Review and Outlook
In the prior quarter, we remarked on the high inter-connectedness of global markets in a period of high leverage, fragile confidence, and increasingly unconventional policy intervention. The second quarter was marked, of course, by the surprise outcome of the British referendum regarding participation in the European Union. Both "Brexit" and a remarkably strong Yen captivated the attention of investors and risk managers worldwide. While Japan’s challenges are significant, we view them as fairly well understood and less threatening to global economies and markets. On the other hand, Brexit, rather than a local U.K. event, or even a pan-E.U. event, potentially challenges the political-economic-financial equilibrium we have come to take for granted over the past several decades. Since the 2009 financial crisis, political leaders, central bankers and policymakers have worked hard to maintain stability and sustain the existing equilibrium, but in recent years imbalances have been growing. Brexit should not have happened in the sense that it was not the logical or most economic outcome. Therefore, we must consider whether existing imbalances are pushing for an exit of the equilibrium, and if so, what will be the key changes in terms of long-term trends in globalization, E.U. political and financial integration, and security cooperation? How will the U.K.’s global trade relations proceed? Will Brexit increase or reduce the momentum of fringe anti-establishment movements in other E.U. countries? Material changes to these previous “knowns” would surely have global effects and could likely redefine opportunity and leadership throughout economies and markets. Such questions are complex and will not be answered overnight. Rather, several outcomes are possible, including the upside case of a “walking back” of Brexit, and we will be closely watching political and financial events unfold. As of now, we have done little in reaction given our comfort with our existing positioning, the substantial range of potential outcomes, and the fact that markets initially moved to discount an adverse scenario, particularly for the U.K. and Europe.
Regardless of what scenario plays out, we think the surprise Brexit outcome raises the stakes for global leaders, and will likely move politicians and central bankers to prepare to act aggressively – to again seek to mute the impact of stress and sustain a stable equilibrium. As we have said in the past, we believe a global stress event is likely to provide political cover and provoke the Fed to join in more aggressive policy measures such as fiscal QE or “helicopter money.” Brexit may well be the catalyst we have been looking for, as we believe such measures would likely mark the end of the U.S. Dollar bull market, drive global investors to embrace rising inflation expectations, and stimulate global nominal GDP growth. In such an environment, we would expect emerging market equities to return to leadership amid a global advance. For now, we believe the leadership of the emerging markets during the quarter, including in the aftermath of Brexit, at a minimum confirms the rising likelihood of sustainable outperformance of the emerging markets, although we cannot guarantee that it will.
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.
Baron Emerging Markets Fund increased 4.78% in the second quarter and outperformed the MSCI EM IMI Growth Index by 336 basis points. During the quarter, stock selection and, to a lesser extent, relative country weights contributed to relative results.
On a country basis, outperformance of investments in China, India, Brazil, Russia, and Hong Kong added the most value. Lack of exposure to Malaysia and Poland and lower exposure to China, which all experienced declines in the index during the quarter, also aided relative performance. These positive effects were partly offset by underperformance of investments in Taiwan and Panama.
On a sector level, outperformance of Consumer Discretionary, Financials, and Information Technology (IT) investments contributed the most to relative results. Strength in Consumer Discretionary was mostly attributable to the outperformance of Brazilian advertising holdings Smiles SA and Multiplus SA, both of which benefited from an improving political situation in Brazil and the strengthening of the Brazilian Real. Investments in TAL Education Group, a leading K-12 tutoring provider in China; PVR Ltd., the largest multiplex operator in India; and Man Wah Holdings Ltd., a Hong Kong-based furniture manufacturer, also aided relative performance. TAL’s performance was driven by growth in student enrollments of over 55%, while shares of PVR rose on above-consensus earnings growth helped by strong customer traffic and new store openings. Financials holdings outperformed their index counterparts after increasing 7.1%, driven by gains from SKS Microfinance Ltd. of India and Brazilian financial exchange operators BM&FBOVESPA SA and Cetip SA. SKS was the second largest contributor to absolute results, while shares of BM&FBOVESPA and Cetip were bolstered by solid financial results, shareholder approval of their proposed merger, and appreciation of the Brazilian Real. Within IT, outperformance of Yandex N.V. of Russia and Sunny Optical Technology Group Co. Ltd. of China added the most value. Shares of leading Russian search engine Yandex were up as an improving outlook for oil prices helped strengthen the Russian Ruble and, potentially, that country’s economy. Shares of Sunny Optical, which designs and manufactures optical products, rose after management retained its guidance for three core businesses: handset lenses, vehicle lenses, and camera modules.
Consumer Staples investments detracted the most from results mainly due to the underperformance of Mexican packaged foods & meats holdings Grupo Lala, S.A.B. de C.V. and Gruma, S.A.B. de C.V. Grupo Lala’s stock price came under pressure in the quarter after the company announced a major U.S. acquisition that was viewed unfavorably by investors. Shares of Gruma declined despite reporting operating results in April that showed steady performance with both volume and pricing growth and margin expansion.
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