Review and Outlook
Global equities stayed largely flat in the first quarter of 2014, though several events sparked renewed volatility. Key challenges included political and financial instability in the emerging market countries of Ukraine, Turkey, Thailand and Argentina; by comparison, events and economies in the developed world countries generally continued "up and to the right." However, several previously underperforming emerging markets showed increasing signs of stabilization in advance of upcoming elections; notably India, Indonesia and Brazil. As such, and given our respect for the potential of economic and social reforms in many emerging market countries, we have become marginally more optimistic, though much will likely hinge on future politics and policy. We also believe strength in developed world economies bodes well for stabilization in the emerging markets; particularly export-sensitive economies such as Taiwan, Korea and Central Europe.
Most important, our results during a challenging period for emerging markets returns suggest that our investment discipline, focused on higher quality, capital-efficient growth companies driven by strong and entrepreneurial management teams, is particularly well suited to capitalize on the extraordinary change and opportunity that we currently see in our markets.
Of course, the instability in Ukraine opened the door to Russia's move on the Crimean peninsula, though for now we concur with the consensus view that this event will likely be contained without material impact to broader global equities. With regard to Russia itself, we submit that Putin again proved Russia's lack of concern for capital market participants and reinforced why its equity market trades at a massive discount. We have always been biased against investing in Russian companies precisely due to investor unfriendly institutional and corporate governance, and were not inspired to jump in during the recent significant decline.
We believe that longer-term, the key stimulus for the emerging markets will be reform-driven improvement in prospective return on capital and cost of capital. China and Mexico have already detailed substantive reform agendas, while we believe India and Indonesia are likely on a political course to follow suit subsequent to upcoming elections.
What is happening in China highlights the short-term paradox inherent in reform. The transition from credit-driven growth to a sustainable, productivity-led agenda is rarely smooth, and there are many special interest groups lobbying aggressively against it. We believe the slowdown in China to date is the logical outcome of a deliberate shift by the government in the credit allocation mechanism. However, we are monitoring the situation, as we believe a more severe credit contraction could likely have a significant impact on global liquidity and economic expectations.
We did not make any notable adjustments to our exposures in the first quarter, and we continue to favor investing in countries such as China, which appear committed to investor-friendly reform; and India, Indonesia and Brazil, where reform seems likely. We also maintain a preference for countries that are relatively shielded against rising interest rates, lower commodity prices and shrinking liquidity, such as Taiwan and Korea. That said, ultimately our performance is driven by our fundamental bottom-up stock selection and related process of theme identification.
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) gained 1.82% in the first quarter and outperformed the MSCI EM IMI Growth Index by 132 basis points. For the first time in several quarters, the Fund’s outperformance was driven more by allocation effect than stock selection.
On a country basis, the Fund’s lower exposure to Russian equities, which declined amid the drama between Russia and the Ukraine, added the most value. The Fund’s larger exposure and favorable stock selection in Brazil also aided relative results after equities in the country bounced back due to anticipated political change in upcoming elections. Strength in the Philippines, China, and Taiwan, which fall in the Asia/Pacific ex-Japan region, also contributed to relative performance.
On a sector basis, the Fund's lower exposure to the Energy sector, which was the worst performing sector in the index, and outperformance of its investments within the Industrials, Telecommunication Services, and Materials sectors, contributed the most to relative results. The Fund’s Industrials holdings gained 10.9% during the quarter, led by its two largest holdings in the sector, Amara Raja Batteries Ltd., a manufacturer of lead-acid car batteries in India, and HIWIN Technologies Corp., a leading Taiwanese manufacturer of ballscrews and other equipment used in factory automation. Shares of Amara Raja rose more than 20% after reporting a strong fourth-quarter operating performance. We believe that Amara Raja continued to take market share from various battery vendors because of its products’ superior attributes and a growing distribution network. Shares of HIWIN outperformed as increasing automation demand from Chinese companies and the improving economy in Europe bolstered investor conviction that the Taiwanese automation sector is set for a ramp up in sales growth. Within Telecommunication Services, outperformance of the Fund’s Indonesian wireless tower investments, Tower Bersama Infrastucture Tbk PT and Serana Menara Nusantara Tbk PT, added the most value. Both companies reported strong financial results during the quarter. Strength in Materials was largely attributable to outperformance of Sociedad Química y Minera de Chile SA, which is the world's top supplier of iodine, lithium, potassium nitrate, and solar salts. Sociedad Química’s shares rallied in the quarter driven by Tesla’s plans to build a $4-5 billion “gigafactory,” which would be the largest lithium battery plant in the world. Even though lithium is about 11% of the company’s profits, as the leading lithium producer, Sociedad Química’s stock responded favorably to the news.
The Fund’s investments within the Information Technology sector were the largest detractors from relative performance. Weakness in the sector was mainly due to the underperformance of the Fund’s broadband Internet and eCommerce holdings, led by Sina Corp. and Yandex N.V. Shares of Yandex, the leading search engine provider in Russia, fell more than 30% due to a decline in the Russian ruble and rising geopolitical tension over Crimea. Although we expect the conflict to negatively impact the company's growth rate in the near term, we continue to hold Yandex due to its strong competitive positioning and positive long-term growth prospects relative to its current valuation.
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