Review and Outlook
Global equity markets, while fairly volatile intra-quarter, captured significant gains as the U.S. Federal Reserve announced a decision to delay tapering. While several developing world economies displayed signs of weakening fundamentals, other key economies, including the U.S., Europe, Japan, and China, appeared to be in a synchronized recovery for the first time in many quarters. We suspect this is an important factor in the strength we have recently seen in equity markets worldwide. While some of the improvement may be cyclical, we believe the market-friendly political, financial, and economic changes occurring in Japan and China more likely represent investable secular developments.
We were pleased with our third quarter performance, and remain confident in the long-term outlook for this strategy and the companies in which we are invested. Developing world equities struggled again as a group during the third quarter, but our strong stock selection far exceeded any negative impact from our developing world exposure. The strongest performance came from our investments in Information Technology (IT), particularly those related to our broadband Internet and mobile theme. Our conviction in this theme is evident from the IT/Internet investments we have made in China, Europe, and Japan. Where portfolio performance lagged was in the Consumer Discretionary sector, where several positions consolidated prior gains and retreated during the quarter.
The Fund maintains broad diversification by sector, country and by market cap. At the end of the third quarter, the Fund was invested 76.2% in developed countries, 21.5% in developing countries, and 2.3% in cash. By design, the Fund has maintained a developing world bias, given superior growth and, in our opinion, long-term value creation potential. At the end of the quarter, the Fund’s median market cap was $5.4 billion, and was invested 51.1% in large/giant-cap growth companies, 31.0% in mid-cap growth companies, and 15.6% in small-cap growth companies, as defined by Morningstar.
We established five new positions during the quarter and sold nine positions where poor execution, deteriorating fundamentals or a more stringent regulatory environment caused us to reassess our expectations.
In the developed world, we see signs of improving fundamentals in Japan and Europe, and have increased exposure here on the margin. Within the developing world, we are looking for new investment ideas in countries less impacted by rising interest rates, shrinking liquidity, and lower commodity prices, such as China, Taiwan, and Korea. In addition, we find China and Mexico attractive as they are contemplating investor-friendly reforms.
In general, we maintain confidence that our investment approach, focused on higher quality, capital-efficient growth companies driven by strong and entrepreneurial management teams, is a particularly well-suited approach to international investing.
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 14.75% in the third quarter and significantly outperformed the MSCI AC World ex USA IMI Growth Index by 550 basis points.
The Fund’s outperformance was driven by stock selection across developed and emerging markets investments. Favorable stock selection was led by the outperformance of the Fund’s investments in China, Japan, and Germany, respectively.
On a sector basis, outperformance of the Fund’s investments in Information Technology (IT), Financials, Health Care, and its lack of exposure to the underperforming Consumer Staples sector contributed the most to relative results. Stock selection was the highest in IT largely due to outperformance of three of the Fund’s Chinese Internet and technology holdings, NQ Mobile, Inc., Sina Corporation, and Kingdee International Software Group Co. Ltd. Shares of Kingdee, a leading provider of enterprise management software and cloud and e-commerce platforms, rose in the quarter after the company announced financial results, suggesting that the reorganization of its sales priorities was beginning to bear fruit. Other meaningful contributors in the sector were Kakaku.com, Inc., an operator of several websites in Japan, and RIB Software AG, a German technology company offering a unique, 5D (3D modeling plus time and cost management) modeling capability for the construction industry. Within Financials, the majority of the Fund’s investments in the sector added value, led by outperformance of Multi Commodity Exchange of India Ltd., the third largest commodity trading exchange in the world, and Julius Baer Group Ltd., one of the largest independent private banks based in Switzerland. Strength in Health Care was mainly attributable to the outperformance of the Fund’s two largest holdings in the sector, Eurofins Scientific SE and Agilent Technologies, Inc., which are both life sciences tools businesses. Eurofins is a French analytical testing company that provides services to clients in the food, pharmaceutical, and environmental industries, while Agilent is the world’s largest supplier of test and measurement hardware and software products to the electronics, life sciences, chemical analysis, and diagnostics industries.
The Fund’s investments within the Consumer Discretionary sector detracted the most from relative results. Weakness in the sector was mostly the result of underperformance of the Fund’s cable & satellite media holdings, led by KT Skylife Co. Ltd., which is South Korea’s largest satellite TV provider with over four million subscribers, and DEN Networks Ltd., one of India’s largest cable TV providers. DEN faced headwinds due to weakness in the Indian Rupee. Another detractor in the sector was SodaStream International Ltd., an Israeli company that develops, manufactures, distributes, and markets a home carbonation system, allowing customers to make their own seltzer and soda. All three of these companies consolidated prior gains and retreated during the quarter.
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