Dear Baron Emerging Markets Fund Shareholder:
The Baron Emerging Markets Fund (the “Fund”) gained 0.85% (Institutional Shares) for the first quarter while its principal benchmark index, the MSCI EM IMI Growth Index, rose 2.97% for the quarter. Emerging market and global equities exhibited a broad-based and fairly steep decline in January and early February only to recover impressively at the end of the quarter. For a change, emerging market equities exhibited global leadership in closing with a positive advance for the quarter.
Global equity, credit and commodity markets remained highly correlated and highly sensitive to policy initiatives, and, to a lesser extent, rumors of Middle East geopolitical maneuvers and the direction of oil prices. We highlight what appeared to be the return of global policy synchronization following the G20 meeting of finance ministers and central bank governors in late February, underlined by a key shift in rhetoric by the U.S. Federal Reserve (the “Fed”) in favor of the likely deferral of rate hikes. This shift was notably accompanied by the introduction or extension of negative interest rate policies in Japan and Europe and aggressive fiscal and monetary stimulus measures in China.
The apparent global coordination of extraordinary stimulus appears sufficient for now to lift forward expectations of economic activity and inflation, thereby relieving the pressure on oil and commodities, credit spreads and the Chinese RMB. While we are encouraged and respect the various signs of improvement, we suspect confidence in the above may prove fragile and would prefer to see the markets respond favorably to a de-escalation of policy support. In any event, we remain optimistic that emerging market equities have perhaps entered a “bottoming phase” on a relative if not absolute basis and view their outperformance during the first quarter as a sign of confirming evidence.
For the first quarter, we underperformed our key EM benchmark indexes as the pendulum swung against high-quality growth strategies. While disappointed with our relative results, after several years of solid outperformance during a difficult period for emerging markets, we note that many of our stronger performing positions during the quarter were added or increased in recent months, suggesting our strategic adjustments have contributed positively. We do not expect to outperform in all markets and believe the recent mean reversion in leadership within the emerging markets toward cyclical and leveraged sectors will ultimately prove transitory.
During the quarter, the largest drivers of positive relative performance were stock selection effect in the Financial sector, driven by BMF Bovespa SA (BVMF3, Financial) and Cetip SAÂ (CTIP3) – Mercados Organizados, which announced formal merger discussions during the quarter, and in the Industrials sector, driven by Copa Holdings S.A. (CPA, Financial), the pan-Latin American airline, and Bidvest Group Ltd. (BVT), a South African diversified services and industrial company. During the quarter, the largest detractors from our relative performance were stock selection in the Health Care sector, driven by our India generic pharmaceutical theme, and allocation and selection effect in the Consumer Discretionary sector, largely as a result of poor performance in our India digital media and Asian textile manufacturer themes.
BMF Bovespa SAÂ operates financial exchanges in Brazil. The stock increased during the first quarter along with the broader Brazilian equity market and currency due to increased optimism that political changes will lead to structural improvements in the Brazilian economy. Shares also benefited from a proposed merger with Cetip that would create a unified financial clearinghouse for the Brazilian capital markets. We continue to own the stock because we expect the acquisition of Cetip will create significant shareholder value. (Josh Saltman)
Shares of Steinhoff International Holdings N.V. (SNF, Financial), the second-largest European furniture retailer (behind Ikea), rose in the first quarter, driven by strong financial performance. Steinhoff also announced its intent to acquire London-based Darty PLC (DRTY) to expand its product offering into electronic and white goods. The acquisition is a good strategic fit for Steinhoff and was well received by investors. We retain conviction in Steinhoff as we believe it is well managed by an excellent executive team and remains a beneficiary of accelerated industry consolidation in Europe. (Anuj Aggarwal)
Taiwan Semiconductor Manufacturing Co. Ltd. (TSM, Financial) is the world’s leading semiconductor foundry, supplying many of the world’s leading fabless semiconductor design companies in the computing, communication, automotive and other end markets. The shares advanced during the first quarter on perceived strength in order visibility and market share as concerns over a slowdown in mobile communications chips receded. We maintain a core holding in this highly profitable and competitively advantaged business. (Michael Kass)
