Baron Emerging Markets Fund (the “Fund”) retreated 8.23% (Institutional Shares) for the fourth quarter of 2016, while its principal benchmark index, the MSCI EM IMI Growth Index, declined 7.32% for the quarter. Emerging market equities reversed last quarter’s solid gains and underperformed developed world equities, in our view, largely as a result of Donald Trump’s surprise election victory. For the full year 2016, the Fund gained 4.08%, while its primary benchmark index rose 5.84%.
Prior to the U.S. election in early November, sovereign interest rates had already begun to rise as policymakers from Japan and the U.S. signaled a likely shift towards greater fiscal stimulus and an accommodation of moderately higher inflation, in our view, in response to a widening wealth gap and associated rise in global populism. The Trump victory added fuel to the fire, as his policies suggest an emphasis on fiscal stimulus, higher inflation and interest rates, and a strong U.S. dollar. Particularly noteworthy with regard to the emerging markets, Trump appears poised to take an aggressive position on trade, marked by a willingness to revisit NAFTA and a tax reform proposal that may institute a broad tax on imported goods. A key question looking forward is whether the significant market repricing that has already occurred is appropriate or overdone. We suspect the move may be directionally appropriate, but excessive in magnitude, reflecting investor positioning that was unprepared for the election outcome, and the decline in market liquidity across many markets since the advent of Dodd-Frank legislation. On a positive note, at least in the developed world markets, it appears a shift of capital flows from fixed income into equities may have begun coincident with bond yields passing through secular lows. While emerging market equities have underperformed with an abrupt sell-off subsequent to the election of Trump, we believe they are reasonably positioned to absorb tighter conditions given longer-term productivity enhancing reforms underway in many countries, and we remain optimistic about the high quality growth businesses in which we have invested.
For the fourth quarter of 2016, we modestly underperformed our key EM benchmark growth index. The quarter was dominated by a swift reaction to the U.S. election, leading to material underperformance by higher quality growth stocks worldwide, while commodity and cyclical-biased shares outperformed. During the quarter, the largest driver of adverse relative performance was stock selection effect in the Health Care sector, principally driven by a significant decline in Divi’s Laboratories Ltd., an India-based pharmaceutical manufacturer that received unexpected and negative U.S. FDA inspection observations. In addition, our underweight position in Samsung Electronics Co., Ltd., one of the largest index weightings within the Information Technology sector, drove poor relative performance in that sector as it appreciated in a down market for technology shares. On the positive side, our cash position helped relative performance as emerging market equities broadly retreated, while we also generated positive relative performance within the Industrials sector, as Copa Holdings, S.A., the Panama-based airline, and Bidvest Group Ltd. of South Africa both appreciated in absolute terms.
From a country-specific perspective, India stood out as a drag on our relative performance, as the Modi administration’s surprise demonetization movement led to poor short-term earnings visibility, particularly in the Consumer Discretionary and Financials sectors, driving adverse selection and allocation effect for the Fund.
Shares of Russia’s largest bank Sberbank of Russia PJSC (MIC:SBER, Financial) were up in the fourth quarter. The company is delivering higher profitability from a reduction in credit costs, higher margins, and disciplined cost control. The stock also benefited from an increase in oil prices and a more benign outlook for the Russian economy post-U.S. elections. We continue to like Sberbank given its dominant position in the banking sector, its ability to sustain high-teens return on equity, and the potential for an improving Russian economy. (Jose Barria)
Tullow Oil plc (LSE:TLW, Financial) is an exploration and production company focused mainly on Africa. Shares grew in the fourth quarter after OPEC’s decision to cut output caused oil prices to rise. In addition, Tullow reduced balance sheet concerns after receiving additional commitments from lenders and secured insurance payments for business interruption at its largest producing asset, Jubilee. We retain conviction based on Tullow’s operational improvements, production ramp up in Ghana, exploration upside in South America, and potential monetization of East Africa assets. (Chingiz Gadimov)
Shares of Russia’s leading convenience store operator Magnit PJSC (LSE:MGNT, Financial) gained in the fourth quarter in line with peers and a strengthened ruble currency. Magnit is investing in several opportunities that, coupled with store growth reacceleration in the medium term, should lead to double-digit earnings growth for several years to come, in our view. (Aaron Wasserman)
Bidvest Group Ltd. (JSE:BVT, Financial) is a leading South African conglomerate with business operations in financial services, automotive dealerships, electrical equipment, and freight services, among others. Shares rose in the fourth quarter after the company reported steady earnings growth despite a tough macro environment in South Africa. We are optimistic about Bidvest’s long-term prospects due to its defensive, diversified, asset-light businesses that are, in our view, operated by a best-in-class management team. (Anuj Aggarwal)
Shares of Global Logistic Properties Ltd. (SGX:MCO, Financial), the leading provider of modern logistics facilities in China, Japan, Brazil, and the U.S., contributed to the fourth quarter performance. The stock appreciated following rumors that Global Logistic is exploring strategic alternatives, including a potential sale of the company. Shares also rose on reported quarterly financial results that beat Street expectations. (David Kirshenbaum)
Table III.
