Baron Emerging Markets Strategy | Q2 2024

Baron Emerging Markets Strategy (the Strategy) gained 4.48% during the second quarter of 2024, while its primary benchmark index, the MSCI Emerging Markets Index (the Benchmark), was up 5.00%. The MSCI Emerging Markets IMI Growth Index (the Proxy Benchmark) also gained 5.00% for the quarter. The Strategy modestly underperformed both the Benchmark and the Proxy Benchmark during a solid quarter for global equity returns.

During the second quarter, inflation readings failed to decelerate sufficiently to clearly justify the initiation of a Federal Reserve (the Fed) easing cycle, while global growth and employment conditions presented mixed signals. As a result, equity market breadth and leadership continued to narrow as the uncertain macro environment, contrasted by robust near-term fundamentals for the so-called Magnificent Seven and associated AI proxies and beneficiaries worldwide, ensured that such AI proxies dominated second quarter returns. Beneath the surface, we note that in contrast to the first quarter, the momentum of U.S. and global growth and employment conditions appeared to peak early in the quarter and subsequently moderate, with consumption clearly weakening late in the quarter. This allowed bond yields, and more importantly, real yields, to decline throughout the quarter, ending notably below April highs and well below the recent peak levels of October 2023, which preceded the Fed’s subsequent pivot. Our current bias is that recent moderating trends will trigger a Fed easing cycle sooner rather than later, a development that would likely induce a mean-reverting inflection point for many market underperformers, including emerging market (EM) equities. Interestingly, we point out that despite the year-to-date rise in bond yields and the U.S. dollar, the Benchmark slightly outperformed the S&P 500 Index during the second quarter, while strongly outperforming the Dow Jones Industrial Average, the equal-weighted S&P 500 Index, and the Russell 2000 Index. We find this performance particularly admirable and perhaps a foreshadowing in the face of widespread skepticism and capital outflows.

As we referenced in our previous letter, a portion of this surprisingly solid showing can be attributed to the broadening recognition of AI-related equities in the Benchmark. Further, as AI enthusiasm has spread from the “GPU/data center arms race” to the notion of “edge AI,” or AI on server/PC/ handset, many more individual companies can be seen as at least cyclical beneficiaries as edge AI would necessitate a significant and long-deferred replacement cycle for such edge devices. As the second quarter progressed, updates from Apple, Taiwan Semiconductor, Dell, Lenovo and others drove growing interest in the many companies in the hardware/handset ecosystem – a substantial portion of which reside in EM jurisdictions, in addition to the well-recognized semiconductor and high-bandwidth memory leaders, and, in our view, this phenomenon helped drive solid EM relative performance. We remain confident that EM equities currently offer an attractive long-term entry point with valuations and relative earnings expectations near multi-decade lows, high investor skepticism, and fundamental catalysts that we view as underappreciated by investors and allocators. As always, we remain confident that our diversified portfolio of well-positioned and well-managed companies can capitalize on their potential over the coming years, regardless of the external environment.

For the second quarter of 2024, we modestly underperformed the Benchmark as well as our all-cap EM growth Proxy Benchmark. From a sector or theme perspective, poor stock selection effect in the Financials sector, primarily attributable to our investments in XP Inc., PT Bank Rakyat Indonesia (Persero) Tbk, and BDO Unibank, Inc., was the largest detractor to relative performance this quarter, in our view, associated with the pushing out of central bank easing expectations and upward pressure on global bond yields. In addition, adverse stock selection in the Materials sector, owing largely to a single investment in Suzano S.A., was also a secondary detractor to relative results. Partially offsetting the above was favorable allocation effect together with solid stock selection in the Communication Services sector, primarily attributable to our India digitization investments (Indus Towers Limited and Bharti Airtel Limited). Positive stock selection effect in the Health Care (Max Healthcare Institute Limited) and Consumer Discretionary (Trent Limited, Mahindra & Mahindra Limited, and Coupang, Inc.) sectors also bolstered relative performance.

