Review and Outlook
Emerging market equities appreciated in the first quarter as global markets in general responded to declining sovereign interest rates, driven, in our view, by aggressive ECB monetary policy. Although the majority of emerging market economies, particularly China and Brazil, showed signs of ongoing deterioration, details regarding ECB quantitative easing soothed concerns over anticipated Fed rate hikes, pushing asset prices higher.
High quality growth stocks, our principal investment focus, lagged their lower quality, more capital intensive and cyclical peers. We attribute this primarily to ECB easing, as the attendant decline in cost of capital worldwide drove a mean-reverting relief rally for such lower quality equities. In contrast, the companies in which we seek to invest tend to be steady, value-creating entities driven by organically high return on capital, and are much less sensitive to changes in the cost of or access to capital.
While disappointed with our first quarter performance, we recognize that our investment discipline cannot outperform at all times. We remain committed to our strategy, which has outperformed our broad peer group, defined as the Lipper Emerging Market Funds Average, by over 600 basis points per annum since inception slightly over four years ago. During the quarter, by far the largest detractor from performance was our investment in Brazil. For several years, we offset the macro and currency headwinds in Brazil by owning well-positioned and strong performing companies, particularly in Education. However, by mid-January this year, when the scope of the government’s excessive fiscal mismanagement, coupled with the Petrobras corruption scandal became clear, Brazil sacrificed its credibility with the capital markets. The new and more orthodox finance minister announced a rash of policies to restore fiscal balance which, for the first time, squarely targeted the private sector. We reduced exposure to Brazil beginning in January.
We view the strength of the U.S. dollar, exacerbated by ECB policy, as a key risk factor as we believe it could produce a potential change in appetite for emerging market bonds, particularly for countries most exposed to declining commodity prices and/or dollar denominated liabilities. Another risk is the possible gradual or more abrupt devaluation of the Chinese Renminbi. We do not view either as a likely event in the near term. We believe the key catalyst for long-term value creation in emerging markets remains the ongoing shift in opportunity, resources, and capital towards those companies and entrepreneurs most capable of driving capital efficiency and economic productivity. This phenomenon remains in play across our investment universe, particularly in the reform-driven countries such as India, China, Indonesia, and Mexico, which collectively represent over 50% of our invested capital. After a sustained period of relative underperformance for emerging market equities, we suspect we may soon see increasing opportunities; and we remain focused on the future value creation latent in our markets and inherent in our discipline.
Top Contributors/Detractors to Performance
Quarterly Attribution Analysis
When reviewing performance attribution on our portfolio, please be aware that we construct the portfolio from the bottom up, one stock at a time. Each stock is included in the portfolio if it meets our rigorous investment criteria. To help manage risk, we are aware of our sector and security weights, but we do not include a holding to achieve a target sector allocation or to approximate an index. Our exposure to any given sector is purely a result of our stock selection process.
The Baron Emerging Markets Fund (Retail Shares) declined 0.42% in the first quarter and trailed the MSCI EM IMI Growth Index by 452 basis points, primarily due to stock selection.
On a country basis, underperformance of the Fund’s investments in Brazil, Korea, and China detracted the most from relative results. The Fund’s lower exposure to outperforming Chinese and Korean equities also hurt relative performance.
On a sector basis, the Fund's Consumer Staples investments were the largest contributors to relative results, increasing double digits as a group in the quarter. Strength in the sector was mostly attributable to the outperformance of the Fund’s packaged foods & meats holdings, led by China Mengniu Dairy Co. Ltd. of China and Universal Robina Corp. of the Philippines. Shares of China Mengniu, the leading dairy conglomerate in China with over 20% market share, benefited from strong earnings growth driven by a product mix shift and ongoing rationalization of operating costs. Shares of Universal Robina, a leading manufacturer of branded food products in the Philippines, rose as the company continued to bolster its brand and product portfolio through its recent acquisition of Griffins and joint ventures with Danone and Calbee.
The Fund’s investments within the Information Technology (IT), Consumer Discretionary, and Industrials sectors and its average cash exposure of 11.6% in favorable conditions for emerging market equities were the largest detractors from relative results. Within IT, underperformance of the Fund’s Internet software & services holdings and its significantly lower exposure to outperforming Samsung Electronics Co., Ltd., which has a 6% weight in the index, detracted the most from relative results. The Fund’s Internet software & services investments fell 10.4% as a group, with Opera Software ASA of Norway and Alibaba Group Holding Ltd. of China driving the decline. The Fund eliminated its position in Opera after management disclosed that the company’s foreign currency exposure to the Russian Ruble was greater than previously indicated. Additionally, the Fund’s lower exposure to outperforming Tencent Holdings Ltd., which also has a meaningful weight in the Internet software & services sub-industry in the index, hurt relative performance. Within Consumer Discretionary, the Fund’s larger exposure to declining education services companies detracted approximately 172 basis points from relative performance. These stocks plummeted more than 42% in the index. In particular, fiscal problems in Brazil caused the government to change the rules for FIES, a student financing program. Positive stock selection in education services added 55 basis points of relative performance. Weakness in Industrials was mainly due to the underperformance of Brazilian airline GOL Linhas Aéreas Inteligentes SA, which was also the Fund’s largest detractor on an absolute basis.
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