Review and Outlook
The third quarter witnessed a reversal of prior quarter trends. Equities gave up a large portion of previous gains. Key economies, including China and broader Europe, shifted into a slowdown. Some political reforms lost momentum, while, on the bright side, the geopolitical environment appeared to stabilize somewhat. On the liquidity front, the status quo prevailed. While the U.S. Federal Reserve inched closer to the final tranche of scheduled Quantitative Easing (QE), the European Central Bank and Bank of Tokyo announced plans for their own versions of QE – perhaps as an offset to the U.S. wind-down. Last quarter, we questioned whether the complacency grounded in record low sovereign bond yields was fundamentally based, and whether prevailing low measures of volatility were sustainable, given apparent rising levels of risk-taking and leverage in many markets. We are, therefore, not surprised by the recent turn of events and rise in market volatility to more normalized levels, and suspect such conditions are likely to continue. Increasing volatility is typically consistent with a maturing bull market in equities.
Over the past year, we have suggested that reform momentum across multiple countries was a key catalyst for improving performance in EM equities. Of course, markets are forward looking, so the recent pause in momentum has driven a pullback. The quarter saw several unwelcome developments. In China, authorities began to debate the merits of an aggressive reform agenda as the economic slowdown prevailed over targeted easing. In Brazil, as the first-round election date neared, the market-unfriendly incumbent Dilma Rousseff recaptured the lead in the polls. Indonesia’s President “Joko” was challenged by an aggressive parliamentary block, in a clear sign of contempt for Joko’s reform agenda. In India, Prime Minister Modi’s pace of reform appears potentially distracted by a Supreme Court ruling striking down the prior award of coal blocks, potentially compounding India’s economically limiting power shortage. To a large degree, we consider such reactionary developments as a part of the “two steps forward, one step back” nature of progress in EM economies.
Short term, several divergences suggest an upcoming period of higher volatility, and a possible continuation of the recent correction in EM equities. Key divergences include the recent weakness in commodity prices relative to equities, the strength in sovereign bonds relative to equities, and the recent strength in EM sovereign bonds relative to underlying currencies. All suggest a potential change in liquidity and risk conditions in such markets. On the plus side, we continue to see solid capital flows into the EM fixed income markets.
Most importantly, we believe the ongoing shift in opportunity, resources and capital towards companies most capable of driving needed economic efficiency and productivity is not only a long-term change, but also a primary driver of developing world value creation. We believe this trend underlies the Fund’s strong performance to date, as we invest nearly exclusively in what we believe are value creating entrepreneurs, running attractive businesses grounded in intellectual capital and competitive advantage.
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 (Institutional Shares) declined 4.63% in the third quarter and trailed the MSCI EM IMI Growth Index by 137 basis points due to stock selection.
On a country basis, the Fund’s meaningfully lower exposure to Russia and its higher exposure to the Philippines added the most value, while weakness in Brazil, largely due to election expectations, and in China, as economic momentum retreated, detracted the most from relative performance.
On a sector basis, the Fund's larger exposure to the top performing Health Care sector, its average cash exposure of 10.2% in a down market, and its lower exposure to the lagging Information Technology (IT) and Materials sectors contributed the most to relative results. Within Health Care, a combination of stock selection and the Fund’s larger exposure to pharmaceuticals and life sciences, tools & services stocks, which rose 10.2% and 21.8%, respectively within the index, aided relative performance. Strength in the sector was largely attributable to outperformance of the Fund’s Indian generic pharmaceutical holdings, led by double-digit gains in the shares of Divi's Laboratories Ltd. and Lupin Ltd. These companies were also the Fund’s two largest contributors on an absolute basis. Another contributor in the group was Torrent Pharmaceuticals Ltd. whose shares increased over 19% in the quarter, driven by above-consensus financial performance and a broad re-rating on Indian mid-cap pharmaceutical stocks. Within IT, Samsung Electronics Co., Ltd. represents nearly 6% of the index’s exposure to the sector and the Fund’s lower exposure to this stock, which declined 14.1%, lifted relative results.
The Fund’s investments within the Consumer Discretionary, Consumer Staples, and Industrials sectors were the largest detractors from relative performance. The Fund’s Consumer Discretionary holdings fell 9.0% as a group during the quarter, with its two advertising holdings, Brazil-based Multiplus SA and Smiles SA, detracting the most. Shares of Multiplus SA, the largest loyalty program provider in Brazil and partner to TAM, Brazil’s leading domestic airline, came under pressure after the company reported weak points issuance. The Fund’s three cable & satellite investments, all of which are based in India, hurt relative performance after regulators pushed back the deadline for pan-India digitization by two years. Another detractor in the sector was Steinhoff International Holdings Ltd., a leading European furniture retailer based in South Africa. The company is planning to dual-list on the Frankfurt Stock Exchange and was required to raise roughly $1.6 billion of equity capital to satisfy all listing procedures. We believe the potential earnings dilution from the equity raise caused the stock to decline. Weakness in the Consumer Staples sector was mainly due to the underperformance of Chinese holdings Biostime International Holdings Limited and Yashili International Holdings Ltd. Both companies cut earnings expectations due to a weak pricing environment and a transition towards online distribution in the infant nutrition market. Within Industrials, the underperformance of HIWIN Technologies Corp., the Fund’s second largest detractor on an absolute basis, weighed on relative results.
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