From a country perspective, weak stock selection effect in China, largely a result of our consumer and software-related holdings (Kingdee International Software Group Company Limited, Baidu, Inc., Kweichow Moutai Co., Ltd., Yum China Holdings Inc., and China Mengniu Dairy Co. Ltd.), was the largest detractor to relative performance this quarter. While Chinese equities staged a recovery during the period and outperformed the broader EM universe, private sector, growth-oriented businesses in China continued to lag mega-cap banks and SOEs. While we are disappointed with the pace of consumption growth in China, we are encouraged by early signs of stabilization, driven by recent government stimulus measures along with easing monetary and regulatory policies. While we acknowledge the negative investor sentiment regarding China, we continue to believe that many of our China holdings trade well below fundamental intrinsic value, providing favorable risk reward at current market prices. Our overweight positioning together with adverse stock selection effect in Brazil and the Philippines were also detractors to relative performance this quarter. In our view, this is largely attributed to a delay in central bank easing as well as concerns over Brazil’s commitment to fiscal discipline. Partially offsetting the above was solid stock selection in Korea, primarily attributable to select holdings in our sustainability (HD Korea Shipbuilding & Offshore Engineering Co., Ltd. and HD Hyundai Heavy Industries Co., Ltd.) and digitization (Coupang, Inc. and SK hynix Inc.) themes. Positive stock selection together with our large overweight in India also bolstered relative results. We remain excited about our investments in India and are encouraged by the recent reelection of Prime Minister Modi to a historic third term, which bodes well for policy continuity and further implementation of productivity enhancing economic reforms. In our view, India has become a standout investment destination within EM and has entered a multi-year virtuous investment cycle.

Semiconductor giant Taiwan Semiconductor Manufacturing Company Limited (TSMC) contributed in the second quarter due to expectations for a continued strong cyclical recovery in semiconductors and significant incremental demand for AI chips. We retain conviction that TSMC’s technological leadership, pricing power, and exposure to secular growth markets, including high-performance computing, automotive, 5G, and IoT, will allow the company to sustain strong double-digit earnings growth over the next several years.

Tencent Holdings Limited operates the leading social network and messaging platforms (QQ, WeChat), the largest online entertainment and media business, and the largest online gaming business in China. Shares were up this quarter, given better-than-expected domestic games growth and continued strength in recent game releases. We continue to believe in Tencent’s ability to compound earnings, given its growth structure, massive scale, and focus on efficient operations. Although on the earlier side, we also believe Tencent could be the largest generative AI beneficiary in China, given its ability to improve existing products and enter adjacent markets with massive scale and distribution. We continue to monitor the regulatory environment.

HD Korea Shipbuilding & Offshore Engineering Co., Ltd. is the holding company of Hyundai Heavy, the largest global shipbuilder based on orderbook size and the global leader in high-end vessels including liquified natural gas (LNG)-powered ships. Shares contributed on strong quarterly results at subsidiary Hyundai Samho, which delivered better-than-expected margins on higher pricing. In addition, year-to-date newbuild ship order demand and pricing for the group was better than expected. We retain conviction. Korean shipbuilders have an oligopoly in LNG carrier shipbuilding, LNG dual-fueled container ships, and tankers. The tightening regulation on carbon emission, which will be fully adopted by the International Maritime Organization (IMO) by 2030, should drive higher demand for LNG dual- fueled ships as well as carbon-free ammonia-fueled ships. We expect a structural shortage of compliant ships to emerge as the IMO deadline nears, which should benefit HD Korea Shipbuilding given its leading position.

PT Bank Rakyat Indonesia (Persero) Tbk is a lender serving Indonesia’s micro, consumer, and small-to-medium-enterprise segments. Shares declined after the company reported higher-than-expected credit costs driven by the impact of rising inflation on clients’ repayment capacity. Management decided to tighten underwriting standards to prioritize asset quality over loan growth. While this decision is having a negative impact on near-term earnings expectations, it does not alter our thesis of increasing credit penetration within the segments Bank Rakyat serves. We expect Bank Rakyat to deliver above-industry returns in a growing segment for credit in Indonesia.

Suzano S.A. is the world’s largest and lowest-cost producer of pulp, which is primarily used in paper, tissue, and packaging. Shares declined after reports that the company was looking to acquire one of the largest integrated paper producers, International Paper, at a premium to market price, and would take on significant debt to finance the transaction. The company later dropped the bid, but some investors still had concerns about its international expansion plans. We continue to like shares of Suzano. The company is expanding into new, higher-margin markets for pulp with fossil-to-fiber substitution for textiles, plastics, fuels, and chemicals. The company’s pulp production removes more greenhouse gas emissions from the atmosphere than it emits. Suzano has a goal to remove 40 million tons of CO2 over the next five years, and we see an opportunity to monetize these carbon credits. In addition to our positive view on pulp prices, we expect sustainability/ESG factors to drive multiple positive re-ratings for Suzano. Finally, Suzano is starting production at its Cerrado project, which should significantly improve free cash flow generation.

XP Inc. is the leading independent financial investments platform in Brazil. Shares declined during the quarter, reflecting weaker-than-expected top line growth. Investors have been waiting for a monetary easing cycle to drive faster growth assets and a change in client investment mix. However, higher inflation expectations in Brazil have pushed out the timeline for further rate cuts and delayed the positive impact of these changes for XP. We believe XP is uniquely positioned to benefit from the deepening of the capital markets in Brazil and a shift in allocation of household assets away from plain-vanilla savings products into higher-return assets. We retain conviction in XP as a high-quality, long-term investment.

