»A Pe r s p e c t i ve O n F i n a n c i a l To p i c s Fo r O u r I nve s t o r s

REPORTT. ROWE PRICE

Issue No. 115 Spring 2012

Seeking New Investment FrontiersFrontier markets are rapidly gaining attention for offering compelling long-term opportunities in some of the world’s smaller but fastest-growing economies.

Many investors have long shunned these developing and sometimesexotic markets because of their volatility and relatively high risks. But T. Rowe Price managers say these investors could be missing outon the long-term growth potentialof companies that are making sig-nificant strides in far-flung countries that often boast high growth rates, attractive demographic profiles, andrapidly expanding consumer bases.

Moreover, they see the pace of the transformation in frontier marketsaccelerating and note that manycountries, particularly in Africa and the Middle East, are beginning toshow the kind of promise that gave rise to the powerhouse emerging markets of China, Brazil, and Indiaonly a couple of decades ago.

“Quite simply, these countries aretomorrow’s emerging markets,” saysOliver Bell, manager of the Africa &Middle East Fund. “The long-termexpectation is that things will con-tinue to improve, and you can see theseeds of that progress now.”

Over the last decade, frontier mar-rrkets outperformed emerging marketsin a few years but lagged emergingmarkets overall and were generallymore volatile. (See chart, page 3.)

Still, T. Rowe Price managers, drawing on the firm’s global researchnetwork, are finding selective invest-ments within frontier markets with potential for outsized gains.

“We are mindful of frontier markets’ higher risk profile, but we believe their long-term prospects arefavorable,” says Gonzalo Pángaro,manager of the Emerging MarketsStock Fund, who recently traveled through the Middle East and Africawith Mr. Bell. “At the same time,we are finding many compellingopportunities in more-established emerging markets, where valuations may be more reasonable.”

Essentially, Mr. Pángaro stresses,“We invest in stocks, not countries,and seek out attractive companies anywhere outside developed markets that are taking market share in industries that are growing faster thanGDP [gross domestic product].”

Higher Growth

Mr. Bell says economic growth rates of more than 6% across many frontier markets have made them potentially more promising than inthe past. (See chart, page 2.) High government debt levels, which had

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strangled investments in critical infra-structure, have fallen significantly, and these countries are doing a much better job managing inflation.

In Africa, for example, nations’ debt-to-GDP ratio has fallen from 60% in 2001 to 20% in 2011, accord-ing to the International Monetary Fund (IMF). By contrast, developed countries’ debt-to-GDP ratio has jumped from about 46% in 2007 to more than 70% in 2011, the IMF says.

Similarly, Middle Eastern countries are tackling their debt problems. To be sure, enormous wealth from energy reserves has long supported the six Gulf Cooperation Council countries (Bahrain, Kuwait, Oman, Qatar, the United Arab Emirates (UAE), and Saudi Arabia). But some have had large sovereign debt loads that now are steadily declining.

What’s more, many frontier markets have instituted other criti-cal changes, including bank reforms, privatization of industries, and improved corporate governance.

“We are witnessing a new dynamic in many frontier markets,” Mr. Bell says. “While they are certainly vulnerable to unanticipated shocks,

growth is accelerating, the middle class is expanding, and the future is looking more promising.”

Frontier markets tend to be young and have relatively low levels of foreign ownership of their stocks and bonds. Governance rules are sometimes rudimentary or ineffec-tive, leading to a greater potential for corruption.

But there is widespread agreement on their potential. Consider that Africa’s annual GDP is forecast to rise from $1.6 trillion in 2008 to $2.6 trillion in 2020, anchored by a burgeoning population in which 60% is younger than 25 years old.

While the majority of Africa’s almost one billion people live on less than $2 a day, the continent’s middle class is growing rapidly, now accounting for 34% of the population, about 315 million people, according to the African Development Bank.

Africa illustrates “the old adage that the best investments are made where the difference between per-ception and reality is the greatest,” says Chris Alderson, president of T. Rowe Price International and for-mer manager of the Africa & Middle

East Fund. “In Africa already, many multinational companies are thriving and operating successful businesses that are generating strong earnings growth.”

Mr. Bell says that Nigeria recently has proven to be an interesting growth story that could generate significant stock gains going for-ward. Nigeria’s economy grew by an annual average rate of 8.7% from 2000 to 2010, according to the IMF.

He credits the reform govern-ment’s determination to clean up the country’s financial system. “It has gotten tough on mismanagement and corruption and allowed only the well-managed, healthy banks to continue operating normally,” he says.

Casting a Wide Net

Leigh Innes, manager of the Emerging Europe Fund, also mines frontier markets that are not on the radar of many investors and do not represent a significant weighting in the MSCI Emerging Markets Index. In addition, Ms. Innes occasion-ally invests in companies located in developed markets that have exposure to frontier markets.

