Review and Outlook
While the second quarter of 2015 closed largely unchanged, this result masked significant volatility expressed by an ebullient early quarter rally and subsequent reversal, as leading economic indicators in the developed world markets peaked and then declined. At quarter-end, risks related to a Greek default and local China A share markets came to dominate investor sentiment and market activity.
Recent events suggest the risk of further deflationary pressure remains in the near term. The decline in oil prices, the breaking of the Swiss franc/euro peg, the relative strength of the dollar and the recent decline in China-related equities all suggest to us that the looming commencement of a Fed rate hike cycle as currently discounted may not be initially well received by the global markets. Of course, such events also raise the likelihood that the Fed again defers. As for emerging market equities in particular, we believe the discounting of such rate hikes is well advanced, and thus we would likely view any directly associated volatility as an opportunity to deploy incremental cash into long-term beneficiaries of our identified themes at potentially attractive rates of return.
We consider China a more significant risk than Greece to emerging market equities, and believe significant further stress could perhaps trigger an RMB devaluation, which would likely transfer some of the deflationary impulse to broader Asia and the world markets. At the time of this writing, China A share markets have retraced roughly half of their prior twelve month gains and remain positive year to date, though a large number of companies’ shares have been granted trading suspensions. Outside of the major “blue chip” listed issues, trading is generally driven by retail investors and can be quite volatile and speculative. Having said this, it is estimated that less than 10% of the Chinese population has an active brokerage account – far less than in developed world countries. In response to the selloff, Chinese authorities took measures intended to support prices and prevent large scale, margin-call driven selling. These measures initially backfired, and when combined with widespread trading halts, increased selling pressure on those shares still trading. This put pressure on the Hong Kong listed and U.S. ADR markets where institutional investors, such as ourselves, principally invest. We do not believe the A-share liquidation must necessarily have a lasting impact on the Chinese or global economy, and we expect to see further stabilizing measures, including rate cuts, reduced reserve requirements, and outright purchasing by government entities and sovereign wealth pools.
In summary, we would characterize the broad and indiscriminate selloff in China-related equities as emotional and exacerbated by forced margin loan liquidation. Such conditions favor long-term, fundamental investors such as ourselves, as we can remain grounded in the conviction afforded by our process, themes and company specific due diligence. We remain comfortable with the long-term prospects for the companies in which we have invested and suspect the coming months may offer further attractive investment opportunities.
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 0.76% in the second quarter and outperformed the MSCI EM IMI Growth Index by 40 basis points, mainly due to stock selection.
On a country basis, outperformance of investments in India, Taiwan, Brazil, and China added the most value. Larger exposure to lagging equities in India, the Philippines, and Indonesia; underperformance of Korean investments; and lack of exposure to Russia, which rose 11.8% in the index, detracted the most from relative performance.
On a sector basis, Information Technology (IT), Health Care, and Consumer Discretionary were the largest contributors to relative results. Within IT, outperformance of Kingdee International Software Group Co. Ltd., the largest contributor on an absolute basis, and lower exposure to the sector, and in particular to declining Samsung Electronics Co., Ltd., contributed the most to relative results. Uncertain demand for its newest cellphone, the Galaxy S6, hurt Samsung’s performance. Health Care holdings outperformed their index counterparts, rising 6.0%, led by Glenmark Pharmaceuticals Ltd. and Sinopharm Group Co., Ltd. Shares of Glenmark, an Indian generic drug company, increased due to acceleration in U.S. product approvals. Shares of Chinese pharmaceutical giant Sinopharm were bolstered by support for its acquisition strategy and expectations for reform of state-owned enterprises. Strength in Consumer Discretionary was mostly attributable to the outperformance of Dish TV India Ltd. and new investments in Taiwanese textile manufacturers Eclat Textile Co., Ltd. and Makalot Industrial Co., Ltd. Dish TV and Eclat were the second and third largest contributors to absolute performance, respectively. Shares of Makalot, the fourth largest contributor, benefited from strong quarterly results.
Consumer Staples, Financials, and Industrials were the primary detractors from relative results. Within Consumer Staples, underperformance of packaged foods & meats holdings and lack of exposure to the personal products and food retail sub-industries, which increased 15.7% and 8.0%, respectively, within the index, detracted the most from relative performance. The challenging Filipino economy pressured shares of packaged foods & meats holding Universal Robina Corp. Within Financials, underperformance of diversified banks holdings, led by Bank Rakyat Indonesia (Persero) Tbk PT and BDO Unibank, Inc. of the Philippines, weighed the most on relative results. Bank Rakyat was the third largest detractor on an absolute basis, while shares of BDO declined due to weaker-than-expected quarterly trends and the challenging Filipino economy. The Fund’s Industrials investments trailed their index counterparts, falling 3.1%, with HIWIN Technologies Corp. of Taiwan driving the decline. Shares of HIWIN, a manufacturer of linear motion components, faltered as the global machine tool industry began to experience cyclical weakness.
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