Review and Outlook
After a marked decline in the third quarter, the fourth quarter of 2015 began with an abrupt and powerful rally in international equities, commodities and credit. Coincident with the Fed’s deferral of an October rate hike, indicators began to suggest improving economic growth, global trade, and stabilization in China and 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 stunted the rally. An increase in terrorism and rising Middle East tensions exacerbated the mid-quarter rise in risk premium, leading international 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; commodity and oil prices; and increasing Middle East hostilities. We see the first two as directly related; any increase in the market-discounted rate of Fed tightening will force a more aggressive response from China and increase the risk of a more material RMB depreciation. This phenomenon was on display in the second half of 2015. RMB depreciation acts as a safety valve for China and deflects the deflationary pressure being absorbed back at the rest of the world. In the zero-sum world of subpar global economic growth and credit saturation, we 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 European Central Bank; in our view, it is now simply China’s “whac.”
The silver lining is that much of the developed world continues to exhibit reasonable economic growth and momentum while much damage has already been done in the emerging and commodity-sensitive markets. To us, the key question is whether the current tightening of financial conditions triggers an international credit event or enough RMB depreciation to suggest global contagion and the risk of recession. Should this occur, we believe associated volatility would likely force the Fed to reverse course, with the most likely result an abrupt and sustainable market recovery. It is also possible that global growth and leading economic indicators 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.
Over the past 18 months, we have maintained below-market exposure to emerging market equities given prevailing headwinds, while we have increased our investments in what we believe are well-positioned and high-quality domestic European and U.K.-based companies. While we remain comfortable that our current positioning is well aligned given the existing environment, we believe there are substantial investment opportunities 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 International Growth Fund rose 4.66% in the fourth quarter, yet modestly trailed the MSCI ACWI ex USA IMI Growth Index by 59 basis points.
Emerging market investments outperformed their index counterparts after increasing 12.8%, led by holdings in China. This positive effect was overshadowed by underperformance of developed market holdings in Japan, Germany, Norway, and the U.S.
On a sector basis, outperformance of Consumer Discretionary and Health Care investments and meaningfully larger exposure to the top performing Information Technology (IT) sector contributed the most to relative results. Within Consumer Discretionary, outperformance of restaurant holdings Domino's Pizza Enterprises Ltd. of Australia and Domino's Pizza Group plc of the U.K. added the most value. The two companies formed a joint venture to acquire the largest pizza retailer in Germany and consolidate the German business of Domino's Pizza Group. Investments in TAL Education Group and Ctrip.com International Ltd. of China also aided relative performance after their shares rose 44.4% and 27.8%, respectively. TAL was the second largest contributor on an absolute basis, while shares of Chinese online travel agency Ctrip rose after the company consolidated its leadership position with its acquisition of a stake in number two player Qunar. Strength in Health Care was mostly attributable to the outperformance of Eurofins Scientific SE of France, Agilent Technologies, Inc. of the U.S., and Abcam plc of the U.K. In particular, shares of Eurofins, which provides analytical testing services to clients in the food, pharmaceutical and environmental industries, performed well on solid organic revenue growth and enhanced mid-term financial objectives. Lack of exposure to the lagging pharmaceutical sub-industry also lifted relative performance.
Financials, Energy, and Consumer Staples investments were the primary detractors from relative results. Weakness in Financials was partly due to the underperformance of property & casualty insurance holdings Arch Capital Group Ltd. of the U.S. and Lancashire Holdings Limited of the U.K. Arch’s shares gave back some gains following a period of a significant outperformance, while shares of Lancashire declined for no fundamental reason. Mitsui Fudosan Co. Ltd. and Daiwa Securities Group, Inc. of Japan and BM&FBOVESPA SA of Brazil also hurt relative performance. Energy holdings trailed their index counterparts after falling 18.3%, with Golar LNG Ltd. of Norway and Petroleo Brasileiro SA of Brazil leading the decline. Golar was the second largest detractor from absolute performance, while shares of Petroleo Brasileiro fell sharply as the rout in oil prices and weakness of the Brazilian Real magnified balance sheet concerns. We exited our position due to concerns about company’s ability to monetize non-core assets and fix the balance sheet. Within Consumer Staples, underperformance of the Fund’s only sector holding, Nomad Foods Ltd., weighed on relative results. Nomad was the third largest detractor on an absolute basis.
Yearly Attribution Analysis
Baron International Growth Fund increased 1.48% for the year and outperformed the MSCI ACWI ex USA IMI Growth Index by 174 basis points, due to stock selection.
Stock selection in developed markets added the most value, driven mostly by investments in Canada, Australia, the U.K., Spain, and France. Emerging markets investments detracted from relative results as underperformance of investments in Brazil and Indonesia and larger exposure to these lagging countries outweighed double-digit gains from holdings in China.
On a sector basis, IT, Industrials, Materials, and Health Care investments were the largest contributors to relative results. Within IT, outperformance was broad-based across software, Internet, and payment services, led by application software holdings Constellation Software, Inc. of Canada and Kingdee International Software Group Co. Ltd. of China. Constellation Software was the third largest contributor to absolute performance, while shares of Kingdee rose on reports of improvements in gross profit generation. JUST EAT plc and Worldpay Group plc of the U.K. and Ingenico Group of France also added value. Strength in Industrials was mainly due to the outperformance of MonotaRO Co., Ltd. of Japan and Aena SA of Spain. MonotaRO was the second largest contributor on an absolute basis, while shares of Spanish airport operator Aena benefited from growing air traffic and the renegotiation of several vendor contracts in its favor. Budget airline Ryanair Holdings plc of Ireland also aided relative results after reporting guidance that beat Street expectations. Within Materials, outperformance of Symrise AG of Germany and Syngenta AG of Switzerland and lower exposure to this lagging sector contributed to relative results. Shares of Symrise, a flavor and fragrance producer for food, home and personal care companies, were up on reports of above-market growth and margin expansion. Shares of crop chemical and biotech seed company Syngenta were sold after rising sharply following several acquisition attempts by Monsanto. Within Health Care, outperformance of Eurofins Scientific SE of France and Abcam plc and EMIS Group plc of the U.K. was somewhat offset by lack of exposure to outperforming pharmaceutical stocks, which make up nearly 10% of the index.
Lower exposure to the outperforming Consumer Staples sector and underperformance of Utilities and Telecommunication Services holdings detracted the most from relative results. Within Utilities, underperformance of TerraForm Global, Inc. hurt relative results. The company was the largest detractor on an absolute basis. Weakness in Telecommunication Services was mostly attributable to the underperformance of Tower Bersama Infrastructure Tbk PT, the second largest independent owner and operator of wireless telecommunication towers in Indonesia. Tower Bersama’s shares fell sharply due to a weakened demand environment from carrier customers, a cancellation of the Mitratel acquisition, and rupiah depreciation.
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