Why invest in emerging markets? Emerging markets offer appealing demographics, solid growth potential, and diversification. However, higher growth rates in emerging economies have not necessarily translated into market growth. In our view, the key to successful investing in many emerging markets hinges in large part on pro-market governmental reforms, as countries transition from low-wage commodity- and industrial-based economies to higher-wage, consumer-based economies.

Reform is critical because historically, the emerging markets have been notoriously inefficient, encumbered by poor capital allocation and a high degree of “leakage” due to corruption and bureaucratic incompetence. While the path to reform is never smooth, successful implementation can help improve productivity and efficiencies and reduce leakage, which in turn should result in equity share price growth as value creation drops down to its rightful owner – the shareholder. In addition, reform can lead to long-term structural improvements in the economies of these countries, which can give them an edge over their peers and help generate investor confidence.

For these reasons and others, we believe a truly active approach is preferable when investing in this dynamic asset class. Active management allows portfolio managers the flexibility to invest in the most attractive opportunities while avoiding or shifting away from high-risk situations before such adverse conditions are discounted by the market. The active manager’s investment universe can include stocks of all capitalizations, while an emerging markets index fund is typically dominated by the giant caps whose performance tends to be tied more closely to global events. Active managers also have the ability to access promising companies and markets that are not in the index at all.

Baron Emerging Markets Fund

Baron Emerging Markets Fund is our emerging markets growth equity investment option. The Fund is managed by Michael Kass, who also manages Baron International Growth Fund®. Michael, who has managed Baron Emerging Markets Fund since its inception, brings 37 years of experience managing significant portfolios to his role. Michael is assisted by Anuj, who serves as the Fund’s assistant portfolio manager, as well as a team of five research analysts focused solely on non-U.S. investing. He combines Baron Capital’s long-term perspective and bottom-up, fundamental research approach with forward-looking theme identification to help focus research in the most promising, high-impact growth areas.

We believe our emphasis on value-creating private sector entrepreneurs, analytical depth, and long-term view distinguishes the Fund. In addition, we think our unique, forward-looking approach to theme identification and stock selection is a key differentiator that has helped drive positive long-term risk-adjusted outperformance. Finally, we take a disciplined, multi-faceted approach to risk management, which we believe is critical to successful investing in this space.

Bottom-up Research With a Thematic Overlay

Investable themes

Given the breadth and diversity of the emerging markets equity universe, we often begin the process of researching our investments by searching for and developing defined, long-term investable themes. We look for conditions precedent to improving financial returns and accelerating growth on a forward-looking basis. We avoid screens, because we consider them to be inherently backward looking, identifying companies that are already reporting improved returns and thus more likely to be recognized and appropriately valued as a result.

Our themes are predicated on significant changes or trends that suggest the potential for sizable improvement in profitability, return on capital, or growth potential, frequently for an entire industry or group of companies. The themes fall into two broad categories. The first involves region- or country-specific trends or developments, which are most commonly driven by political developments and/or productivity-enhancing policy reforms that offer material opportunities to target industries or companies. The second involves industry-wide trends that are often global, such as a shift toward consolidation or vertical integration, or technology-driven transformation. In addition, to better balance opportunity and risk, we monitor global macroeconomic developments to assess their potential impact on our holdings.

Research-intensive bottom-up stock selection

While themes may serve to focus our research, ultimately, we add value through fundamental, bottom-up stock selection. We apply Baron Capital’s investing approach to emerging markets, favoring best-in-class companies with competitive advantages, meaningful and increasing market share, and experienced yet entrepreneurial management, as well as revenue visibility, stable profit margins, and significant growth potential over the long term. We develop and confirm an investment thesis and validate key criteria through extensive due diligence, including meeting with management; consulting with industry experts; speaking with local contacts such as vendors, suppliers, and competitors; and evaluating the company’s public filings.

We are valuation-conscious, buying when we believe stocks trade inexpensively enough to earn a 15% annualized return over the next three to five years. To assess the growth opportunities of an investment, we build a company-specific five-year model focused on revenue growth drivers, capital structure, cost structure, and profitability. We model five years of forward-looking earnings and financial metrics. We stress test returns under different scenarios. Finally, we continually update our models based on new data points and developments.