For example, Ms. Innes has invested in companies in Ukraine and Kazakhstan, both considered frontier markets. In Kazakhstan, which is rich in natural resources, the Emerging Europe Fund holds shares of copper producer Kazakhmys. As Ukraine’s economy remains highly dependent on demand for its steel and agricultural products, the fund owns an iron ore producer, Ferrexpo, listed in Britain but doing business there.

In Asia, by contrast, there are few opportunities for the time being in frontier markets, says Ernest Yeung, co-manager of the small-cap International Discovery Fund. “Such

Frontier MarketsContinued from page 1

Frontier Market Growth Annual Average Gross Domestic Product Growth

2000–2010 Actual 2011–2016 Projected Angola 10.8% Mozambique 7.7%

Myanmar 10.6 Zambia 7.4

Nigeria 8.7 Ghana 7.3

Kazakhstan 8.6 Tanzania 6.9

Chad 8.2 Vietnam 6.8

Ethiopia 8.1 Indonesia 6.8

Cambodia 7.9 Kenya 6.4

Rwanda 7.7 Ethiopia 6.4

Mozambique 7.4 Nigeria 6.3

Vietnam 7.2 Congo 5.6

Note: Growth rates projected in 2010 and 2011 by the International Monetary Fund (IMF). For some nations for some other recent years, actual growth rates are IMF estimates.

Source: IMF.

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nations as Vietnam and Sri Lanka are improving their investment profiles,” he says, “but they’re not there yet. Liquidity remains an issue.”

Frontier market opportunities also include corporate and govern-ment bonds.

As a result, the Emerging Markets Bond Fund invests in bonds in about a dozen young markets, from Angola to Vietnam, follow-ing improvements in public sector balance sheets.

“Frontier bond markets, while less stable, are the next generation of emerging markets,” says the fund’s manager, Mike Conelius. “So we believe small allocations to their gov-ernment bonds provide exposure to their macro policy improvements.”

Challenges and Promises

In frontier markets, the challenges and promises are frequently intertwined.

For example, transportation throughout much of Africa can be difficult at best. The trip by road from the seaport in Mombasa, Kenya, to Kigali, the capital of Rwanda, takes about 19 hours by automobile, according to Google Earth calculations. But actually delivering goods from the port city to the Rwandan capital takes about 27 days, Mr. Bell says.

So T. Rowe Price analysts identified a UAE company, Aramex, that could provide a solution to the transporta-tion bottleneck. The global transport and logistics operator is installing a system that aims to move merchan-dise from Mombasa to Kigali in a week or less, Mr. Bell says.

The World Bank estimates that the continent’s demands for road-ways, ports, water development, power generation, and other such infrastructure projects could cost $1 trillion over the next decade.

What’s more, technological advances are enabling countries to leapfrog outdated systems. Smartphones, for example, allow millions of Africans to pay bills and transfer balances thanks to a mobile phone service developed by network provider Vodacom. The service has almost 48 million customers in five sub-Saharan countries—many without ready access to banks.

Mr. Bell says that Vodacom’s expanding network across country borders also points to the grow-ing connections among African countries. In South Africa, where domestic growth is slowing, some companies have begun expanding into other countries such as Kenya and Nigeria. “Suddenly they’ve realized there are a billion people on their doorstep,” Mr. Bell says.

Beyond the RisksInvesting in frontier markets, of course, entails a range of risks, including volatility, liquidity, regulation, corporate governance, and valuation.

In addition, several frontier markets are closely linked to

commodity prices, especially in the Persian Gulf, Africa, and Latin America.

Moreover, external headwinds could thwart market advances. Such global political or economic shocks as increased tensions between Iran and the West or a sudden slowdown in China would likely have an amplified negative effect on these markets.

“Many of these markets are young, some are vulnerable to political upheaval, and quite a few are heavily dependent on natural resources to generate wealth,” Mr. Bell says. “But we believe growth in both emerging and frontier markets will remain an enduring theme, offering investors the potential for above-average performance over time, as well as diversification benefits.”

As of March 31, 2012, Kazakhmys and Ferrexpo made up 2.2% of the Emerging Europe Fund and Aramex and Vodacom Group accounted for 4.1% of the Africa & Middle East Fund.

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Frontier Markets’ Relative PerformanceTotal Return Indexed to 100 from May 31, 2002, to March 31, 2012

Note: MSCI EAFE Index reflects stocks in the international markets of Europe, Australasia, and the Far East.The MSCI Frontier Markets Index measures performance of 25 frontier equity markets. Source: MSCI RIMES.

— MSCI Emerging Markets— MSCI Frontier Markets— MSCI EAFE Index