* The Strategy’s exposure to Russia was less than 0.1%.

Exposure by Market Cap: The Strategy may invest in companies of any market capitalization, and we have generally been broadly diversified across large-, mid-, and small-cap companies, as we believe developing world companies of all sizes can exhibit attractive growth potential. At the end of the second quarter of 2024, the Strategy’s median market cap was $14.7 billion, and we were invested 51.3% in giant-cap companies, 34.1% in large-cap companies, 11.3% in mid-cap companies, and 0.4% in small- and micro-cap companies, as defined by Morningstar, with the remainder in cash.

During the second quarter, we added several new investments to our existing themes while also increasing exposure to various positions established in earlier periods. We continue our endeavor to add to our highest-conviction ideas.

We were most active in adding to our global security/supply chain diversification theme by initiating positions in Power Grid Corporation of India Limited, Cummins India Limited, SRF Limited, and WEG S.A. Power Grid is a leading power utilities company in India, controlling approximately 85% of the country’s inter-state power transmission capacity. Being majority-owned by the Government of India, the company is deemed a sovereign entity, which serves as a competitive moat from a cost and access to capital perspective. In our view, given India’s robust economic growth and accelerating industrial capacity expansion, significant investment in power generation and transmission infrastructure will be required, creating a multi-year growth opportunity for Power Grid. Additionally, as India targets achieving 50% of electricity generation capacity through non-fossil fuel sources by 2030, Power Grid will be a key enabler of the country’s power transition toward renewable energy. We expect the company to deliver low-teen total shareholder returns over the next three to five years alongside an attractive dividend yield.

Cummins India, a subsidiary of U.S. based Cummins Inc., is a leading power generation engine manufacturer in India. The company is a dominant player in power generators, with over 50% market share in the highly profitable medium and high horsepower ranges. The company also has a distribution and aftermarket vertical along with an export division that caters to regions including North America, Europe, the Middle East, and Africa. In our view, the company’s key competitive advantages include best-in-class technology and product quality, wide product range across categories, high penetration with channel partners, and leading aftermarket services. We believe Cummins India is well positioned to benefit from the rising demand for backup power supply in India, driven by higher capital expenditure by the government and private sector companies in segments such as infrastructure and manufacturing. In addition, Cummins India’s dominance in the high horsepower range positions the company in new growth verticals such as data centers. We expect the company to generate mid-teens EBITDA growth over the next three to five years.

SRF is an Indian multi-national that manufactures specialty chemicals, refrigerant gases, packaging film, and technical textiles. The company serves various end markets, including automotive, agrochemicals, pharmaceuticals, air conditioning (AC) & refrigeration, and fast-moving consumer goods. In our view, SRF’s key competitive advantage is its R&D/innovation capabilities. The company invests about 3% of its specialty chemical revenue in R&D, the highest among peers. SRF is also the leader in R-32 manufacturing in India. R-32 is currently the most efficient refrigerant for ACs and has low global warming potential (GWP). We view SRF as a key beneficiary of global customers phasing out of high GWP refrigerants to lower their carbon footprint and greenhouse gas emissions. With planned capex investment over the medium term, we believe SRF is well positioned to scale up its specialty chemicals business and deliver mid-teens earnings growth over the next three to five years.

WEG, a leading Brazilian industrial conglomerate, is one of the world’s largest manufacturers of industrial electric motors and related equipment. Compared to most global peers, WEG has a vertically integrated business model with large scale manufacturing facilities. This, in our view, is a key competitive advantage, creating cost efficiency, product customization, and on-time customer deliveries. WEG has a strong track record in generating high teens compounded revenue growth over past decades while maintaining high double-digit return on invested capital and EBITDA margins. Sales should continue to benefit from significant market share gains globally in electric motors, drives, and gear boxes, in addition to the megatrend of greater energy efficiency. WEG also has a strong presence in the energy generation, transmission, and distribution segment. It offers solutions ranging from wind turbines and solar power to energy storage and EV charging stations. The company benefits from the increasing adoption of renewable energy and electric mobility. Finally, we see an emerging opportunity in the power transformer and substation markets, particularly in North America, where WEG should capitalize on recent investments in production capacity in the U.S. and Mexico.

During the quarter, we also increased exposure to our digitization theme by initiating a position in ASPEED Technology Inc., a Taiwanese semiconductor design company and the dominant global supplier of Baseboard Management Controllers (BMC), a mission-critical chip used to remotely monitor and manage the key components in a server, such as the processor, memory, and power supply. We expect the company to maintain a 70%-plus market share in BMCs, given its superior technology, scale advantage, and strong relationships with key Taiwanese server manufacturers and U.S. hyperscale customers. AI servers have significantly higher BMC content than traditional servers, and we expect surging demand for AI servers to drive a dramatic acceleration in demand for BMCs. ASPEED’s growth will be further boosted by the transition to its new-generation BMC, which is priced at a significant premium, reflecting major advancements in performance and functionality. We are also optimistic that the company will leverage its customer relationships and strong design capabilities to successfully expand into new products, including a Platform Firmware Resilience chip which prevents malware attacks. In our view, ASPEED is uniquely positioned as a long-term AI beneficiary, and we expect the company to maintain industry-leading top-line growth and profit margins over the next five years.

