Baron Rising Markets Fund Q2 2022 Shareholder Letter

DEAR BARON EMERGING MARKETS FUND SHAREHOLDER:

PERFORMANCE

Desk I: Efficiency^† Annualized for durations ended June 30, 2022

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Baron Rising Markets Fund (the “Fund”) declined 10.33% (Institutional Shares) in the course of the second quarter of 2022, whereas its principal benchmark index, the MSCI EM Index, declined 11.45%. The MSCI EM IMI Progress Index retreated 12.83% for the quarter. The Fund outperformed its principal benchmark index and the all-cap development proxy in the course of the quarter, led by a reversal and modest restoration of latest declines in China-related equities.

In our view, this reversal in efficiency was coincident with ebbing considerations over China’s potential help of Russia’s invasion of Ukraine, a consensus view that China can handle its COVID problem with out economically harmful lockdown measures, and ongoing proof that authorities are doubling down on coverage easing, stimulus, and regulatory aid measures. As we highlighted the eventual chance of the above in our earlier letter, the one shock to us in second quarter efficiency was maybe the pace at which market sentiment relating to China recovered.

We provide the above as proof of our view that China’s macroeconomic, liquidity, and coverage cycle is more and more inversely correlated with that of the U.S./developed world and that China-related equities probably skilled a capitulation section within the spring of 2022.

Lastly, we’re inspired by the bettering relative efficiency of high quality development equities that materialized late within the second quarter alongside the obvious peaking of inflation expectations and sovereign bond yields. Whereas happy with our relative efficiency in the course of the quarter, we imagine the historic scale of underperformance of development shares that started final yr presents substantial extra restoration potential, ought to, as we presently envision, the main indicators of inflation stay average.

As at all times, we’re assured that we’ve got invested in lots of well-positioned and well-managed corporations on a bottom-up foundation which might be poised to profit from long-term and enticing funding themes.

For the second quarter of 2022, we outperformed our major benchmark, the MSCI EM Index, whereas additionally comfortably outperforming our all-cap development proxy. From a broad market perspective, rising market (“EM”) equities outperformed each U.S. and different developed markets primarily pushed by strong relative good points in China. We’re inspired by China’s rising dedication towards coverage easing and regulatory help, in addition to a scarcity of proof that China is supporting Russia’s marketing campaign in Ukraine.

As we advised final quarter, China’s challenges with COVID and its “zero COVID” coverage are probably transitory and this realization supported a modest restoration in equities in the course of the previous quarter, particularly inside our A share, China value-added investments. Whereas nonetheless underperforming in the course of the interval, development equities staged a restoration within the latter half of the quarter as buyers more and more rotated out of economically delicate shares, significantly vitality and commodity producers, on rising considerations of aggressive financial tightening and a worldwide financial slowdown.

From a sector or theme perspective, strong inventory choice within the Communication Companies sector, most notably investments in our China value-added (Kingsoft Company Ltd.) and digitization (Baidu, Inc.) themes contributed probably the most to relative efficiency this quarter.

Favorable inventory choice within the Data Know-how sector additionally contributed, led as soon as once more by our China value-added holdings (Kingdee Worldwide Software program Group Co. Ltd., Glodon Firm Restricted, and Venustech Group Inc.).

Our underweight positioning in Taiwan Semiconductor Manufacturing Firm Ltd. (TSM) additionally stood out as a key contributor within the sector. As well as, robust inventory choice impact within the Industrials sector throughout a number of of our themes, particularly digitization (Full Truck Alliance Co. Ltd.), automation/ robotics (Estun Automation Co., Ltd.), China value-added (Zhejiang Dingli Equipment Co., Ltd. and Jiangsu Hengli Hydraulic Co., Ltd.), sustainability/ESG (Hyundai Heavy Industries Co., Ltd. and Korea Shipbuilding & Offshore Engineering Co., Ltd.), and world safety (Korea Aerospace Industries, LTD.) bolstered relative outcomes.

