Review and Outlook
Global equity markets, while fairly volatile intra-quarter, captured significant gains as the U.S. Federal Reserve announced a decision to delay tapering. While several developing world economies displayed signs of weakening fundamentals, other key economies, including the U.S., Europe, Japan, and China, appeared to be in a synchronized recovery for the first time in many quarters. We suspect this is an important factor in the strength we have recently seen in equity markets worldwide. While some of the improvement may be cyclical, we believe the market-friendly political, financial, and economic changes occurring in China more likely represent investable secular developments.
We were pleased with our third quarter performance, and remain confident in the long-term outlook for this strategy and the companies in which we are invested. Developing world equities struggled again as a group during the third quarter, but our strong stock selection drove solid performance. Investments within the Information Technology sector, which encompasses our broadband internet and mobile theme, contributed the most to performance in the quarter. Other contributors came from the Health Care and Consumer Staples sectors. Where portfolio performance lagged most was in the Materials sector. In Consumer Discretionary, positions in the cable & satellite media industry retreated partially due to sensitivity to declining local currencies against the U.S. dollar.
The Fund maintains broad diversification by country, sector and market cap. During the quarter, we increased our exposure to China, while moderating our exposure to Indonesia. At the end of the quarter, the Fund’s median market cap was $2.4 billion, and was invested approximately 43.3% in large/giant cap companies, 41.7% in mid-cap companies and 9.4% in small-cap companies, as defined by Morningstar.
We continue to believe that in the long-term, global growth and value creation is likely to be led by the developing world. Developing world equity markets are unlikely to sustainably outperform until clear signs of investment-friendly reforms emerge in response to deteriorating productivity and the rising cost of capital. To this point, new leadership in China recognizes that they must transition towards a more market-driven and credit sensitive system, while reducing inefficiency and corruption. This quarter, commitment towards such reform gained credibility and momentum, evidenced by further financial sector liberalization efforts, experimentation with asset-backed securitization, and particularly the introduction of the Shanghai Free Trade Zone ("SHFTZ"). This is the type of long-term, investable inflection point that underlies our core discipline, and we have already identified many potential beneficiaries. While we recognize remaining short-term risks in China and several other related markets, we believe the longer-term opportunity warrant our exposure to investments there.
We maintain confidence that our investment approach, focused on higher quality, capital-efficient growth companies driven by strong and entrepreneurial management teams, is a particularly well-suited approach to emerging market investing.
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 8.89% in the third quarter and again significantly outperformed the MSCI EM IMI Growth Index by 461 basis points.
Emerging market equities underperformed developed market equities for a second quarter in a row. Nevertheless, the Fund outperformed in this weak equity environment due to stock selection, particularly in China.
On a sector basis, the Fund's investments within the Information Technology (IT), Consumer Staples, and Health Care sectors were the largest contributors to relative results for the quarter. Strength in IT was largely attributable to outperformance of the Fund’s Internet and software holdings, led by NQ Mobile, Inc., Sina Corporation, Kingdee International Software Group Co. Ltd., and 21Vianet Group, Inc. in China and Yandex N.V. in Russia. Shares of 21Vianet, the largest carrier-neutral Internet data center provider in China, performed well as investors became more comfortable with the demand for its extensive build out after its joint venture with Microsoft for cloud computing went live. Within Consumer Staples, stock selection in a lagging sector contributed to relative results. Favorable stock selection was driven by the outperformance of the Fund’s largest holding in the sector, Biostime International Holdings Ltd. Shares of Biostime, a fast-growing baby nutrition business in China, rose in the quarter due to above-consensus financial performance as the company has utilized its strong brand positioning and a unique direct marketing approach to drive increased sales of infant milk formula. Another contributor in the sector was M. Dias Branco SA, a leading manufacturer and distributor of cookies, crackers, and pasta in Brazil. Within Health Care, the majority of the Fund’s investments outperformed, led by WuXi PharmaTech (Cayman) Inc., which is China's largest Contract Research Organization with an estimated 25% market share. The Fund’s pharmaceuticals holdings also added value in the sector, led by the outperformance of CFR Pharmaceuticals SA, a Chilean-based company operating in 15 countries across Latin America.
The Fund’s investments within the Consumer Discretionary sector was the largest detractor from relative performance. Weakness in Consumer Discretionary was mostly due to the underperformance of the Fund’s cable & satellite media holdings, led by KT Skylife Co. Ltd., which is South Korea’s largest satellite TV provider with over four million subscribers. The company’s decline in the quarter was largely attributable to a slowdown in subscriber growth and a delay in finalizing negotiations related to home shopping commissions. Others detractors in cable & satellite media were DEN Networks Ltd. and Dish TV India Ltd. in India and MNC Sky Vision Tbk PT in Indonesia, whose shares all retreated partially due to sensitivity to declining local currencies against the U.S. dollar. The Fund's cash position was also a modest detractor from relative results. Some of the countries in which we invest are facing difficult macroeconomic conditions, which have led to deteriorating fundamentals at a company level. As a result, we remain selective in deploying excess cash. We started the quarter with a higher-than-normal level of cash, which declined as we identified several compelling investment opportunities.
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