Shares of Copa Holdings rose in the first quarter. Copa is a leading Latin American airline with a Panama City hub, a strategic location with reach to major destinations across the Americas and superior infrastructure to neighboring airports. While the challenging economy and currency devaluations in Latin America were headwinds last year, Copa’s performance in the first quarter improved as airline capacity in the region declined, low fuel prices helped costs and price declines seemingly stabilized. (Kyuhey August)
Zhaojin Mining Industry Company Limited (HKSE:01818, Financial) is a gold mining company operating in eastern China. Shares performed well after we initiated our position in the first quarter due to a 15% rise in gold prices. Zhaojin is one of the largest and lowest-cost gold producers in China. The company is leveraged to both rising gold prices and potential lower costs from RMB devaluation. We maintain our positive view on gold given more “dovish” comments from the major central banks and anticipated capital controls, particularly in China, that we believe will help increase demand. (Chingiz Gadimov)
Shares of Kingdee International Software Group Co. Ltd. (HKSE:00268, Financial) declined during the first quarter after it reported unexpectedly weak fourth-quarter earnings results. Kingdee is a software vendor to small- and medium-sized businesses in China. Its legacy software business, which funds the development costs for the fast-growing Cloud business, was weak due to delays in IT spending by Chinese enterprise clients. We believe Kingdee is well funded and can make the necessary Cloud investment despite the current slowdown in China. (Aaron Wasserman)
Shares of TerraForm Global Inc. (GLBL, Financial), an owner of renewable energy power plants in emerging markets, fell during the first quarter due to uncertainty related to the implications of a potential bankruptcy of parent company SunEdison (SUNEQ). In addition, TerraForm Global was unable to execute on transactions to create its formation portfolio. These factors make the company difficult to value, and the stock sold off as a result. We continue to hold the stock as we believe the company’s net asset value materially exceeds the current stock pile and believe it has significant value-enhancing alternatives. (Rebecca Ellin)
Shares of Ginko International Co. Ltd. (ROCO:8406), a leading Taiwan-based contact lens manufacturer principally serving the mainland China market, retreated during the first quarter, reversing the prior quarter’s solid advance. We are not concerned over the short-term revenue deceleration in January and February and maintain our position and optimism of Ginko’s long-term prospects. (Michael Kass)
China Life Insurance Co. Ltd. (LFC) is a leading provider of life insurance products in China. The stock fell during the first quarter along with the broader Chinese equity market due to deteriorating economic conditions and a weakening of the RMB. Government stimulus measures resulted in lower interest rates, which negatively impacted the company’s margins and returns on its investment portfolio. We continue to own the stock because we expect the company to benefit from Chinese financial reforms that will likely shift savings toward regulated life insurance products. (Josh Saltman)
SouFun Holdings Ltd. (SFUN) is a leading online real estate services company. The stock retreated during the first quarter in anticipation of weak short-term earnings relating to rising expenses incurred in the company’s transition from an online information portal to a transaction-driven business model. While we are attracted to the long-term potential, we exited our position during the quarter amid signs of rising competitive intensity and associated spending to defend market share. (Michael Kass)
Recent activity
We are high-quality growth investors in all seasons, and for the past few years we have generally been reluctant to initiate positions in companies that operate in countries or end markets that we viewed as most exposed to the anticipated fundamental deterioration across the commodity, credit and emerging markets. This is a function of our risk management discipline, which we believe has benefited our overall performance. However, beginning late last year we became increasingly intrigued as these are precisely the places where investor sentiment has plummeted and risk premium has markedly risen, particularly through year-end 2015 and into early 2016. As mentioned in our past letter, we suspect that we have entered the late stages of the relative and absolute bear market in emerging markets, and while we have no specific catalyst yet in view for a major reversal, we have considered the likely pathways to a recovery and see a few viable scenarios.