Lastly, our money place in a weak market additionally stood out as a key contributor in the course of the quarter. Partially offsetting the above was hostile inventory choice impact within the Shopper Discretionary sector, primarily attributable to a few of our digitization-related investments (Americanas S.A. and Bundl Applied sciences Non-public Restricted). Poor inventory choice in Financials (Bajaj Finance Restricted, XP Inc., and Credicorp Ltd.) and Actual Property (Godrej Properties Restricted and Ayala Land, Inc.) additionally detracted from relative efficiency.

From a rustic perspective, robust inventory choice impact mixed with our underweight positioning in Korea was the biggest contributor to relative efficiency this quarter. Moreover, our decrease weighting to Taiwan together with increased publicity to Hong Kong and China additionally stood out as key contributors.

Partly offsetting the above was hostile inventory choice along with our obese positioning in Brazil and India. We stay optimistic a couple of continued restoration in our China holdings. In our view, present inventory costs don’t totally replicate basic intrinsic worth for a lot of of our investments, particularly inside our China value-added theme.

Desk II: High contributors to efficiency for the quarter ended June 30, 2022

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Full Truck Alliance Co. Ltd. is the biggest digital freight platform on the planet. Shares of the China-based firm rallied after a cybersecurity overview greenlighted using its Apps so as to add new person registrations. We stay buyers given digital platform penetration into China’s 4 trillion RMB full truck-load market remains to be simply within the single digits. We see main upside primarily based on the anticipated rollout of transaction commissions to truckers from the present 6% market penetration and fewer than 1% take charge, and we anticipate income to develop at 50% CAGR over the following 5 years.

China Tourism Group Obligation Free Company Restricted, the biggest operator of duty-free shops in China, was a contributor to efficiency. COVID-related lockdowns throughout Shanghai and several other different cities within the prior quarter pressured shares. Within the second quarter, shares bounced again as restrictions had been eased and Chinese language customers confirmed indicators of catch-up spend. We imagine China Tourism Group Obligation Free would be the prime beneficiary of repatriation of abroad responsibility free spend again to China over the following half decade.

Alibaba Group Holding Restricted is the biggest retailer and e-commerce firm in China. Alibaba operates buying platforms Taobao and Tmall and owns 33% of Ant Group, which operates Alipay, China’s largest third social gathering on-line fee supplier. Shares of Alibaba rose in the course of the quarter, pushed by an growing give attention to bettering capital allocation, an bettering regulatory surroundings, and authorities stimulus concentrating on Chinese language customers. We retain conviction that Alibaba will profit from speedy development in cloud providers, logistics, and retail.

Estun Automation Co., Ltd. is one in all China’s largest home producers of commercial robots. Estun contributed to efficiency on market share good points and a rise in costs regardless of the general slowdown in industrial exercise. Estun is probably the most superior robotics participant in China, with the best high quality and worth premium relative to home friends. We anticipate Estun to consolidate the home robotic area and develop market share from the present 3.5% to 10% and lead import substitution of international manufacturers. We additionally anticipate Estun to profit from better scale and vertical integration.

Shares of Kingsoft Company Ltd., a number one Chinese language workplace software program, interactive leisure, and cloud computing firm, elevated in the course of the quarter as a result of robust development in workplace software program subscription income and customers, the resumption of regulatory approvals for brand spanking new video video games, and stabilizing margins. We stay shareholders, as we anticipate Kingsoft would be the major beneficiary of the speedy development of China’s workplace software program market.

Desk III: Top detractors from efficiency for the quarter ended June 30, 2022

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Semiconductor big Taiwan Semiconductor Manufacturing Firm Ltd. detracted within the second quarter as a result of macroeconomic uncertainties and softening demand for client electronics. We retain conviction that Taiwan Semi’s technological management, pricing energy, and publicity to secular development markets, together with high-performance computing, automotive, and IoT, will permit the corporate to ship robust income development over the following a number of years.

Shares of South Korean conglomerate Samsung Electronics Co., Ltd. decreased in the course of the quarter as a result of macroeconomic headwinds, finish demand deterioration, and declining costs for DRAM and NAND semiconductors. We’re assured Samsung will stay a worldwide chief in reminiscence, smartphones, and foundry providers and is a key beneficiary of long-term semiconductor demand development.

