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Cody Eustice
Cody Eustice
Articles (560)  | Author's Website |

Baron International Growth Fund's Third Quarter Letter

Fund declines by nearly 10%

The Baron International Growth Fund (the “Fund”) declined 9.96% (institutional shares) for the third quarter of 2015, while its principal benchmark index, the MSCI ACWI ex USA IMI Growth Index, retreated 10.59% for the quarter. Global equities declined significantly in response to diminishing growth prospects, particularly in the emerging markets, as well as to widening credit spreads and a broad increase in risk premium. In our view, a key catalyst during the quarter was a volatile progression of policy moves in China – first, a failed attempt to stabilize the local A Share equity markets, and subsequently a modest, but in our view meaningful, devaluation of the Chinese RMB. Such measures resulted in rising uncertainty over economic and financial stability as well as political leadership in China, an undisputed leading driver of global investment and growth over the past decade. We understand the global market reaction but will detail our perhaps out of consensus interpretation of the RMB devaluation later in this letter.

The other major catalyst of market activity during the quarter was the shifting market anticipation over an imminent start to the U.S. Fed rate hike cycle. As we have suspected, expectations of such an event have been pushed out for now due to concerns over the global economic and financial growth. We do note however that, although the Fed currently remains on hold, during the quarter a very significant tightening of conditions has been priced into the global credit markets, particularly high-yield and EM sovereign bonds where credit concerns are concentrated. As such, while we believe we are now in the late stages of the current market correction, we note that tightening of the recent conditions has increased the possibility of a related credit event, which in our view could mark the “ninth inning” and perhaps set up the stage for a sustainable recovery. Also worth noting on the positive side during the quarter, immediate concerns over a Greek insolvency and euro exit faded as a referendum resulted in a pro-euro parliamentary majority.

Though the current investment environment remains somewhat uncertain, we remain enthusiastic about the many companies and entrepreneurs in which we have invested. Further, we believe such companies and entrepreneurs in general represent the solution to the primary challenge facing many economies, particularly those in the developing world experiencing the greatest stress and threatening global growth; we would define this challenge as deteriorating capital efficiency and economic productivity coincident with sustained credit growth. We remain confident that we are well positioned to deliver on the long-term potential inherent in the international and emerging equity markets.

While down in absolute terms, our third quarter return modestly outperformed our key international benchmark indexes. During the quarter, the largest drivers of positive relative performance were stock selection effect in the Industrials and Consumer Discretionary sectors. Within Industrials, our performance was driven by Aena SA (AENA), the leading airport operator in Spain, which we profiled in our March letter, Ryanair Holdings PLC (NASDAQ:RYAAY) and easyJet PLC (EZJ), both leaders in low-cost European air travel, and MonotaRO Co. Ltd. (TSE:3064), a fast-growing Japan-based B-to-B ecommerce distributor of maintenance, repair and operations consumables. Within Consumer Discretionary, the drivers of outperformance were Domino’s Pizza Group PLC and Domino’s Pizza Enterprises Ltd., the highly efficient operators of Domino’s (NYSE:DPZ) franchise rights in the U.K. and Australia, ProSiebenSat.1 Media SE (PBSFY), a leading German broadcast and digital media operator, and AO World PLC (AO.), the leading online vendor of appliances and televisions in the U.K. and Germany. The largest negative impact to relative returns was a significant underweight position in Consumer Staples, as well as adverse stock selection within the Utilities sector, where our recently established investment in the IPO of TerraForm Global Inc. (GLBL) was a victim of poor timing in the context of the rapid decline in energy prices and a significant increase in emerging market credit spreads.

Shares of Ryanair Holdings PLC rose in the third quarter after reporting stronger-than-expected full-year guidance. Ryanair is a European budget airline. While we think low oil prices will buoy all airlines in the short term, we expect Ryanair to attract passengers with the lowest fares in the industry, leading to profitability in any oil price environment. We believe that Ryanair’s cost advantage is sustainable, and that it will continue to gain significant market share in the European short-haul passenger market. (Aaron Wasserman)

