Review and Outlook
After a marked decline in the third quarter, the fourth quarter of 2015 began with a powerful rally in global equities, commodities, and credit. Coincident with the Fed's deferral of an October rate hike, indicators suggested improving economic growth, global trade, and stabilization in China and of the RMB. Such stability inspired the Fed to signal the start of a rate hike cycle in December, which seemed to act as an immediate financial tightening and stunt the rally. An increase in terrorism and rising Middle East tensions exacerbated the mid-quarter rise in risk premium, leading global equities to fade into year end.
For the year ahead, we expect further volatility. In our view, the key variables are the Chinese economy, policy and the RMB; the slope and duration of Fed tightening; the outlook for commodity and oil prices; and the geopolitical implications of increasing Mideast hostilities. We see the first two variables as directly related; any increase in the market-discounted rate of Fed tightening will force a more aggressive policy response from China and increase the risk of a more material RMB depreciation. This phenomenon was on display through the second half of 2015. RMB depreciation acts as a safety valve for China and deflects the deflationary impulse being absorbed back at the rest of the world, weighing on global prices and asset values, particularly in the most vulnerable and leveraged countries and sectors. In the zero-sum world of subpar global economic growth and credit saturation, we should continue to expect the "whac-a-(deflation)mole" policy response initiated by the Fed in 2009 and carried on by the Bank of Japan and the ECB; in our view, it is now simply China's "whac."
The silver lining is that we believe we are in the advanced stages of a bear market in the emerging markets, where much of the damage has already been done. We envision three potential pathways to a major inflection point, which, for the first time in several years, we now see emerging on the horizon. The first two pathways, most likely triggered by an international credit event or RMB depreciation, would likely involve a final, ninth-inning decline, followed by an abrupt and sustainable recovery as the Fed reverses course. We believe the 1998 credit crisis and/or Euro-periphery crisis of 2012 serve as reasonable proxies for this scenario. In the third, and preferred, pathway, global growth and leading indicators would continue to improve upon what appeared a bottoming in early October; in effect, the Fed would now be appropriately hiking into a global re-acceleration, reducing the odds of a credit incident, and suggesting a re-acceleration of corporate earnings growth.
We believe RMB depreciation has emerged as a key catalyst, as China’s ability to underpin the RMB appears suspect following the brief period of stabilization that preceded November’s historic inclusion into the IMF basket of global reserve currencies. While we remain comfortable that our positioning is well aligned given the existing environment, we believe substantial investment opportunities lie ahead and are identifying specific candidates as well as a strategy to take advantage.
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 3.41% in the fourth quarter and outperformed the MSCI EM IMI Growth Index by 62 basis points due to stock selection.
On a country basis, outperformance of investments in China, Brazil, and Mexico added the most value. These positive relative results were somewhat offset by average cash exposure of 9.1% in an up market, underperformance of Taiwanese investments, and larger exposure to lagging Indian equities.
On a sector basis, Consumer Staples, Information Technology (IT), and Financials investments were the primary contributors to relative results. Within Consumer Staples, outperformance of LG Household & Health Care Ltd. and lack of exposure to the poor performing food retail and brewer sub-industries added the most value. Shares of LG, a major consumer goods company in Korea, rose on the strength of an earnings beat driven by cosmetics sales in China. Strength in IT was mostly attributable to outperformance of Chinese Internet software & services holdings, led by Alibaba Group Holding Ltd. and Qihoo 360 Technology Co., Ltd. Kingdee International Software Group Co. Ltd. of China and Novatek Microelectronics Corp. of Taiwan also aided relative performance. These positive relative results were partly offset by lower exposure to this top performing sector, which increased 7.5% in the index. Within Financials, outperformance of Bank Rakyat Indonesia (Persero) Tbk PT of Indonesia and SKS Microfinance Ltd. of India contributed to relative results. Bank Rakyat posted resilient 3Q15 results, which helped quell fears of a China-led slowdown in the region and eased concerns about asset quality, while rising demand for rural loans in India boosted shares of SKS Microfinance. Larger exposure to the investment banking & brokerage sub-industry through Chinese companies Haitong Securities Co., Ltd. and Huatai Securities Co., Ltd. also lifted relative performance. Stabilization of Chinese market indexes brought some signs of recovery to the brokerage sector. In addition, the reopening of the IPO market and news about a potential early launch of the Shenzhen-Hong Kong stock connect brought renewed optimism in the positive impacts of financial reforms for the industry.
