Review and Outlook
In the prior quarter, we remarked on the high inter-connectedness of global markets in a period of high leverage, fragile confidence, and increasingly unconventional policy intervention. The second quarter was marked by the surprise outcome of the U.K. referendum regarding participation in the European Union. Both "Brexit" and a remarkably strong Yen captivated the attention of investors and risk managers worldwide. While Japan’s challenges are significant, we view them as fairly well understood and less threatening to global economies and markets. On the other hand, Brexit, rather than a local U.K. event, or even a pan-EU event, potentially challenges the political-economic-financial equilibrium we have come to take for granted over the past several decades. Since the 2009 financial crisis, political leaders, central bankers and policymakers have worked hard to maintain stability and sustain the existing equilibrium, but in recent years imbalances have been growing. Brexit should not have happened in the sense that it was not the logical or most economic outcome. Therefore, we must consider whether existing imbalances are pushing for an exit of the equilibrium, and if so, what will be the key changes in terms of long-term trends in globalization, EU political and financial integration, and security cooperation? How will the U.K.’s global trade relations proceed? Will Brexit increase or reduce the momentum of fringe anti-establishment movements in other E.U. countries? Material changes to these previous “knowns” would surely have global effects and could likely redefine opportunity and leadership throughout economies and markets. Such questions are complex and will not be answered overnight. Rather, several outcomes are possible, including the upside case of a “walking back” of Brexit, and we will be closely watching political and financial events unfold. As of now, we have made only modest adjustments in reaction given our comfort with our existing positioning, the substantial range of potential outcomes, and the fact that markets initially moved to discount an adverse scenario, particularly for the U.K. and Europe. We suspect that at current levels, equities outside the U.K. and E.U. have been far more resilient, creating a divergence that may need to be reconciled if Brexit is reflecting imbalances that exist on a global level.
Regardless of what scenario plays out, we think the surprise Brexit outcome raises the stakes for global leaders, and will likely move politicians and central bankers to prepare to act aggressively – to again seek to mute the impact of stress and sustain a stable equilibrium. As we have said in the past, we believe a global stress event is likely to provide political cover and provoke the Fed to join in more aggressive policy measures such as fiscal QE or “helicopter money.” Brexit may well be the catalyst we have been looking for, as we believe such measures would likely mark the end of the U.S. Dollar bull market, drive global investors to embrace rising inflation expectations, and stimulate global nominal GDP growth. In such an environment, we would expect international, and in particular, emerging market equities to return to leadership amid a global advance.
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 rose 1.96% in the second quarter and outperformed the MSCI ACWI ex USA IMI Growth Index by 165 basis points, primarily due to stock selection.
Emerging market investments added the most value after appreciating 12.0%, led by investments in Brazil, India, Russia, and China. Larger exposure to Brazilian equities, one of the best performing countries across emerging and developed markets, also aided relative results.
On a sector basis, outperformance of Consumer Discretionary, Materials, and Financials investments contributed the most to relative results. Strength in Consumer Discretionary was mainly due to the outperformance of Domino's Pizza Enterprises Ltd. of Australia and Smiles SA of Brazil. Shares of Domino’s Pizza were bolstered by the company’s exceptional execution in its home market and successful implementation of its growth strategy in new markets, while shares of Smiles benefited from general strength in Brazil and improving flexibility for parent company GOL Linhas Aéreas Inteligentes SA to manage its considerable balance sheet leverage. Investments in TAL Education Group of China and Matahari Department Store Tbk PT of Indonesia also helped relative performance. TAL’s performance was driven by growth in student enrollments of over 55%, while Matahari’s shares rose after the company posted strong Q1 financial results and announced that the current CFO will be promoted to CEO this summer. Within Materials, outperformance of gold stocks Newcrest Mining Ltd. of Australia and Agnico-Eagle Mines Ltd. of Canada and larger exposure this strong performing sub-industry added the most value. Financials holdings outperformed their index counterparts after increasing 3.0%, driven by gains from SKS Microfinance Ltd. of India and BM&FBOVESPA SA of Brazil. SKS was the second largest contributor to absolute results, while shares of financial exchange operator BM&FBOVESPA rose along with the broader Brazilian equity market and currency on investor optimism that political changes will lead to structural improvements in the Brazilian economy. The stock also benefited from shareholder approval of its acquisition of rival Cetip SA - Mercados Organizados, creating a unified financial clearinghouse for the Brazilian capital markets.
Meaningfully lower exposure to the outperforming Consumer Staples sector and underperformance of its Industrials investments detracted the most from relative results. Weakness in Industrials was driven by the Fund’s European low-cost airlines theme, where easyJet plc of the U.K. and Ryanair Holdings plc of Ireland declined noticeably in the wake of the Brexit referendum.
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