During the first quarter, for the first time in a long time, we began to strategically target the more depressed areas of EM such as Brazil and Latin America, Russia and the more commodity-sensitive businesses as a source of new investments. Of course, we continue to seek higher-quality growth businesses within these markets; however, given recent valuations and our view that the probability of a positive and investible inflection point is rising, we are comfortable beginning to embrace such investments on the margin. We have established modest positions in Sociedad Quàmica y Minera de Chile SA (SQM), which we believe is well positioned as one of four dominant global suppliers of lithium, a key element in electronic vehicles and distributed power supply;Â Credicorp Ltd. (BAP), the dominant financial services provider in Peru; Yandex N.V. (YNDX), the “Google” of Russia, and Sberbank of Russia (SBRCY), which operates the leading consumer banking franchise in Russia.
We have invested in most of these companies in the past and will be looking for opportunities to increase our exposure in them. In addition, given our view that in an effort to moderate the depreciation of its currency China is increasingly constructing de facto capital controls, we have established a modest position in a new theme related to gold producers, which would be significant beneficiaries of an associated rise in demand for gold as a store of value by Chinese or other emerging market citizens should such a scenario escalate. We see this modest position as attractive from a fundamental as well as a risk management perspective.
As many investors have shunned the more cyclical and commodity-centric emerging market assets in recent years, we have conversely seen a premium placed on the highest-quality businesses in the most shielded countries and end markets. As a result, we have increased scrutiny of some of our most successful positions during the past few years and have concluded that for some, valuation or deteriorating fundamentals suggest lower forward-looking returns. Therefore, during the quarter, we reduced several holdings concentrated in our India generic pharmaceutical, China state-owned enterprises and China financial reform themes. We also exited our position in SouFun Holdings, an online real estate services provider in China, based on concerns over rising competitive intensity and market share loss.
Outlook
The first quarter witnessed a sharp selloff and recovery across the global capital markets. We believe this market behavior reflects the fragility of confidence in forward-looking economic and financial conditions in an era of increasing policy intervention. The global markets have exhibited a high correlation, often reacting in unison to events in the U.S., Europe, Japan and particularly China. We believe the interconnectedness of global markets is likely to remain high while global growth remains subpar and stimulative policy intervention in one jurisdiction often triggers unintended consequences in another.
While we were pleased to see the equity, credit and commodities markets strengthen through the end of the first quarter, we would prefer to see convincing evidence of underlying fundamental strength and an improvement in global imbalances rather than what appears to be ongoing aggressive monetary and fiscal policy tweaks. In our opinion, the most important such tweak was the shift in rhetoric suggesting the deferral of interest rate hikes by the Fed. The good news here is that if the Fed can deliver on recent communications, we are likely seeing a sustained resynchronization of global monetary policy, which would significantly reduce the short-term pressure on the Chinese currency, commodity prices and the emerging markets. Indeed, the commodity and emerging markets took a leadership role in the rally which began in mid-February.
In addition to the revised Fed communiqué, the European Central Bank, Bank of Japan (TSE:8301) and People’s Bank of China as well as Chinese fiscal policymakers all appeared to accelerate easing measures during the quarter, particularly shortly after the G20 gathering of finance ministers in late February. While measures of coincident and leading economic indicators have recently responded in kind with fairly broad-based improvement, in our opinion it is difficult to distinguish cause and effect. Are improving economic indicators driving the rally in capital and commodities markets, or are policy-driven markets leading to improved economic indicators via the channels of rising confidence and recovering financial conditions? We believe that fundamental, lasting confidence in the global economy and markets would be inspired by a successful normalization of interest rates while confidence driven by ever more unconventional measures, such as the recently launched negative interest rate policies in Europe and Japan, will likely remain fragile.
Though we remain somewhat skeptical that the Fed will be able to hold its ground in the face of an anecdotal rise in wage pressures, we respect the improvement in global indicators and reiterate that current conditions favor emerging market equities. While it is certainly possible that emerging and global equity markets have bottomed, we suspect that confidence will at some point likely be tested. We reiterate the view expressed last quarter that we are likely in the late stages of a relative and absolute bear market in the emerging markets, where much damage and currency adjustment has already occurred. We believe recent emerging market leadership confirms our view that a bottoming process is under way, and while we would not be surprised by a return of volatility later this year, we would likely view such an event as an opportunity to continue to increase our exposure to high-quality growth businesses in industries and countries where risk premium has been high and investor sentiment weak. We continue to believe that substantial investment opportunities lie ahead and believe we are strategically and tactically prepared to take advantage.
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