Bajaj Finance Restricted detracted within the quarter. As a number one non-bank monetary firm in India, we predict Bajaj is nicely positioned to profit from rising demand for client monetary providers corresponding to mortgages, private and bank card loans, car financing, and different associated merchandise. Rising inflationary pressures and a probable slowdown in financial exercise in India had been key drivers for weak efficiency in the course of the quarter. We retain conviction in Bajaj as a result of its best-in-class administration staff, sturdy long-term development outlook, and conservative danger administration frameworks.

Gold Fields Restricted is a longtime gold producer primarily based in South Africa with a diversified world portfolio of treasured metals property. Shares fell because of the pullback in gold costs and the corporate’s introduced acquisition of gold producer Yamana Gold at a big premium. We’re optimistic on gold costs and anticipate steady enhancements in Gold Fields’ money prices. We anticipate not less than 50% manufacturing development over the following decade as the corporate ramps up volumes, together with Yamana’s top quality growth tasks in Chile, Canada, and Brazil.

Hapvida Participacoes e Investimentos S.A. detracted within the quarter as a result of disappointing earnings efficiency led by an surprising drop in membership lives and better medical loss ratios than the corporate had estimated. As Brazil’s main well being upkeep group, the corporate is nicely positioned to profit from rising demand for well being care providers. We predict the corporate’s competitively priced well being care plans and nationwide presence will allow it to maintain mid-teens earnings development over the following three to 5 years.

PORTFOLIO STRUCTURE

Desk IV: High 10 holdings as of June 30, 2022

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EXPOSURE BY COUNTRY

Desk V: Proportion of securities by nation as of June 30, 2022

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Publicity by Market Cap

The Fund could spend money on corporations of any market capitalization, and we’ve got typically been broadly diversified throughout large-, mid-, and small-cap corporations, as we imagine growing world corporations of all sizes can exhibit enticing development potential. On the finish of the second quarter of 2022, the Fund’s median market cap was $10.0 billion, and we had been invested 44.7% in giant-cap corporations, 38.3% in large-cap corporations, 10.9% in mid-cap corporations, and a couple of.4% in small- and micro-cap corporations, as outlined by Morningstar, with the rest in money.

RECENT ACTIVITY

Throughout the second quarter, we added a number of new investments to our present themes, whereas additionally growing publicity to a number of positions that had been established in earlier durations. We proceed our endeavor so as to add to our highest conviction concepts.

We had been lively in including to our digitization theme by initiating a place in Coupang, LLC, (CPNG) which operates the biggest e-commerce portal in Korea. The corporate listed in early 2021 on the relative peak of excessive development web shares and subsequently underperformed as a result of a sequence of COVID associated earnings misses and a number of compression throughout its peer group. By the second quarter of 2022, the inventory was buying and selling roughly 70% under its IPO worth.

In our view, the fabric correction in Coupang’s inventory worth created a pretty entry level. We’re impressed by the corporate’s proprietary logistics community that required practically a decade and billions of {dollars} to construct, permitting Coupang to supply supply speeds and repair ranges unmatched by different operators in Korea (or nearly any operator globally). We imagine it is a supply of long-term, sturdy aggressive benefit that was now not mirrored within the valuation and thus supplied a pretty alternative.

Including to our conviction, the corporate’s first quarter earnings outcomes demonstrated that COVID-related headwinds that had plagued its efficiency in 2021 had been subsiding and margins in its core e-commerce enterprise had been turning a nook and rising, a development we imagine will proceed. Korea’s unusually fragmented e-commerce trade implies Coupang can maintain years of speedy development as a consolidator in an trade the place market leaders have a tendency to profit from inherent community results.

Moreover, the corporate’s income development more and more consists of increased margin earnings streams (discretionary vs. staples, commissions on third-party gross sales, success, promoting, subscription), a optimistic signal for margin trajectory and supreme profitability, opposite to many world operators that began with increased margins and at the moment are experiencing margin dilution in a drive in direction of better buyer frequency.

Throughout the quarter, we elevated publicity to our EM client theme by initiating a place in Kweichow Moutai Co., Ltd. Moutai is a dominant distiller of ultra-premium baijiu, China’s nationwide spirit. Amongst native customers, its flagship merchandise have the strongest model fairness of any Chinese language spirits firm (and certain of any Chinese language client model extra broadly), evidenced by its 95%-plus market share of baijiu priced above RMB 1,500 per 500 ml bottle at retail.

