Dear Baron International Growth Fund Shareholder:
The Baron International Growth Fund (the “Fund”) gained 4.66% (Institutional Shares) for the fourth quarter of 2015, while its principal benchmark index, the MSCI ACWI ex USA IMI Growth Index, rose 5.25% for the quarter. For the full year, the Fund gained 1.48% while the benchmark index was nearly flat with a decline of 0.26%. From a longer-term perspective, in the seven years since the inception of the Fund, our investment performance exceeds the vast majority of the International multicap equity peer group tracked by Lipper.*
Global equities began the quarter with a strong rally, only to later reverse course, still closing the quarter with reasonable gains. Equity markets appeared to move inversely with prospects for the much-anticipated Fed rate hike cycle, at first deferred and subsequently confirmed. In our view, while central bank behavior remains an important driver, the stability of the Chinese RMB has emerged as perhaps the most critical catalyst for global asset prices in the near term. RMB depreciation resumed late in the quarter, following a brief period of stability preceding the late-November International Monetary Fund (IMF) decision to include the RMB in its basket of global reserve currencies.
We anticipate an ongoing gradual tightening of liquidity conditions and a widening of risk premium in the event of ongoing RMB depreciation. Notwithstanding the considerable attention of the financial press, in our view the resumption of local China A Share equity volatility is a symptom of the above rather than itself a driver of global concern. Further, we suspect the real economy in China remains reasonably stable, if not even improving, and, as such, we anticipate that, when the RMB reaches an equilibrium level, China and emerging market equities have the potential to outperform developed world peers.
As stated in our prior letter, we believe we are now in the late stages of the emerging markets' absolute and relative bear market and further suspect that either a notable credit event or volatility coincident with RMB depreciation would likely cause a reversal of Fed policy and a major bottom for global equities. We remain enthusiastic regarding the many companies and entrepreneurs in which we have invested worldwide, which generally represent a collection of companies that we believe are well positioned to help solve pressing challenges by driving productivity, capital efficiency and developing intellectual capital while creating long-term shareholder value. We remain confident that we are well positioned to deliver on the long-term potential inherent in the international and emerging markets.
For the fourth quarter, we modestly underperformed our key International benchmark index, the MSCI ACWI ex USA IMI Growth Index, while for the full year we outperformed. We are pleased to report that, over the seven years since inception, the Fund ranks in the 11th percentile against its international multicap growth equity peer group as defined by Lipper.* During the year, the largest driver of positive relative performance was stock selection in the Information Technology and Industrials sectors. Within IT, our success was fairly broad-based across software, Internet and payments services, led by Constellation Software Inc. (TSX:CSU, Financial), Just Eat PLC (LSE:JE., Financial), Kingdee International Software Group Co. Ltd. (KDIC, Financial), Ingenico Group (ING, Financial) and Worldpay Group PLC (WPG, Financial). Within Industrials, MonotaRO Co. Ltd. (MONOY, Financial) and Aena SA (XMCE:AENA, Financial) stood out. Poor stock selection in the Telecommunication Services sector, driven by our investment in PT Tower Bersama Infrastructure Tbk. (ISX:TBIG), and the Utilities sector, driven exclusively by disappointing developments at TerraForm Global Inc. (GLBL), were the key offsetting negative factors to relative performance for the full-year period.
Domino’s Pizza Enterprises Ltd. (DPZ) is the largest master franchiser of Domino’s Pizza, with operations in Australia/New Zealand, certain European countries and Japan. The share price has performed well during the fourth quarter as the company has been executing exceptionally well in its existing markets by expanding stores and improving store productivity and margins. Additionally, Domino’s Pizza Enterprises announced entry into a new market, Germany, a strategic and synergistic market for the company and another avenue for long-term growth. (Kyuhey August)
TAL Education Group (XRS) was a leading contributor to performance for the fourth quarter. The education services provider reported favorable earnings during the fourth quarter, as enrollment growth reached 50% and revenue and operating earnings exceeded Street expectations. We continue to believe the investments TAL Education is currently making suggest sustainable long-term growth with attractive margins. (Michael Kass)
Shares of Qihoo 360 Technology Co. Ltd. (QIHU), the leading online security provider in China, rose during the fourth quarter in concert with a broad rally in Chinese Internet services and software stocks. Late in the fourth quarter, Qihoo confirmed earlier-announced plans to go private in one of the largest such transactions announced to date involving a U.S. ADR-listed Chinese company. (Michael Kass)
Worldpay Group PLC provides technology solutions to merchants to enable them to accept electronic payments. It serves a diverse set of 400,000 merchants around the world. Worldpay completed an initial public offering in mid-October at 240 pence per share. While there has been no meaningful news since the offering, shares have appreciated as sell-side analysts have initiated mostly favorable coverage and investor awareness has grown. We continue to own the stock due to its attractive growth profile and dominant competitive position. (Josh Saltman)
Alibaba Group Holding Ltd. (BABA) is the largest ecommerce company in China. It owns and operates the two largest online shopping platforms in China, Taobao and Tmall. It also participates in the profits of Ant Financial, which owns Alipay, the largest third-party online payment provider in China. Shares of Alibaba increased in the fourth quarter on positive momentum in monetization of mobile customers, the increasing majority of its customer base. We expect this mobile transition will be completed in 2016 and believe shares of Alibaba stand to benefit accordingly. (Ashim Mehra)
RIB Software AG (HAM:RIB) is a German software company with a 5D modeling capability for the construction industry. With construction highly prone to inefficiencies and interruptions to work flow, we think RIB’s innovative software can bring significant value to projects. While RIB is quickly becoming the new project management software standard and share price has risen in concert, the company remains beholden to contract wins, which can be lumpy. As a result, RIB is likely to come one project short in 2015, which resulted in share weakness during the fourth quarter. (Kyuhey August)
