Examining Fundamental Quality on the Frontier of Equity Investing

Abstract

In order to examine the fundamental quality of companies with listed equities in the frontier markets relative to the emerging markets, a Quality Z-score was constructed of four commonly used financial metrics applicable in each sector. The frontier markets have shown above-average fundamental quality, as defined by these measures in terms of higher capital efficiency, lower indebtedness, and greater balance sheet strength and capitalization relative to the mainstream emerging markets. The fundamental quality of the frontier market universe as defined by these measures has declined relative to the emerging markets over the period from 2001 to 2012. Fundamental quality is less priced-in to the frontier markets than it is in the emerging markets, as demonstrated by a lesser premium in terms of price-to-book ratios between the higher and lower quintiles of the Quality Z-score.

By the end of October 2014, above-average quality companies in the frontier markets traded at lower price-to-book ratios than below-average-quality companies in the emerging markets. While higher-quality companies did not achieve greater market returns in the full period of study in emerging markets, quality companies did outperform in the frontier. In addition, quality companies outperformed in both categories during the high volatility period post-2008, suggesting that fundamental quality may provide some degree of protection from market declines. The outperformance of higher-quality companies in the frontier markets, combined with the relatively low valuation premium for higher fundamental quality, may continue to drive active portfolio managers into higher-quality frontier stocks.