Provide grows slowly as a result of inherent manufacturing constraints and is vastly exceeded by demand, a lot in order that market costs on its core merchandise typically hover round two to 4 occasions the ex-factory worth at which the corporate sells baijiu to its wholesale distributors, suggesting important pricing energy and latent earnings energy.

Moutai’s ongoing shift in channel combine away from conventional wholesale and into direct relationships with key accounts and a brand new direct-to-consumer digital channel also needs to drive important ASP development and permit the corporate to progressively seize a few of that latent pricing energy; these measures additionally signify an elevated give attention to shareholder worth creation relative to prior years, a welcome growth.

Mixed with gradual quantity development, we imagine these channel combine shift initiatives can drive not less than a doubling of earnings over the following half decade, with the potential for continued compounding thereafter.

As a part of our China value-added theme, we initiated an funding in Jiangsu Hengli Hydraulic Co., Ltd. The corporate is China’s largest producer of hydraulic elements corresponding to cylinders, pumps, and valves. These are mission vital elements of development equipment with excessive limitations to entry. We had been impressed with Hengli’s success in displacing international competitors in China to change into the dominant provider of hydraulic cylinders for excavators commanding greater than 50% market share.

The corporate has efficiently competed with worldwide manufacturers each domestically and overseas as a result of its high-quality merchandise at decrease prices, whereas traditionally producing over a 30% return on invested capital. Not too long ago, Hengli has expanded into hydraulic pumps and valves in addition to non-excavator development equipment segments with a lot bigger addressable markets. We anticipate Hengli to duplicate its success in gaining market share from international competitors in these new verticals and preserve double-digit earnings development.

Throughout the quarter, we additionally re-initiated a place in Lufax Holding Ltd (LU), as a part of our fintech disruption theme. We’re inspired by China’s elevated dedication towards coverage easing and regulatory help, which is creating enticing funding alternatives in a number of technology-related companies, together with Lufax. The corporate is a number one monetary know-how platform in China that focuses on lending to underserved small- and medium-sized enterprises (SMEs) and supplies wealth administration options to the middle-income and prosperous segments of the inhabitants.

In our view, facilitating credit score to SMEs is vital for China’s financial success. After a protracted regulatory reboot of the sector, Lufax now stands to profit from potential authorities and regulatory help towards the SME phase. The corporate has an efficient distribution technique and differentiated risk-sharing mannequin in comparison with conventional lenders, which we imagine represents a sturdy aggressive benefit.

Lastly, we added to a number of of our present positions in the course of the quarter, together with Hong Kong Exchanges and Clearing Restricted (OTCPK:HKXCF), Hapvida Participacoes e Investimentos S.A., WuXi Biologics Cayman Inc. (OTCPK:WXXWY), Baidu, Inc., StoneCo Ltd. (STNE), Techtronic Industries Co. Ltd. (OTCQX:TTNDY), Will Semiconductor Co., Ltd., Beijing Oriental Yuhong Waterproof Know-how Co., Ltd., and NARI Know-how Co. Ltd.

Throughout the quarter, we additionally exited a number of positions, the biggest of which had been China Molybdenum Co., Ltd. (OTCPK:CMCLF), Yantai Jereh Oilfield Companies Group Co., Ltd., Housing Growth Finance Company Restricted, and Yonyou Community Know-how Co., Ltd. In our endeavor to pay attention capital in holdings for which we’ve got the best conviction round their high quality and return potential and remove decrease conviction or smaller holdings over time, we additionally exited positions in Novatek PJSC (OTCPK:NOVKY), Americanas S.A. (OTCPK:BTOOY), and TCS Group Holding PLC.

OUTLOOK

Whereas the second quarter of 2022 thankfully didn’t ship the geopolitical shock worth of the primary quarter, the worldwide fairness retreat did proceed, whereas volatility throughout capital markets and inter-market management remained excessive. In our view, maybe the seminal occasion in the course of the quarter was a perceived transition in market sentiment regardless of no materials change within the Russia/ Ukraine battle and the related danger of commodity provide disruptions.

