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 that has remained in place for many years. Indeed, sovereign bond markets initially moved aggressively to discount likely global policy support, a stimulative catalyst, particularly for the emerging markets. While we may question the fundamental underpinnings, 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. As such, we remain confident that developing world-biased equities can maintain a leadership position for the time being.
A key question for global investors over 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. 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. As of this writing, financial and economic conditions 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.
We remain optimistic, though we are monitoring several key variables. Japan, while struggling with inadequate growth and inflation, seems poised to enter a fiscal expansion largely financed by money printing, which could spark a rise in equities even if partially offset by currency depreciation. While Europe remains challenged by political and financial complexities, credit and earnings growth appear reasonably healthy. The U.K. economy has held up well in spite of Brexit uncertainties. Further, we believe developing world economies, commodities, and equities have reached a favorable inflection point. In the emerging markets, the cyclical earnings recovery seems to be coalescing with longer-term structural reforms and favorable political evolution in countries such as Brazil and Argentina. More recently, our enthusiasm is balanced by early signs that we may be passing through an important secular bottom in sovereign bond yields. Evolving 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. 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 a question 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 International Growth Fund increased 7.68% in the third quarter and outperformed the MSCI ACWI ex USA IMI Growth Index by 148 basis points, primarily due to stock selection and relative sector weights.
Stock selection in developed markets added the most value, driven mostly by investments in Canada, France, Norway, Australia, and the U.S. Lower exposure to poor performing equities in Switzerland and Denmark also aided relative results in developed markets. Emerging market holdings contributed to relative results, led by outperformance of investments in India and larger exposure to top performing Chinese equities, which rose 17.4% as a group within the index.
On a sector basis, Health Care, Consumer Staples, and Energy investments were the primary contributors to relative results. Within Health Care, outperformance of the largest holding in the sector, Eurofins Scientific SE of France, and lack of exposure to poor performing pharmaceutical stocks added the most value. Eurofins was the largest contributor to absolute performance. Within Consumer Staples, meaningfully lower exposure to this lagging sector and outperformance of Bellamy’s Australia Ltd. contributed to relative results. Shares of Bellamy’s, which is Australia’s leading player in infant nutrition products, rose on strong earnings growth driven by robust demand in China. Bellamy’s continued to gain market share from local Chinese brands as consumers switched to imported, high quality, organic infant formula. Strength in Energy was mostly attributable to the outperformance of Golar LNG Ltd. of Norway and recent addition Encana Corp. of Canada. Shares of liquefied natural gas company Golar appreciated after it finalized a joint venture and made progress on converting vessels to regasification units. Shares of Encana, an exploration and production company with operations in Western Canada and Texas, rose on raised production guidance, lowered cash costs, and increased drilling activity in its highest return area.
Underperformance of investments in Information Technology (IT) and Industrials detracted the most from relative results. Weakness in IT, mainly due to Israeli holdings Mellanox Technologies Ltd. and Check Point Software Technologies Ltd., was somewhat offset by larger exposure to the strong performing Internet software & services and application software sub-industries. Mellanox was the second largest detractor from absolute results, while shares of security software firm Check Point fell on reports of the ongoing shift from upfront product to subscription sales, as well as investor fears that the firewall market is becoming more competitive. Within Industrials, underperformance of MonotaRO Co., Ltd. of Japan and Intertek Group plc of the U.K. hurt relative results. MonotaRO was the largest detractor on an absolute basis, while shares of Intertek, which offers product inspection services, declined on weak revenue growth in the first half of 2016 due to cyclical headwinds.
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