Shares of Divi’s Laboratories Ltd. (NSE:DIVISLAB), a leading Indian manufacturer of complex active pharmaceutical ingredients, declined in the fourth quarter. The stock fell due to a surprise FDA inspection of Divi’s manufacturing facilities resulting in unfavorable observations and regulatory headwinds for the company. We retain conviction in Divi’s due to its industry-leading profitability and long-term relationships with major pharma clients and believe it is well positioned to sustain low-to-mid-teens earnings growth for the next three-to-five years. (Anuj Aggarwal)
Shares of Alibaba Group Holding Limited (BABA), the largest e-commerce company in China, fell in the fourth quarter as a result of weakness in the Chinese currency relative to the U.S. dollar and increased spending by the company on original video programming. We continue to believe that Alibaba represents a unique opportunity to invest in the dominant provider of e-commerce and cloud-related services in the growing Chinese market. (Ashim Mehra)
Shares of Bharat Financial Inclusion Limited (BOM:533228), India’s leading microfinance leading institution, declined in the fourth quarter due to growing concerns over an increase in non-performing loans in the microfinance industry (MFI). MFI operations have also been impacted by post-demonetization political interference in states such as Maharashtra and Uttar Pradesh, adding to industry stress. (Anuj Aggarwal)
Shares of leading Australian infant nutrition company Bellamy’s Australia Limited (ASX:BAL) declined in the fourth quarter. The stock fell after management announced fiscal year guidance that missed Street expectations. The company is losing market share in China to other imported brands from Australia and Europe. We decided to exit our position owing to deteriorating company fundamentals amidst intensifying competition. (Anuj Aggarwal)
Shares of Korea’s leading search company NAVER Corporation (XKRX:035240) fell in the fourth quarter due to a global internet sector correction and asset rotation away from emerging markets. We believe the company’s fundamentals remain strong as the e-commerce platform continues to drive ad revenue and gross merchandise volume. We remain optimistic on NAVER’s performance in 2017. (Shu Bai)
Recent Activity
During the fourth quarter we established four new positions while adding to a number of existing investments. WH Group Ltd (HKSE:00288) (Hong Kong), under the trade name Shuanghui, is the largest pork processor in China, which recently acquired Smithfield Foods, the largest U.S. player. We believe the growth potential in China is significant, given the country’s preference for pork, and particularly given that China appears to be in the early stages of a secular trend towards fresh processed and packaged proteins, which earn premium pricing and margins. The merger will allow for shared best practices, technology transfer, and operating synergies, while allowing this global leader to take advantage of pricing differences across its major markets. The combined company should generate attractive return on capital and cash flow, and with roughly half of its profits now coming from the U.S., we believe WH Group offers an attractive natural hedge against any future depreciation in the RMB. We also initiated positions in three banks. Banco Santander-Chile, in our view one of the best managed Latin American banks, appears set to benefit from a market-friendly shift in political direction in Chile and from the substantial recovery in commodity prices over the past year. We believe the bank is conservatively managed from a credit perspective and should be positioned to participate as a new credit cycle emerges. Late in the quarter, we also established positions in two leading Korean Banks, Shinhan Financial Group Co., Ltd. and KB Financial Group Inc., both of which we believe will benefit from an expected increase in interest rates and steeper yield curves globally. Korea, and particularly Korean banks, appear fairly insulated from most of the risks to emerging markets implied by Trump’s policy positions, and given the lack of credit growth in Korea in recent years, we believe bad debt risk is relatively low. We added to several existing positions, most notably Infraestructura Energetica Nova, S.A.B. de C.V. of Mexico, Sberbank of Russia PJSC, PetroChina Co. Ltd., Baidu, Inc., the “Google” of China, and Magnit PJSC, the Russia-based retailer.