Golar LNG Ltd. (GLNG) is a liquefied natural gas (LNG) shipping, regasification and liquefaction company. During 2015, Golar advanced a gas liquefaction project in Cameroon. While we think this project represents a great long-term investment opportunity, declining oil prices made LNG less attractive. In addition, LNG carriers have been trading at day rates that do not cover operational expenses. As a result, Golar’s stock price fell. Long term, we think progress in floating LNG projects and focus around midstream opportunities rather than shipping will create value. (Gilad Shany)
Nomad Foods Limited (NOMD) is an acquisition-driven frozen food business in Europe. Its stock price fell as the rising cost of capital resulted in a difficult acquisition environment. Macroeconomic and competitive headwinds in the U.K., Germany and Italy also spurred discounting and consumer preference for private label (cheaper) brands. We remain invested based on Nomad’s strong management and solid long-term fundamentals while we evaluate whether its growth strategy remains viable in light of current capital market conditions. (David Goldsmith)
Shares of Steinhoff International Holdings Ltd. (JSE:SNF) declined in the fourth quarter. The company is the second-largest European furniture retailer (behind Ikea) with a vertically integrated business model. The key driver of weak performance was a broad market selloff in South Africa, which was compounded by a devaluation of the South African rand. We believe the company’s business fundamentals remain attractive. Steinhoff has a strong management team and is a beneficiary of accelerated industry consolidation. (Anuj Aggarwal)
Shares of Japanese ecommerce company Rakuten Inc. (TSE:4755) declined during the fourth quarter, detracting from performance. During the fourth quarter, the company’s third-quarter earnings release was modestly disappointing as core ecommerce revenue growth trailed expectations. We maintain our position and believe Rakuten continues to offer attractive long-term growth potential and represents one of the most entrepreneurial and dynamic companies in Japan. (Michael Kass)
Exposure by Country: At the end of the fourth quarter of 2015, the Fund was invested 76.9% in developed countries and 19.1% in developing countries, with the remaining 4.0% in cash. The Fund seeks to maintain broad diversification by country at all times.
The Fund may invest in companies of any market capitalization, and we strive to maintain broad diversification by market cap. As of Dec. 31, 2015, the Fund’s median market cap was $7.9 billion, and we were invested approximately 58.0% in large/giant-cap companies, 32.4% in mid-cap companies and 5.6% in small/micro-cap companies, as defined by Morningstar, with the remainder in cash and unassigned securities.
Outlook
After a marked decline in the third quarter, the fourth quarter of 2015 began with an abrupt and powerful rally in global equities, commodities and credit. Coincident with the Fed’s deferral of an October rate hike, several indicators began to suggest improving economic growth, global trade and particularly stabilization in China and the RMB. As the quarter progressed, such stability inspired the Fed to again signal the commencement of a rate hike cycle in December, which seemed to act as an immediate financial tightening and stunted the rally. Soon, an increase in terrorism and rising Mideast tensions were exacerbating the mid-quarter rise in risk premium, leading global equities to uncharacteristically fade into year end.
As we shift to the outlook for the year ahead, we continue to view the global financial equilibrium as complex and expect further volatility. In our opinion, the key variables are the Chinese economy, policy and the RMB; the slope and duration of Fed tightening; the outlook for commodity and oil prices, and the geopolitical implications of rising sectarian tensions in the Middle East. We see the first two variables as being directly related; the greater the slope and duration of Fed tightening, the greater the pressure on China to support economic and financial stability. Therefore, any increase in the market-discounted rate of Fed tightening will force a more aggressive policy response from China and also increase the risk of a more material RMB depreciation. This phenomenon was clearly on display through the second half of 2015, and we submit will likely be a key variable as we navigate the year 2016. Ongoing RMB depreciation acts as a safety valve for China and deflects the deflationary pressure it would otherwise absorb back at the rest of the world, weighing on global prices and asset values. In the zero-sum world of subpar global economic growth and credit saturation, we continue to expect the “whack-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 “whack.”
The difficult macroeconomic environment for now continues to weigh on emerging market equities and, more recently, developed world equities. The silver lining is that much damage has already been done in the emerging and commodity-sensitive markets while much of the developed world continues to exhibit reasonable economic growth and momentum. 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 being an abrupt and sustainable market recovery. We believe the 1998 credit crisis and/or euro-periphery crisis of 2012 serve as reasonable proxies for this scenario. Of course, it is also possible that, in coming months, global growth and leading economic indicators continue to improve upon what appeared to be a bottoming in early October; in effect, the Fed would now be appropriately hiking into a global re-acceleration, significantly reducing the odds of a policy accident and suggesting that a re-acceleration of corporate earnings growth is on the horizon.
We now believe RMB depreciation has emerged as a key global catalyst, representing perhaps greater risk to the major equity markets outside of China, as China’s ability to underpin its currency appears suspect following the brief period of stabilization that preceded November’s historic inclusion into the IMF basket. 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. In addition, we have elaborated in prior letters on the appeal of a deliberate movement toward a more market friendly and shareholder return-oriented environment in Japan. While we remain comfortable that our current positioning is well aligned given the existing environment, we believe there are substantial investment opportunities ahead in the emerging markets, and are now identifying specific candidates, as well as a tactical strategy, to take advantage of them.
