Dear Baron Emerging Markets Fund Shareholder:
Performance
The Baron Emerging Markets Fund (the “Fund”) gained 3.41% (Institutional Shares) for the fourth quarter of 2015, while its principal benchmark index, the MSCI EM IMI Growth Index, rose 2.79% for the quarter. For the full year, the Fund declined 10.97% (Institutional Shares), while the benchmark index declined a similar 10.51%. From a longer-term perspective, over the threeyear and five-year periods just ended, we note that our investment performance stands above the vast majority of our diversified emerging market peer group as defined by Morningstar.
Emerging market equities began the quarter with a powerful rally, only to later reverse course and close the quarter with modest gains. Globally, equities and credit also began the quarter with an impressive rally, which ultimately faded, as prospects for the much anticipated Fed rate hike cycle were 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. 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 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, and particularly, emerging market equities. Though the current investment environment remains complex, we remain enthusiastic about the many companies and entrepreneurs in which we have invested, 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 emerging markets.
For the fourth quarter, we outperformed our key benchmark index, while for the full year our performance slightly underperformed the MSCI EM IMI Growth Index. We are pleased to report that over the past three and fiveyear periods, respectively, the Fund ranks in the third and first percentile against our diversified emerging market equity peer group as defined by Morningstar*. During the year, the largest drivers of positive relative performance were our Health Care investments, driven largely by our India generic pharmaceutical theme, and solid stock selection in the Consumer Staples sector. From a country perspective, strong stock selection in India, Mexico and China was a positive driver, while poor stock selection in Brazil and significant underweight positions in the outperforming countries of Russia and Korea were offsetting negative factors.
TAL Education Group was a leading contributor to performance for the fourth quarter. The education services provider reported favorable earnings during the 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)
The share price of Ctrip.com International, Ltd., China’s leading online travel agency, rose in the fourth quarter. With its recent acquisition of a stake in number two player Qunar, Ctrip has consolidated its leadership position. Industry observers predict China will become the world’s largest travel market in two years. With less than 20% of travel bookings in China currently online, we think Ctrip’s dominant online market share positions it to benefit as consumers shift to online bookings. (Ashim Mehra)
Alibaba Group Holding Ltd., is the largest e-commerce 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)
LG Household & Healthcare Ltd. is one of the premier consumer products companies in South Korea, specializing in cosmetics, home & personal care, and beverages. The company is well known for its brand and distribution strength in South Korea, which drives many foreign brands like Danone to partner with it for distribution. Its brands are highly regarded in China, which has accelerated sales growth, especially at its cosmetics division. During the fourth quarter, LG posted a strong earnings beat, and we retain conviction that there is further upside. (Kyuhey August)
Shares of Qihoo 360 Technology Co. Ltd., 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)
Shares of Steinhoff International Holdings Ltd. 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 sell-off 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)
Makalot Industrial Co., Ltd. is a Taiwanese apparel manufacturer and supplier to fast fashion and sportswear brands. Makalot has benefited from the two biggest trends in apparel – growth in functional fabrics and fast fashion – as well as a currency tailwind and possible tariff reduction. While share price has been strong most of the year, it gave away some gains in the fourth quarter as sportswear customers had a tough quarter due to unseasonably warm weather and increased inventory. We think this setback is temporary and long-term growth prospects are solid. (Kyuhey August)
Despite strong earnings, India battery manufacturer Amara Raja Batteries Ltd. detracted due to competitive concerns. After years of strong sales in the auto aftermarket channel, Amara Raja is now selling into industrial markets rebounding with the robust Indian economy. These markets can be volatile and competitive, but we believe they can offer meaningful incremental operating leverage. Amara Raja has an excellent distribution network to compete with the incumbent, and we think it will produce strong cash flow once its expansion is complete. (Aaron Wasserman)
Grand Korea Leisure Co., Ltd. is one of two foreigner-only casinos in South Korea. Share price has been under pressure due to a steep decline in Chinese visitors who had driven up sales in the recent past. This decline is as a result of the Chinese government cracking down on foreign casinos from marketing to its citizens. With possible long-term effects from this, the company gave up its long-held desire to open an integrated resort which further weighed on share price sentiment. We reduced our position. (Kyuhey August)
Eclat Textile Co., Ltd. is a Taiwanese manufacturer of high performance yarn and garments. Eclat has benefited from the two biggest trends in apparel – growth in functional fabrics and fast fashion – as well as currency tailwind and possible tariff reduction. While share price has been strong most of the year, it gave back some gains as sportswear customers experienced a difficult quarter due to unseasonably warm weather and increased inventory. We think this is a temporary setback and retain conviction in Eclat’s long-term growth prospects. (Kyuhey August)
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 (ECB); in our view, it is now simply China’s “whack.”
While the current difficult macroeconomic environment continues to weigh on emerging market equities, and more recently, developed world equities, the silver lining is that, to reiterate our third quarter outlook, we believe we are in the advanced stages of an absolute and relative bear market in the emerging markets, where much damage has already been done. Further, as previously stated, we currently envision three potential pathways to a major inflection point, which, for the first time in several years, we now believe is emerging on the horizon. The first two pathways, most likely triggered by an international credit event or RMB depreciation, would likely involve a final, ninth-inning decline, followed by an abrupt and sustainable recovery as the Fed reverses course. We believe the 1998 credit crisis and/or Euro-periphery crisis of 2012 serve as reasonable proxies for this scenario. In the third, and preferred, pathway, global growth and leading indicators would continue to improve upon what appeared 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 a re-acceleration of corporate earnings growth is on the horizon.
As stated previously, we now believe RMB depreciation has emerged as a key catalyst, as China’s ability to underpin the RMB appears suspect following the brief period of stabilization that preceded November’s historic inclusion into the IMF basket of global reserve currencies. While we remain comfortable that our current positioning is well aligned given the existing environment, we believe there are substantial investment opportunities ahead and are now identifying specific candidates, as well as a tactical strategy, to take advantage of them.
Thank you for investing in the Baron Emerging Markets Fund.
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