In addition, in recognition of the complexities and risks of the emerging markets, we emphasize the following in the companies in which we invest:

Entrepreneurial management

• Founders with significant ownership stakes
• Leaders with strategic vision and financial sophistication
• Management that thinks and acts as an “owner”

Capital efficiency

• High return on invested capital
• Asset-light business models
• Private sector businesses and more competitive state owned enterprises

Shareholder-friendly governance

• Alignment of interests between management and minority equity shareholders
• Independent directors

We believe these attributes, which help to align our interests as minority shareholders with those who control and manage the business, are key to successful investing in emerging markets. We also believe that our disciplined approach in emphasizing these features, which we believe represent scarcity value in these markets, differentiates us from the index and many of our peers.

Multi-Faceted Risk Management

The complex interplay and uncertainties inherent in the geopolitical, economic, and financial conditions that impact the emerging markets require disciplined risk management. Our multi-pronged risk strategy is based on four key tenets:

• Emphasis on higher-quality businesses
• Use of forward-looking investable themes
• Vigilant monitoring of liquidity, currency, and credit risks
• Disciplined approach to position management

Emphasis on higher-quality businesses

First, we manage risk at the company level, investing in higher-quality businesses with high returns on capital, less leveraged balance sheets, and reduced need for external capital to fund the targeted growth rate. We find that these types of businesses tend to be less adversely affected by an increase in the cost of capital or closure or tightening of access to capital. We believe this approach is the main driver of our historic outperformance in mediocre or deteriorating economic conditions.

Use of forward-looking investable themes

Second, we believe the possibility of improving returns or accelerated growth potential for a company or industry is bolstered by our development and use of investable themes. If we understand correctly the factors at play and likely to play out within a theme over the next year or several years, we think we will likely see improving fundamentals in the companies we own. This has the potential to provide a margin of safety. As the theme matures and is discounted by the market, the margin of safety may decline. At that time, we will ask ourselves whether we should reduce our allocation to the theme.

Vigilant monitoring of liquidity, currency, and credit risks

Third, we continually monitor the potential impact of global liquidity conditions, and currency and sovereign credit risks. We weigh these risks through a fixed income lens, seeking to anticipate and understand the possible impacts of the factors at play before the environment is repriced.

Disciplined approach to position sizing and management   

Finally, we think it is well worth drawing attention to our disciplined approach to initiating, building, reducing, and exiting positions. This approach reflects, in part, Kass’s extensive hedge fund experience, with an emphasis on absolute returns and minimizing of the permanent loss of capital

Investable Themes

Many – but not all – of our holdings fall within defined, long-term investable themes. Some themes include:

• Digitization
• India economic reforms
• China value-added
• EM consumer
• Sustainability/ESG
• FinTech disruption
• Global security/ supply chain diversification

Digitization

The world is going digital. Digitization – the use of connected digital technologies and applications by consumers, enterprises, and governments – is in the process of transforming the way we live, work, learn, socialize, and entertain ourselves. More people today have access to a mobile phone than to electricity.1 The pandemic – and the consumer and business reactions to it – has simply accelerated the changes underway from the past decade or so of digitization. Yet in many emerging market countries, digitization is only in the most nascent stage of development, implying a massive and lengthy runway for growth.

We are invested in a sizable number of companies that are leading and/or benefiting from digitization. One example is InPost S.A., which operates the largest automated parcel locker network in Poland, increasingly the preferred method among Poles to receive and return online purchases. The company’s dense, technology-enabled logistics network has facilitated efficient package delivery times and e-commerce frequency levels generally not seen in any other emerging market outside of China. The company is also expanding to new markets, with a nascent position in the U.K. and its 2021 acquisition of Mondial Relay, a logistics network in France.

The next Amazons

There is no question that Amazon.com, Inc. has been one of the most successful U.S. stocks of the past 30 years. A large part of the return has come from two driving forces. First, Amazon has vastly expanded its reach. Launched as an online bookseller, Amazon now has its fingers in everything from cloud computing to online media to groceries to health care. Second, Amazon has managed to maintain a growth stock valuation for over two decades, and there’s little sign of that ending any time soon.

It’s an impressive combination, and one that’s likely impossible to duplicate. But we think several emerging market stocks have the potential to at least replicate parts of the Amazon success story.

China’s Alibaba Group Holding Limited is the best known of these companies, and in fact is sometimes referred to as the Amazon of China. The company’s core business is massive; it is the world’s largest e-commerce company by gross merchandise value. After attempting for years to compete against Alibaba and China’s other e-commerce giant, JD.com, Amazon finally admitted defeat in 2020, announcing that it would be shuttering its Chinese e-commerce business.