Arch Capital Group Ltd. (NASDAQ:ACGL) is a Bermuda-based specialty insurance and reinsurance company. Shares rose on reports of good quarterly financial results with 9% growth in book value per share. Despite soft industry pricing conditions, Arch continues to generate above-average returns due to profitable underwriting, benign catastrophe losses, and favorable reserve development. The recently acquired mortgage insurance business is scaling up. M&A activity in the property and casualty insurance industry has also helped boost share prices. (Josh Saltman)

Shares of easyJet PLC rose in the third quarter after reporting a stronger-than-expected summer result and expectation for the fall period. easyJet is a low-cost European airline. While average fares can fluctuate over a short period of time due to incremental capacity shifts from competitors over specific routes, we believe the long-term consolidation under way will be difficult to reverse, and we expect easyJet to continue gaining market share from larger, loss-making incumbent airlines. (Aaron Wasserman)

AO World PLC is the leading online seller of major domestic appliances in the U.K. AO sets itself apart through its optimization of proprietary software and logistics and focus on customer service. Shares of AO recovered in the third quarter as the company reiterated its longer-term growth forecast. The company expects growth to reaccelerate in the latter half of the year, along with a continued ramp in German operations, a market that is twice as large as the U.K. market. (Ashim Mehra)

Domino’s Pizza Group PLC is the master franchisee of the Domino’s Pizza brand in the U.K., Ireland and other European countries. The company entered continental Europe with the goal of replicating its success in the U.K. When its share price corrected substantially due to lack of progress in Germany, we built a position on the belief that the market had overpenalized it for the weakness in Germany and that its business there would make progress. During the third quarter, the company reported earnings that demonstrated a solid turnaround in Germany. (Kyuhey August)

TerraForm Global Inc. is a divided growth-oriented renewable energy company (a yieldco) focused on emerging markets. The company went public in the third quarter at a lower-than-expected valuation. Its debt capital raise was also more expensive than anticipated, given difficult conditions in high yield and emerging markets. We believe in the secular renewable energy story and that parent SunEdison Inc.’s (SUNE) large development pipeline will benefit its yieldcos. We think the market dislocation is technical and temporary and that TerraForm Global will resume future growth. (Rebecca Ellin)

Nomad Foods Limited (NHL) owns Iglo Foods, Europe’s leading frozen-food company. Nomad gave back some of its second-quarter gains as its business remained challenging as a result of discounting and more private label competition. To grow, Nomad continues to acquire, recently purchasing Findus, a European seafood and frozen food business. We think Findus overlaps nicely with Iglo’s products and geography, presenting the potential for significant synergies for Nomad, and we retain conviction in the company. (David Goldsmith)

Shares of Kingdee International Software Group Co. Ltd. (HKSE:00268) declined during the third quarter amid significant volatility in the Chinese market. Kingdee is a software vendor to small and medium-sized businesses in China. Following an investment from leading Chinese ecommerce operator JD.com (JD), Kingdee is undergoing a strategic transformation from a direct to an indirect sales model. We think the indirect sales model will allow Kingdee to reach more potential customers more profitably and earn higher returns on its capital over the long run. (Aaron Wasserman)

Shares of semiconductor company Mellanox Technologies Ltd. (MLNX) fell in the third quarter in the wake of its late quarter announcement that it had acquired EZChip (EZCH), creating concerns around the current level of organic growth. Initial results for the third quarter released after quarter end alleviated these concerns and sent the stock back to its pre-M&A levels. We believe the organic growth path for Mellanox remains intact, and this acquisition will be meaningfully accretive to earnings and provide substantial cost and revenue synergies that will accrue to shareholder value over time. (Gilad Shany)

Haitong Securities Co. Ltd. (SHSE:600837) declined materially during the quarter in sympathy with the broad decline in China equities, particularly given the company’s sensitivity to margin balances and equity market trading volumes. We remain comfortable with Haitong’s long-term prospects given the anticipated shift in China credit provision from the traditional bank sector in favor of the securities industry which we believe is currently in the very early stage. (Michael Kass)

The Fund may invest in companies of any market capitalization, and we strive to maintain broad diversification by market cap. As of Sept. 30, the Fund’s median market cap was $6.97 billion, and we were invested approximately 53.9% in large/giant cap companies, 37.6% in mid-cap companies and 6.2% in small/micro cap companies, as defined by Morningstar, with the remainder in cash and unassigned securities.

