Review and Outlook
The fourth quarter featured broad swings in stock prices and currencies, with emerging market equities ultimately retreating through the year-end and leaving the key related indexes slightly down for the full year (in dollar terms). The fourth quarter also marked a return to a macro-driven market environment, dominated by key variables including monetary policy expectations, the U.S. dollar, and the price of oil.
We believe a critical question for the global capital markets remains whether the multi-year offensive against deflation and deleveraging in most key economies will achieve lasting success. In the recent quarter, economic weakness and deteriorating inflation readings in Europe, Japan and China raised enough doubt to force the Bank of Japan, the ECB and China’s authorities to “reload” expectations of aggressive monetary and fiscal support. Such moves, when juxtaposed with a strengthening U.S. economy and a tighter Fed, undermine the host currencies against the dollar. In our view, a material rise in the dollar raises the specter of deflation, and generally coincides with weak commodity and oil prices, and often, falling interest rates. These conditions represent a challenge for emerging markets, particularly those with significant commodity-based exports and/or U.S. dollar borrowings. We would not be surprised to see a crisis in a commodity exporting country, as we have likely already seen initiated in Russia and/or Venezuela. We anticipate the standard deviation of returns among countries, currencies and sectors will remain wide for the time being.
To us, this is where the benefit of active management comes into focus. Recent macroeconomic developments support a dichotomy of relative outcomes. We suspect those countries and companies benefitting from weaker oil and commodity prices, and/or generally insulated from a rising cost of capital, will continue to experience relative strength in currency values and equity prices. We believe we remain well-positioned for such an environment. Further, several market-friendly and value enhancing reforms are underway across emerging markets, particularly in the countries and industries in which we are most heavily invested. We believe the relative fundamental strength of such countries suggests these reforms are likely to advance to implementation, with value creation to follow. Specifically, we are encouraged by the renewed commitment demonstrated in India, Indonesia and China, after some backtracking and political posturing in the third quarter. Even in Brazil, after a disappointing election result, we are relieved that President Rousseff appears to have shifted to the right on multiple fronts, and remain comfortable with our overweight position, which we note has been purely based on bottom-up and theme-driven investments.
The ongoing shift in opportunity, resources and capital towards the emerging market companies and entrepreneurs most capable of driving economic efficiency and productivity remains on course. We believe this trend underlies the Fund’s strong performance to date, and we remain enthusiastic regarding the long-term prospects for the many companies in which we are invested.
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) increased 0.28% in the fourth quarter and outperformed the MSCI EM IMI Growth Index by 339 basis points, largely due to stock selection and country weightings.
For the quarter, the outperformance of the Fund’s investments in India and, to a lesser extent, its meaningfully larger exposure to India added the most value. Indian equities rose sharply in the index as investors anticipated market friendly reforms following Narendra Modi’s landslide victory in India’s general election this past Spring. The Fund’s lower exposure to Russian equities, which declined sharply due to tensions in the Ukraine and the steep drop in oil prices, as well as the outperformance of its investments in Brazil also aided relative results.
On a sector basis, the Fund's investments within the Financials, Industrials, and Telecommunication Services sectors were the largest contributors to relative results. Within Financials, Haitong Securities Co., Ltd., a leading Chinese securities and brokerage firm, contributed the most as results from financial reform emerged and China announced new stimulus measures. The Fund’s investments in diversified banks also aided relative results, led by Axis Bank Ltd., which is India’s leading private sector bank. Axis Bank shares benefited from strong earnings growth and a broad re-rating of the Indian banking sector in anticipation of a long-awaited economic recovery. Strength in Industrials was mostly attributable to the outperformance of Indian car battery manufacturer Amara Raja Batteries Ltd. and low-cost Brazilian airline GOL Linhas Aéreas Inteligentes SA as strong fundamentals drove significant gains. Within Telecommunication Services, the outperformance of Tower Bersama Infrastructure Tbk PT of Indonesia and Far EastTone Telecommunications Co., Ltd. of Taiwan added the most value. Shares of Tower Bersama rose on news of its significant acquisition of Mitratel. We believe this transaction will be cash flow positive, will improve the creditworthiness of the company’s customer mix, and will help deleverage its balance sheet. Shares of Far EasTone, which is Taiwan's third largest telecom provider, increased due to market share gains and improvement in its average revenue per user following the launch of its 4G services.