We added to several of our existing positions during the quarter, including Indus Towers Limited, PDD Holdings Inc., Dino Polska S.A., eMemory Technology Inc., Kaynes Technology India Limited, Banco BTG Pactual S.A., and Kingdee International Software Group Company Limited.

During the quarter, we also exited our positions in B3 S.A. – Brasil, Bolsa, Balcao, Venustech Group Inc., Max Financial Services Limited, Pernod Ricard SA, Aarti Pharmalabs Limited, Lufax Holding Ltd, and Divi’s Laboratories Limited, as we continue our endeavor to allocate capital to our highest convictions ideas.

The market behavior in the second quarter of 2024 largely mirrored that of the first. Inflation remained persistent, not slowing enough to justify a clear start to the Federal Reserve’s easing cycle. Meanwhile, global growth and employment conditions sent mixed signals. Equity market performance became increasingly concentrated, with leadership focused almost entirely on the so-called Magnificent Seven and their AI-linked counterparts. However, a closer look reveals a more complex picture. Unlike in the first quarter, U.S. and global growth momentum seemed to peak early in Q2, followed by a slowdown. This was particularly evident in weakening consumption as the quarter progressed, allowing bond and real yields to soften. By the end of the quarter, yields were significantly lower than their April highs and far below their peak levels in October 2023, just before the Fed shifted its policy. We are closely monitoring employment and consumption trends, as their influence on growth and inflation expectations could prompt the Fed to ease monetary policy sooner rather than later. Such an easing could set the stage for a rebound among many underperforming stocks, similar to what we saw in late 2023. However, if this easing represents a more profound economic turning point, any resulting leadership change in the market may be more sustainable.

Interestingly, despite rising bond yields and a strong U.S. dollar this year, the MSCI Emerging Markets Index slightly outperformed the S&P 500 Index in the second quarter. It also significantly surpassed the Dow Jones Industrial Average, the equal-weighted S&P 500 Index, and the Russell 2000 Index, maintaining its year-to-date lead over all but the S&P 500 Index, heavily skewed by NVIDIA and other Magnificent Seven members. Given widespread EM skepticism and capital outflows, this performance is remarkable. Part of this robust showing can be linked to the significant representation of AI-related stocks in the EM Index, which we noted in our previous letter. As enthusiasm for AI has expanded from the “GPU/data center arms race” to the idea of “edge AI” – AI integrated into servers, PCs, and handsets – many more companies are now seen as potential beneficiaries of this trend. The anticipated demand for new hardware to support edge AI could spur a long-overdue replacement cycle for these devices. As the quarter progressed, updates from companies like Apple, Taiwan Semiconductor, Dell, and Lenovo fueled interest in firms across the hardware and handset ecosystem, many of which are based in EM jurisdictions. In our view, this helped boost EM equities performance relative to developed markets. This development could have significant implications for traditional AI leaders like the Magnificent Seven. While the long-term prospects for AI remain strong, current valuations suggest that any slowdown in the GPU race, or a shift from data center capital expenditures to the rollout of AI software applications, could trigger a major shift in market leadership. It may take time to fully utilize the massive AI processing capacity being built in data centers, even as a global upgrade cycle for handsets, servers, and PCs looms. In such a scenario, we anticipate a shift away from the dominance of the Magnificent Seven and U.S. equities, with EM equities poised to perform relatively better.

A word on recent elections and political catalysts throughout EM: during the quarter, we witnessed surprising outcomes in closely watched elections in Mexico and India, while in Brazil, President Lula offered disturbing rhetoric regarding fiscal balance and central bank independence. We see the final election result in India, and the ensuing government/ministerial makeup, as supportive of a healthy and quite positive status quo, while developments in Latin America appear more populist and potentially adverse to the interests of capital owners. We note that in Latin America, a quite small percentage of the EM Benchmark weight even in the aggregate, left-leaning ideology and political rhetoric is notoriously over-discounted on the surface, while in the intermediate term, political and market “breakers” tend to materially dilute the feared impact, allowing elevated risk premium to recede. While the process can be frustrating and volatile, we suspect this pattern is likely to prevail. And while we have modestly reduced exposure in both Brazil and Mexico out of caution, we believe patience is warranted and likely to be rewarded.

Sincerely,