Underperformance of Telecommunication Services and Energy investments detracted the most from relative results. Within Telecommunication Services, underperformance of wireless telecommunication services holdings, led by Advanced Info Service Public Co., Ltd., and larger exposure to this lagging sub-industry hurt relative results. Shares of Advanced Info, Thailand’s largest mobile phone operator, declined after 4G spectrum auctions resulted in the entry of a new player. China Mobile Ltd. of China and Far Eastone Telecommunications Co., Ltd. of Taiwan also hampered relative performance in the sub-industry. Weakness in Energy was mainly due to underperformance integrated oil & gas holdings, led by Petroleo Brasileiro SA of Brazil and PetroChina Co. Ltd. of China.
Yearly Attribution Analysis
Baron Emerging Markets Fund fell 10.97% for the year and trailed the MSCI EM IMI Growth Index by 46 basis points.
On a country basis, outperformance of Indian investments and meaningfully larger exposure to Indian equities, which outpaced the broader index, added the most value. Outperformance of investments in Mexico and China and lack of exposure to lagging Turkish equities, which fell 28.9% in the index, also aided relative results. These favorable relative results were overshadowed by underperformance of investments in Brazil, the U.S., Norway, and Thailand, and lower exposure to better performing equities in South Korea and no exposure in Russia.
On a sector basis, Health Care, Consumer Staples, and Consumer Discretionary investments and lower exposure to the underperforming Financials sector contributed the most to relative results. Within Health Care, outperformance of pharmaceuticals, biotechnology & life sciences holdings and larger exposure to this industry group added the most value. Among the largest contributors to relative results were Indian companies Torrent Pharmaceuticals Ltd., Divi's Laboratories Ltd., and Lupin Ltd., which benefited from substantial growth in the U.S. as branded drugs continued to go off-patent. Investments in Ginko International Co., Ltd. of Taiwan and Sinopharm Group Co., Ltd. of China also aided relative performance. Strength in Consumer Staples was mainly due to the outperformance of LG Household & Health Care Ltd., a Korean consumer goods company. Mexican holdings Fomento Económico Mexicano, S.A.B. de C.V., a soft drink producer, Grupo Lala, S.A.B. de C.V., a packaged foods & meats company, and Wal-Mart de Mexico, S.A.B. de C.V., also contributed to relative results after being helped by lower input costs and improving consumer spend during the year. Within Consumer Discretionary, outperformance of TAL Education Group and Ctrip.com International Ltd. of China, and Dish TV India Ltd. contributed the most to relative results.
Energy, IT, and Utilities investments were the largest detractors from relative performance. Energy holdings trailed their index counterparts after falling 27.0%, with PetroChina Co. Ltd. of China, Lekoil Ltd. of the U.K., and Petroleo Brasileiro SA of Brazil leading the decline. Weakness in IT was mostly attributable to lower exposure to Internet software & services holding Tencent Holdings Ltd., which increased 35.9% and represented a weight of 4.3% in the index. Underperformance of Internet software & services, semiconductor, and systems software holdings, led by Opera Software ASA of Norway, MediaTek, Inc. of Taiwan, and TOTVS SA of Brazil, respectively, also hurt relative results. The Fund exited its position in Opera early in 2015 after management disclosed that its exposure to the Russian Ruble was greater than previously indicated. Within Utilities, underperformance of the Fund’s only U.S. holding, TerraForm Global, Inc., a renewable energy company focused on emerging markets, detracted the most from relative performance.
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