Like Amazon, Alibaba’s operations extend far beyond online commerce. It has fast-growing businesses in areas such as mobile payments, digital advertising, cloud computing, and health care. In addition, Alibaba has positioned itself as a valuable partner to brick-and-mortar retailers by providing them with the ability to accept mobile payments and offer home delivery. It is also expanding its reach beyond China. It has invested more than $2 billion in India through stakes in mobile payment service Paytm, online grocer BigBasket, e-commerce platform Snapdeal, and others. Alibaba holds a controlling stake in Singapore-based Lazada, the top e-commerce player in Southeast Asia, and acquired London mobile payment company WorldFirst in 2020.

Reliance Industries Limited is India’s leading conglomerate, with businesses that encompass petrochemicals, refining, and oil-and gas-related operations as well as retail, telecommunications, and media. CEO Mukesh Ambani has embarked on an initiative to leverage Reliance’s vast telecom network Jio to pivot to a digital services company, offering e-commerce, video streaming, and broadband services. The company is also laying the groundwork to create an online marketplace that will connect over 12 million mom & pop retailers to Jio’s more than 400 million mobile/internet subscribers. Its app will allow consumers to place orders to be fulfilled by local merchants, a business model known as O2O (online to-offline) pioneered by Alibaba. Reliance benefits from first-mover advantage, massive infrastructure, and deep pockets, along with recent government rulings that we believe will favor domestic internet companies. We think Reliance will emerge as the most likely “Amazon of India” in coming years.

India’s productivity enhancing economic reform

We are excited about India as an investment destination driven by the implementation of several productivity-enhancing economic reforms by the Modi government over the past several years, which are now beginning to yield meaningful results. Such policy initiatives are accelerating formalization of the economy, yielding higher tax collections, attracting foreign direct investment, and driving financialization of household savings, all contributing to the foundation of our investment themes within India. In our view, India is entering a virtuous investment cycle that is further supported by growing domestic consumption owing to attractive demographics, a rising middle class, and growing disposable income. As a result, we believe India is well positioned to be the fastest growing major economy this decade. We are also enthusiastic about India’s rapidly expanding digital ecosystem, which, in our view, is 10 to 15 years behind that of China and is powered by over 800 million (and growing) active internet users.

Our principal investment themes within the country are as follows:

• Digitization (example: Reliance Industries Limited)
• India consumer finance (example: Bajaj Finance Limited)
• Financialization of savings (example: Nippon Life India Asset Management Limited)
• Supply-chain diversification (example: Aarti Industries Limited)
• Formalization of the economy (example: Titan Company Limited)

China-based value-added businesses

In its pursuit of self-sufficiency and proficiency in core technologies, the Chinese government is actively looking for ways to support higher value-added domestic companies with more intellectual capital through subsidies and other privileges and advantages. Made in China 2025 calls for $350 billion in subsidies to 10 strategic sectors, such as robotics, next-generation information technology, biomedicine, and new-energy vehicles. China has also been pressuring competing foreign firms with regulations and other restrictions. Although state owned enterprises have been the primary beneficiaries, the private sector is also gaining from this initiative.

One investment within our China value-added theme is Kingsoft Corporation Ltd., a gaming, office software (WPS) and cloud services company. We think the market underappreciates Kingsoft’s industry leadership and the substantially untapped software sector in China. On the biomedical front, another industry in which the Chinese government aspires to have a larger domestic position, we own Zai Lab Limited, an early leader in the nascent and developing biotechnology sub-industry.

Conclusion

We believe EM equities are poised for a sustained period of outperformance. After a 30-year period of globalization that led to subdued capital investment, the changing nature of U.S./China relations and Russia’s aggression against Ukraine necessitate a global capital investment cycle. Such a cycle has nearly always correlated with EM outperformance as these economies and markets are more sensitive to the beneficiaries of such an environment. In addition, we remain encouraged by longer-term fundamental factors such as economic reforms in India and other key EM countries, the shift toward value-added and high-return sectors in China, and what we believe may be the peak of global dollar demand, which suggests a dollar bear market awaits, which has historically favored EM assets. As always, we are confident we have invested in well-positioned and well-managed companies with substantial long-term investment return potential.