Review and Outlook
The third quarter of 2016, "post-Brexit" rally suggests there are few signs of political change or contagion strong enough to disrupt the market equilibrium in place for many years. Sovereign bond markets initially moved aggressively to discount likely global policy support, a stimulative catalyst, particularly for the emerging markets. From our vantage point, while we may question the fundamental underpinnings, we must respect that such a significant decline in cost of capital is likely to spark an earnings recovery, particularly in the developing world where previous pressures suggest pent-up demand and trough corporate profit margins. As such, we remain confident that EM equities can maintain a leadership position for the time being.
A key question in the past year has been whether imbalances and strong credit growth in China will ultimately lead to a credit contraction and/or a marked RMB devaluation. While we have previously noted cause for concern, financial and economic conditions now appear to be stable and improving, with economic growth, consumption, and commodity prices holding up well in the face of moderating stimulus measures and increased scrutiny over non-traditional bank lending. We view this as a sign that structural reforms, improved policy coordination and communication, and progress on capital market liberalization, financial reform, and bank non-performing loan recognition, seem to be achieving desired goals. As an important contributor to global demand, we believe stability in China is a key variable in the outlook for global growth and corporate earnings, and are encouraged by recent progress.
Looking forward, we remain optimistic, though as always, we are monitoring several key variables. We believe EM economies and equities have reached a favorable inflection point, where the cyclical earnings recovery seems to be coalescing with longer-term structural reforms across many EM countries, driving outperformance and potentially a sustainable bull market. Such reforms are in direct response to deteriorating economic and financial conditions suffered over the past several years, and often take time to take effect. In particular, we note China, India, Indonesia, Mexico, Brazil, and Argentina as countries where we have invested in companies likely to benefit from economic, financial or labor reforms, or significant political change. More recently, our enthusiasm is balanced by early signs that we may be passing through an important secular bottom in sovereign bond yields. Developing political realities, likely fiscal expansion, signs of rising wage and rent inflation, and comments by the U.S. Federal Reserve and Bank of Japan suggest the central bankers appear to be encouraging inflation expectations to rise, and perhaps “run hot” for the time being. This important shift is occurring after an historic decline in global yields that leaves investor sentiment and positioning vulnerable to “inflation sightings.” We suspect bond market volatility is likely to rise, although it remains an open question as to whether this would be favorable or unfavorable for equities, and we suspect we will have more to report on this at year end.
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 gained 7.33% in the third quarter, yet trailed the MSCI EM IMI Growth Index by 203 basis points due to a combination of stock selection, relative sector weights, and average cash exposure of 8.8% in an up market.
On a country basis, outperformance of investments in India, Panama, and Korea and lack of exposure to poor performing Malaysian and Turkish equities added the most value. These positive effects were overshadowed by underperformance of investments in South Africa, Taiwan, China, Hong Kong, and Indonesia. Lower exposure to outperforming Chinese equities, which rose 17.4% as a group within the index, and larger exposure to lagging equities in Mexico also hampered relative results.
On a sector level, Industrials investments added the most value, mainly due to the outperformance of Panamanian airline Copa Holdings, S.A. and South African conglomerate Bidvest Group Ltd. Copa was the second largest contributor to absolute results, while shares of Bidvest rose after the company successfully spun off its food services division. In addition, Bidvest continued to grow earnings despite a challenging macro environment in South Africa.
Significantly lower exposure to the top performing Information Technology (IT) sector, which rose nearly 18% in the index, and underperformance of investments in Financials and Materials detracted the most from relative results. Within IT, lower exposure to sizeable positions in the index that were up sharply in the quarter, including Tencent Holdings Ltd., Alibaba Group Holding Ltd., and Samsung Electronics Co., Ltd., weighed the most on relative performance. Weakness in Financials was mostly attributable to the underperformance of diversified banks, led by Grupo Financiero Banorte, S.A.B. de C.V. of Mexico and BDO Unibank, Inc. of the Philippines. Shares of Grupo Financiero Banorte declined after the company reported a slight increase in delinquencies within certain consumer portfolios, suggesting potentially higher credit costs ahead, while BDO’s shares underperformed after the company announced an impending equity rights issuance to fund future growth. Brazilian financial exchange operators BM&FBOVESPA SA and Cetip SA also hampered relative performance after performing well early in the year following their announced merger. Uncertainty around the timing of regulatory approval of the deal and a recently launched antitrust investigation by a competitor weighed on these stocks. Within Materials, larger exposure to poor performing gold stocks through investments in AngloGold Ashanti Limited of South Africa and Zhaojin Mining Industry Company Limited of China detracted the most from relative results.
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