, he says, is fulfilling one of his career aspirations: "doing well by doing good."

Harmon had an epiphany in 1998, when Hillary Clinton urged him to pay his first visit to Africa. He flew into Ghana, the democratic nation of 23 million people in western Africa. Within days, he found himself buying used refrigerators for a group of women in a fishing village who were losing much of their daily catch to spoilage. "I didn't think much of it," he remembers. "A couple hundred bucks—worst case I was making a donation." Almost immediately, though, the women multiplied their sales, greatly reducing the time they had to spend out at sea. Harmon was repaid in half the time he expected. Within months, Ex-Im Bank was issuing loan guarantees to the Ghanaian fishing village. "I felt better about myself than I ever did on Wall Street," he says. "I was never happier."

Fast-forward 12 years. Ghana is one of the world's fastest-growing economies. Brokers there report that they can barely keep up with buy orders for Ghanaian shares (Caravel's included). A half-century ago, Ghana and South Korea were economic equals. The latter is now 25 times the size of its sub-Saharan counterpart, churning out hundreds of billions of dollars worth of Samsung LCDs and Hyundai sedans. South Korea, which is now the world's 15th largest economy, has all but graduated to developed-market status. It's the kind of success story that Harmon and his investors love to regale skeptics with.

Back in Lima, on a wave-battered cliff overlooking a gorgeous stretch of the Pacific, sits a new open-air mall with a Chili's (EAT) restaurant and a Starbucks (SBUX). It's midweek, and the venue is crowded with people holding shopping bags and mint lattes. A new luxury Marriott hotel overlooks the plaza. Young couples nibble on roast chicken and sip purple chicha morada, the national beverage.

Prosperity suddenly abounds in this once-bombed-out corner of Latin America. Not that Jim Harmon is so eager for you to know that.

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