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Risky Business: Investing in Cuba Is More Than Just a Financial Gamble

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"It's hard to argue against weeding out corruption. Sometimes, in the process, you break a couple of eggs."

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Why Cuba? What's Wrong With a Mutual Fund?

Investors in emerging markets -- and emerging emerging markets, commonly known as "frontier markets" -- tend to be attracted to accordingly outsized returns. For them, the potential rewards of frontier markets means parking their money far -- both literally and figuratively -- from Wall Street or Canary Wharf. (The countries currently included in the MSCI Frontier Market Index are: Argentina, Bahrain, Bangladesh, Bulgaria, Croatia, Estonia, Jordan, Kenya, Kuwait, Lebanon, Lithuania, Kazakhstan, Mauritius, Nigeria, Oman, Pakistan, Qatar, Romania, Serbia, Slovenia, Sri Lanka, Tunisia, Ukraine, United Arab Emirates, and Vietnam.)

Once a country goes from being a frontier market to an emerging market -- and in the case of China, all the way on to a developed market, it can "start to focus on sustaining its own wealth within its own economy," says Michael St. Germain, a research analyst at Brighton House Associates. And that's when new frontier markets like Kenya, and yes, Cuba, replace them.

"If you go back 12 years, most emerging markets were essentially frontiers in one way or another," Stuart Culverhouse, chief economist of frontier market investment banking boutique Exotix Ltd., tells me. "As people have become more comfortable with the idea of emerging markets, as the Malaysias, the Turkeys, the Brazils of the world all become more mainstream, it has made investors look beyond those countries" to find opportunity.

Naturally, for every reward, there exists a risk. Here's St. Germain, writing in the BHA Investor Monitor:

There's no doubt that frontier-market investing has its risks. Geopolitical risk is the most inherent issue. These burgeoning nations are susceptible to political and social instability, which causes their stock markets to be highly volatile. Additionally, investors can find themselves victims of nationalization. Although frontier governments are opening their markets to outsiders, they often remain apprehensive of foreign investment. As companies grow, therefore, and foreign investment and control increases, they are susceptible to nationalization by the government.

Frontier markets also lack infrastructure. Safeguards such as regulatory oversight that are provided by developed and many emerging markets simply do not exist in frontier markets. As a result, investors are exposed to currency corruption and other risks.
Perhaps the largest risk, though, is illiquidity. Being small in terms of capitalization and trading volume, frontier markets are by nature illiquid meaning it can be difficult for an investor to extract himself from a position, if not impossible. Although you can buy your way in to these markets, you may never be able to cash out of your position.

In addition, frontier markets, for the most part, do not have many ETFs or index funds, and for those that do exist, the lack of investor demand decreases liquidity further as well as poses the threat of traders selling at a discount. Generally, the main reward for taking such risk is larger returns, albeit significant ones.

Overall, the sheer scale of the frontier market combined with its demographic trend paint a rather positive picture.

"Twenty-three percent of the world's population lives in these frontier markets," St. Germain tells me. "That number in itself is staggering. Plus, the available working population is over 10 years younger than those in developed markets. Over the past decade or so, the effects of technology and globalization have given these markets the ability to cheaply educate their people, and such a ready workforce makes frontiers a logical place to invest long-term."

That can mean any one of a number of places. Stuart Culverhouse likes Sub-Saharan Africa. Michael St. Germain likes Nigeria and Sri Lanka. Regarding Cuba, the law doesn't apply to Exotix, which is headquartered in London, doesn't do business in the US, and is off-limits to US residents (and, in turn, US regulators). Culverhouse is "optimistic over a longer time horizon."

"There is a significant scope in the country essentially untapped," he says. "It requires moves both on the Cuban side and the American side; the transition from Fidel to Raul introduced a more pragmatic and commercial agenda and there has been some indication from the US in recent years about a reform agenda, and we have some optimism about where that might lead."

Is This for Real?

Such endeavors as extralegal payments to staff may be an attempt to speed the change that Kirby Jones, a Washington, DC, consultant described by the New York Times as the "man to see about business in Cuba," maintains is coming -- only at the Cuban government's own pace.

"In America, we like immediate change, overnight success," Jones tells me. "I have been struck by the speed at which Cuba has been changing, though by 'speed,' I mean in a Cuban context, not a US one."

Jones, who has advised companies including Abbott Labs (ABT), General Electric (GE), and Caterpillar (CAT) on Cuba issues, says Cuba's reserve stems from their determination not to mimic the Soviet Union's wobbly transition to capitalism.

"I remember walking through Moscow with a World Bank official way back when," Jones recalls. "He pointed out a McDonald's (MCD) and said, 'Look at that -- that's real progress.' To him, it was a victory; a symbol of the defeat of Communism."

No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

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