Amid rising volatility and rapidly shifting macroeconomic conditions, the third quarter was relatively quiet in terms of new positions. While no major new themes emerged, we did initiate investments in Lululemon Athletica Inc. (LULU), the world’s leading designer and retailer of “athleisure” wear, as well as Intesa Sanpaolo S.P.A. (ISP), a leading and high-quality financial services provider based in Italy that we believe is positioned to benefit from the county’s economic reform agenda as well as the revival in European credit growth. During the quarter, we exited modest positions in China Unicom (Hong Kong) Ltd. (CHU) and Syngenta AG, subsequent to a takeover bid from Monsanto Corporation (MON).

In our previous letter, we questioned whether global monetary authorities had successfully engineered escape velocity and asset reflation; indeed, the third quarter confirmed our skepticism over an imminent start to a Fed rate hike cycle as a downgrade in growth and inflation expectations triggered a widespread retreat in financial markets and a return to "risk-off" sentiment. While we are not at all surprised by this turn of events, we suspect that we have now entered the late stages of the current market correction as well as the absolute and relative bear market in emerging market equities, currencies and sovereign bonds. While such asset prices now appear arguably cheap, the key question in our view is what will be the catalyst for a recovery? Or, alternatively, what is the way forward from here?

To answer, we must first analyze the root cause of the dislocation while recognizing that the emerging markets and commodity sector represent the epicenter of current instability and concern. We believe the strong headwinds emerging market economies and equities face today stem in large measure from aggressive quantitative easing by developed world central banks in recent years. Subsequent to the financial crisis of 2008, U.S. quantitative easing led to both a significant decline in global interest rates and expectations for sustained dollar weakness, driving a historic increase in U.S. dollar bond issuance by emerging market sovereigns and corporates. As leverage rose in the emerging markets, the U.S. economy slowly healed, and eventually Fed easing gave way to tapering. As the Fed passed the monetary baton to Japan and subsequently the ECB, conditions in the emerging markets markedly changed. While an easing in Japan or Europe may soothe local conditions, in a very low growth environment, and in the context of Fed tapering, such policy represents a tightening for most EM countries – particularly China whose currency until recently was pegged to the dollar. This is largely because many EM countries have commodity sensitive revenue streams and currencies and/or had previously aggressively borrowed in dollars.

We have consistently suggested that, if dollar strength against EM currencies persists, eventually we should expect China to engineer a depreciation of the RMB; we see no reason to expect China to unilaterally absorb the deflationary pressure resulting from a rising dollar as their Asian neighbors devalue. In fact, we believe maintaining the peg is one reason why China appears the epicenter of global weakness and risk. Indeed, in August, China shocked the markets with a modest currency depreciation, deflecting a portion of the deflationary impulse back at the developed and neighboring emerging countries. In our view, this action represents a warning by China, a precursor of what may come if the Fed engages in a rate hike cycle as currently envisioned, though that we now discount as unlikely. However, given a clear decoupling of economic conditions, we suspect that China would likely seek a market-driven RMB exchange rate in such a scenario, which could drive the RMB at least 10% lower. We believe this would likely exacerbate global deflationary pressures while exposing how complex the global economic balance has become in recent years.

This brings us back to our previous question: what is the way forward from here? In the relative near term, we see three possibilities. First, the global economic indicators could sustainably improve of their own accord in response to months of accumulated easing in the pipeline. We believe this is a possible but unlikely outcome. Second, China could engage in aggressive stimulus and/or devalue materially – also possible, but, in our view, not likely given recent official statements. Third, the Fed could shift its own rhetoric, indefinitely deferring rate hikes and perhaps even signaling a bias towards further easing, an outcome which we would tend to expect if the market based tightening referenced above were to result in an international credit event.

While we certainly cannot predict the future, we do believe any of the above could create an important bottom in global markets and would likely trigger in particular a reversal in the relative performance of hard hit asset classes such as energy, commodities, cyclicals and the emerging markets. Of course, in the long term, we see the principal source of value creation in the international and emerging markets being a shift in capital allocation, resources and subsidies towards private sector entrepreneurs, as well as to the beneficiaries of productivity enhancing economic, financial and labor reforms. As our themes and investments are based on identifying and capturing such long-term value creation, we remain quite confident that we are well positioned to execute on the promise inherent in our markets.

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