Review and Outlook
The third quarter of 2014 witnessed a reversal of second quarter trends: equities retraced a large portion of previous gains, broader Europe and other key economies shifted into a slowdown, political reform momentum slipped, while, on the bright side, the geopolitical environment largely stabilized. On the liquidity front the status quo prevailed; the U.S. Federal Reserve inched closer to the final tranche of scheduled QE, while the ECB and Bank of Tokyo continue to condition market participants for an escalation – perhaps as an offset to the wind-down in the U.S. In our second quarter letter we questioned whether the complacency grounded in record low sovereign bond yields was fundamentally based, and whether prevailing low measures of volatility were sustainable given what appeared to be rising levels of risk-taking and leverage in many markets. We are, therefore, not surprised by the recent turn of events and rise in market volatility to more normalized levels, and further suspect such conditions are likely to continue. Increasing volatility is consistent with a maturing bull market in equities.
We often suggest that our intermediate and long-term enthusiasm for particular international markets is rooted in the potential for, and progress in executing, market-friendly and productivity-enhancing reforms. Over the past year we have suggested that reform momentum across multiple countries was a key catalyst for the improving performance in such equities. Of course, markets are forward looking, so the recent pause in momentum has likewise driven a mean-reverting pullback. Unwelcome developments during the third quarter include intermittent resistance to Prime Minister Abe’s “Third Arrow” reforms in Japan, and ongoing discourse and uncertainty regarding fiscal and monetary flexibility in Europe, given the conflicting positions of Germany and the peripheral countries. Key emerging markets, including China, Brazil, Indonesia, and India, also hit roadblocks in the quarter. To a large degree, we consider such developments as a part of the “two steps forward, one step back” progression, and we remain optimistic particularly regarding the long-term potential of the companies in which we are invested.
In the short term, we observe several divergences suggesting to us that we have likely entered a period of higher volatility, and that the recent correction in international and emerging market equities may have further to go. Key divergences we are monitoring include generally rising credit spreads over sovereign yields, the recent weakness in commodity prices relative to equities, and the strength in sovereign bonds relative to equities. All suggest to us a potential change in liquidity and risk conditions in such markets. On the plus side, we continue to observe solid capital flows into the principal international fixed income markets, and we will carefully follow future developments here.
Most importantly, we remain of the view that that the ongoing shift in opportunity, resources and capital towards those companies most capable of driving sorely needed economic efficiency and productivity is not only a long-term phenomenon, but also a primary driver of value creation. We believe this trend underlies the Fund’s solid performance to date, as we invest nearly exclusively in what we believe to be value creating entrepreneurs, running attractive businesses grounded in intellectual capital and competitive 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.
The Baron International Growth Fund (Retail Shares) declined 6.88% in the third quarter and trailed the MSCI ACWI ex USA IMI Growth Index by 180 basis points, primarily due to stock selection.
Positive stock selection effect from developed markets investments, primarily those in Israel, France, and Australia, added the most value. This was more than offset by the underperformance of the Fund’s emerging markets holdings, led by those in India and Brazil.
On a sector basis, the Fund’s investments within the Information Technology (IT) sector and its average cash exposure of 4.2% in a down market were the largest contributors to relative results. Strength in IT was largely attributable to the outperformance of Mellanox Technologies Ltd. and Ingenico SA, which were also two of the Fund’s largest contributors on an absolute basis. Just Eat plc, a leading online restaurant delivery platform based in the U.K., also aided relative performance. The company’s shares rebounded strongly from the previous quarter’s losses on signs that business remained solid and that competitive concerns had been exaggerated.
Underperformance of the Fund’s investments within the Health Care and Consumer Discretionary sectors detracted the most from relative results. Weakness in Health Care was mainly due to the underperformance of Grifols SA, the Fund’s second largest detractor from absolute performance, and Eurofins Scientific SE, a provider of analytical testing services to clients in the food, pharmaceutical, and environmental industries. These two long-held and successful investments pulled back in the quarter after near-term earnings momentum slowed. The Fund’s lack of exposure to pharmaceuticals stocks, which finished up slightly as a group in the index, also hampered relative performance. Within Consumer Discretionary, a combination of stock selection and the Fund’s meaningfully larger exposure to this lagging sector hurt relative results. More than half of the Fund’s investments in the sector underperformed, led by the Fund’s cable & satellite investments, which are based in India. Shares of DEN Networks Ltd. and Hathway Cable & Datacom Ltd. declined after regulators pushed back the deadline for pan-India digitization by two years. Other key detractors in the sector were AO World plc, the leading online seller of major domestic appliances in the U.K., and Steinhoff International Holdings Ltd., a leading furniture retailer based in South Africa. AO World’s shares fell in the quarter due to contractions in valuations for the online sector in the U.K. Steinhoff is planning to dual-list on the Frankfurt Stock Exchange and was required to raise roughly $1.6 billion of equity capital to satisfy all listing procedures. We believe the potential earnings dilution from the equity raise caused the stock to decline.
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