During the quarter, we exited positions in Mr Price Group Limited, a South African retailer that appears to be losing market share, LG Chem Ltd. of Korea, due to difficulties in accessing the Electric Vehicle battery opportunity in China, and Bellamy’s Australia Limited, a fast-growing organic infant formula manufacturer that recently experienced challenges with a transition of its distribution channels in China. Given risks inherent in India’s demonetization move, we took some profits, reducing our positions in Bharat Financial Inclusion Limited and Zee Entertainment Enterprises Ltd.
Outlook
The year 2016 was unusual in that we perceived two clear inflection points that dominated global market activity. First, the G20 meeting of the world’s most influential central bankers and finance ministers in late February marked what we phrased the resynchronization of global monetary policy. After a protracted period of asynchronous policies, which led to upward pressure on the dollar; and downward pressure on commodity prices, emerging market currencies, and their sovereign credit quality; this important, coordinated policy shift led to a reversal in such trends. This trend reversal was accentuated after the surprise Brexit referendum result, due to a material decline in sovereign bond yields worldwide, which would be particularly stimulative to emerging market economies given significant pent-up demand and compressed corporate profit margins.
The second major inflection point proved less friendly to emerging and international markets. Prior to the U.S. presidential election, several global policymakers had already signaled a tolerance for higher inflation, particularly wage inflation intended to stabilize or reverse the widening wealth gap that has largely driven a global populist resurgence over the past year. The election of Donald Trump added fuel to the fire of rising inflation and interest rate expectations, while also opening a Pandora’s box of potential outcomes with regard to fiscal and monetary policy, taxation, trade, protectionism, and foreign policy. While policy details will remain unclear for some time, the direction of change is fairly apparent, and represents greater uncertainty for emerging market economies. At face value, Trump appears to be a catalyst for a stronger dollar, higher inflation and bond yields, a steeper yield curve, and potentially a reversal of the long-term trend towards trade globalization. Markets were clearly caught off guard by the U.S. election results, and a fairly dramatic repricing occurred in the final weeks of 2016. A key question now is whether the sizeable magnitude of change discounted to date is appropriate or overdone.
In our view, while we believe the adjustment in market prices and leadership across many asset classes may be directionally appropriate, for several reasons we believe the magnitude of change is likely too severe given the likely dilution to several of President Trump’s favored policies. Thus, we suspect the strength in U.S. equities and weakness in emerging market equities and currencies are likely to at least partially mean revert in coming months. First, it remains unknown how aggressive a position Trump will take with respect to import taxation and other forms of protectionism. An aggressive position would elicit a strong response from China, particularly if based on a straw man accusation of currency manipulation. Next, should his
Baron Emerging Markets Fund
proposed policies be endorsed by Congress or pursued by executive order, we believe that a further marked rise in interest rates and the dollar could ensue, which at some point may result in a choke point on the global economy. In fact, we are becoming increasingly concerned that enthusiasm over the U.S. and global growth outlook may already have peaked as a result of Fed tightening, market-based tightening implied by the reversal in post-Brexit yield declines, and the beginning of tightening measures in China. Such a phenomenon would be consistent with the established post-crisis pattern, where expectations regarding economic and interest rate normalization rise, leading ultimately to disappointment and concern over the efficacy of policymakers.
While our broad conclusion is that it will take time for the policy outlook and implications to crystallize, and that therefore a wide range of potential outcomes remains possible, we are confident that new themes and investment opportunities will emerge. Should Trump’s ultimate policy path remain a challenge for the emerging markets, we believe these markets are far better prepared to weather such a development than they were just a few years ago. First, we continue to believe that emerging market corporate earnings have begun a cyclical recovery. Second, we do not believe oil, other commodity prices and/or emerging market currencies will return to the lows
of early 2016, and we are confident that the longer-term structural reforms and political redirection now underway in countries such as India, Indonesia, Brazil, Argentina, Chile, China, and Mexico will provide support and ultimately restore productivity and value creation. China, always a key barometer of emerging market health, remains stable in the face of widespread negative sentiment, with various signs of improving economic activity. We recognize, however, that Chinese authorities have begun to unwind some stimulus measures and we are monitoring key variables including trade tensions and capital flows as well as financial sector funding costs. We remain optimistic regarding the long-term potential for the high quality growth businesses in which we invest, and we look forward to our next update.
Sincerely,
Michael Kass
Portfolio Manager