The Fund’s investments within the Information Technology (IT) sector were the largest detractors from relative performance. Samsung Electronics Co., Ltd. accounts for more than 20% of the index’s exposure to the IT sector and the Fund’s lower exposure to this stock, which increased 8.5% during the quarter, detracted the most from relative results. Underperformance of the Fund’s home entertainment software holdings, WeMade Entertainment Co., Ltd. and Perfect World Co., Ltd., and its lower exposure to semiconductor stocks also hurt relative results. Shares of WeMade, a leading game developer in Korea, declined following weak performance of new games in its mobile game business.
Yearly Attribution Analysis
The Baron Emerging Markets Fund (Institutional Shares) gained 3.75% for the year and outperformed the MSCI EM IMI Growth Index by 390 basis points. During the year, the Fund’s stock selection and, to a lesser extent, sector weightings contributed to relative performance.
The drivers of performance on a country basis for the year were the Fund’s exposure to, and stock selection in, India, which were also the main drivers of performance for the fourth quarter.
On a sector basis, the Fund's investments within the Financials, Health Care, and Industrials sectors were the largest contributors to relative results. Strength in Financials was mainly due to the outperformance of the Fund’s diversified banks, which rose 59.8% as a group, led by Axis Bank Ltd. and Bank Rakyat Indonesia (Persero) Tbk PT. Shares of Axis Bank, the leading private sector bank in India, benefited from growing demand for consumer and corporate loans and strong earnings growth. These company-specific developments, along with a broad re-rating of the banking sector, lifted the company’s stock price. Another contributor to relative performance in the sector was Haitong Securities Co., Ltd., a leading Chinese securities and brokerage firm. Haitong Securities’ shares rose as ongoing reforms in China’s financial sector favor the securities and brokerage industry. Within Health Care, the performance of the Fund’s pharmaceutical holdings and its meaningfully larger exposure to this outperformaning sub-industry added the most value. Among the largest contributors to relative performance in pharmaceuticals were Torrent Pharmaceuticals Ltd. and CFR Pharmaceuticals SA. Torrent was the Fund’s largest contributor on an absolute basis for the year, while shares of Chilean company CFR spiked in mid-May after Abbott Laboratories agreed to acquire the company. The Fund’s larger exposure to the outperforming life sciences, tools & services sub-industry also aided relative performance. As a group, the Fund’s Industrials holdings outperformed their counterparts in the index by 33.2%, due in large part to Amara Raja Batteries Ltd., whose shares more than doubled during the year. The company was also one of the Fund’s largest contributors to absolute performance during the year. Indian holdings Larsen & Toubro Ltd. and Crompton Greaves Ltd., which increased on expectations that India’s new government will implement policies to stimulate infrastructure investment, also lifted relative performance in the sector.
The Fund’s investments within the Information Technology (IT) and Consumer Staples sectors were the largest detractors from relative performance. Within IT, underperformance of the Fund’s Internet software & services holdings, led by Sina Corp. and Yandex N.V., detracted the most from relative results. Sina was one of the Fund’s largest detractors on an absolute basis during the year, while shares of Russian search engine Yandex fell sharply driven by depreciation of the Russian Ruble and a challenging macroeconomic environment. The Fund exited both positions late in the year. The Fund’s lower exposure to outperforming semiconductor stocks also hampered relative performance. Weakness in Consumer Staples was largely due to the underperformance of Biostime International Holdings Ltd. common stock, which was sold in the fourth quarter.
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