Review and Outlook
International equities appreciated in the first quarter as markets responded to declining sovereign interest rates, largely driven, in our view, by aggressive ECB monetary policy. To us, the key event of the first quarter was the detail of the ECB's easing campaign, which clearly "beat" market expectations. Economic momentum worldwide continued to diverge, with relative strength in much of the developed world, led by a recovering Europe, and ongoing signs of deterioration across the developing world, notably in China and Brazil.
Across the globe, high quality growth stocks, our principal investment focus, lagged their lower quality, more capital intensive and cyclical peers. We also attribute this largely to aggressive ECB easing, as the attendant decline in cost of capital worldwide drove a mean-reverting relief rally for such equities. In contrast, the companies in which we seek to invest tend to be steady, value-creating entities driven by organically high return on capital, and are thereby much less sensitive to changes in the cost of or access to capital.
During the quarter, oil prices, currencies, bond yields, and equities remained volatile, we suspect driven by uncertainty over key macroeconomic variables and the divergence in monetary policy expectations. Uncertainty over the timing of anticipated Fed rate hikes, as well as the likelihood of Greece remaining in the EU, has also elevated market volatility. For international equities overall, we view the strength of the U.S. dollar, exacerbated by ECB policy, as a key risk factor, particularly for countries most exposed to declining commodity prices and/or dollar denominated liabilities. For the most part, we have refrained from investing in companies and markets directly exposed.
We suspect interest rates are likely to remain quite low for a sustained period as any material increase is likely to stress the system and derail economic momentum. We view the current financial and investment environment as a conundrum that we might describe as the "Truman Show" market. Here, global monetary authorities present a constructed reality, where developed world interest rates, the key variable upon which all other market instruments must be evaluated on a relative basis, are manipulated rather than set by market forces. While we continue to discover attractive investments, they are marginally more difficult to find. For these reasons, our cash position is moderately above desired levels and we have become a bit more conservative with regard to liquidity and balance sheet quality.
Although the current investment environment appears complex, our discipline seeks to identify attractive investment opportunities in all environments, often precisely due to the rapid evolution of change across our universe. We believe such change-driven opportunity is emerging now in a variety of countries and industries, and remain confident that our discipline will continue to identify the source of tomorrow’s significant value creation. We note Europe, Japan, China, India and Indonesia as particularly fertile ground for such long-term opportunity given significant reforms already underway.
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 (Institutional Shares) increased 2.87% in the first quarter, yet trailed the MSCI ACWI ex USA IMI Growth Index by 188 basis points, primarily due to stock selection.
Stock selection in developed markets added value, driven by outperformance of the Fund’s holdings in Japan, Canada, and Australia; but this positive effect was more than offset by underperformance of its emerging markets holdings. The Fund’s investments within emerging markets fell 3.0% and trailed their benchmark counterparts by 712 basis points, led by those in Brazil. The Fund’s larger exposure to Brazilian equities, which fell sharply in the quarter, also hurt relative results.
On a sector basis, the Fund’s investments within Financials and Industrials were the largest contributors to relative results. Within Financials, outperformance of the Fund’s investments in diversified banks, led by Axis Bank Ltd., and its lower exposure to this lagging sub-industry added the most value. PATRIZIA Immobilien AG of Germany and Azimut Holding S.p.A. of Italy also drove outperformance in the sector. PATRIZIA’s outperformance was driven by the company’s move to transform itself from a real estate owner to an asset light property manager, a business model to which investors assign higher multiples. Shares of Azimut, a leading wealth management and asset management firm in Italy, rose more than 20% after being added to the Fund in late January. We believe Azimut stands to benefit from the decline in deposit rates and yields on European fixed income assets. Strength in Industrials was mostly attributable to the outperformance of Japanese investments MonotaRO Co., Ltd. and FANUC Corp., which were also two of the Fund’s largest contributors on an absolute basis. Other contributors to relative performance in the sector were Larsen & Toubro Ltd. of India and Aena SA of Spain. Shares of Larsen & Toubro, which is India’s largest engineering and construction conglomerate, were bolstered by the Indian government’s continued efforts to stimulate infrastructure spending in the country. Aena, a new position in the Fund since early March, is the principal operator of airport terminals in Spain. Shares of Aena rose for the period held, and we believe Aena is well positioned to benefit from improving travel volumes as a result of stronger economic activity and the weaker Euro.
The Fund’s investments within the Consumer Discretionary and Health Care sectors, and its average cash exposure of 5.9% amid favorable market conditions for global equities detracted the most from relative results. Within Consumer Discretionary, the Fund’s larger exposure to underperforming education services stocks and, to a lesser extent stock selection in this sub-industry, detracted 153 basis points from relative results. Brazilian education stocks, including our holdings Brazilian education companies GAEC Educação SA and Kroton Educacional SA, suffered in the quarter after fiscal problems in Brazil caused the government to change the rules for FIES, a student financing program. AO World plc of the U.K. and Luk Fook Holdings (International) Ltd. of Hong Kong also hurt relative performance in the sector. Shares of AO, the leading online seller of major domestic appliances in the U.K., declined due to a lower growth forecast. Weakness in Health Care was mainly due to the Fund’s lack of exposure to pharmaceutical stocks, which rose 11.5% as a group within the index.
Back to Top
Invest In Baron Funds Today