To us, this implies the probably passing of peak inflation panic, not less than for the present yr. If for the primary 4 of 5 months of the yr the U.S. Federal Reserve appeared misguided and behind the curve, a extra aggressive tone and dedication to tighten monetary situations gained the respect of market contributors and seems for now to have re-established the Fed’s inflation-fighting credentials. Coincident with this transition, market conduct shifted from fearing inflation to fearing a recession, ought to the Fed provoke one whereas remaining principally centered on taming inflation.

The proof is mounting that inflation expectations have peaked and the percentages of recession are rising. Since reaching a peak in latest months to the tip of the second quarter:

• The U.S. 5-year breakeven inflation charge declined 30% from 3.73% to 2.62%.
• The U.S. 2-year breakeven inflation charge declined 33% from 4.93% to three.29%.
• The spot WTI oil worth declined 15% from $124/barrel to $106/barrel.

• The spot copper worth declined 21% from $4.87/lb. to $3.83/lb.
• The spot lumber worth declined 41% from $1,074 to $637.
• The U.S. 10-12 months Treasury bond yield declined 15% from 3.49% to 2.98%.
• The U.S. 10-12 months actual Treasury bond yield declined 27% from 0.89% to 0.65%.

The truth that this repricing has occurred throughout a interval the place the chance of main COVID-related shutdowns throughout China has been receding solely lends better credibility to the notion that inflation has peaked, and will this show to be the case, we might anticipate world development fairness relative efficiency additionally to have bottomed, with materials headroom for restoration within the coming months and quarters. In truth, we observe that development fairness relative efficiency started to enhance as U.S. Treasury yields peaked in June.

Turning to EM, we observe one other key inflection level within the latest quarter; EM equities materially outperformed each the S&P 500 Index and world indexes and have now outperformed for the year-to-date interval. This encompasses a interval when Russian equities had been written down to close zero and China-related equities battled geopolitical, sanction, and COVID considerations. EM outperformance in a weak or world bear market is uncommon and, in our view, probably alerts a significant long-term inflection level in relative efficiency.

Relating to China, we recount from our first quarter letter; “We stay inspired by pervasive proof of impending regulatory aid, monetary easing, and financial stimulus in China. Whereas the latest escalation of COVID-related challenges defers China’s financial and fairness market restoration considerably, in our view, the mid-March fairness market capitulation probably represents a backside for this asset class, and maybe by extension, for EM equities normally.”

In an encouraging but preliminary signal, China-related equities started to get well and outperform, and as outlined by the iShares MSCI China ETF, China was one of many solely jurisdictions to ship a optimistic return within the second quarter, as COVID and geopolitical considerations abated and Chinese language authorities doubled down on coverage easing, stimulus, and regulatory aid measures. In brief, opposite to most jurisdictions, China’s inflation readings are contained, whereas its financial and earnings outlook is bettering.

As fairness valuations stay compressed, we proceed to imagine China provides materials upside potential, however the latest restoration and outperformance.

From a longer-term perspective, we stay assured that EM and worldwide equities are poised for a sustained interval of outperformance following the previous decade of underperformance. After a few false begins lately that, in our view, had been truncated by the exogenous shocks of COVID-19 and Russia’s invasion of Ukraine, we imagine the evolving geopolitical and world safety surroundings suggests this transition in management is much more probably.

After a 30-year interval of globalization that led to subdued capital funding, the altering nature of U.S./China relations and Russia’s aggression necessitate a worldwide capital funding cycle. Such a cycle has practically at all times correlated with EM and worldwide outperformance as these economies and markets are extra delicate to the beneficiaries of such an surroundings.

Whereas we imagine longer-term inflation expectations could also be peaking, we additionally imagine that commodity costs are more likely to stay elevated for a while relative to the previous a number of years, which might be essential to incent long-term funding in safe vitality, commodity, and agricultural provide and assist fund de-globalization. We view this state of affairs as a switch of wealth away from world customers and in direction of the house owners of actual property and producers of commercial items, which occur to be extra concentrated in EM and worldwide jurisdictions.

After all, this phenomenon is along with the longer-term basic components we frequently cite corresponding to financial reforms in key EM international locations corresponding to India, the shift in emphasis in direction of value-added and excessive return sectors in China, and the passing of peak world greenback demand, which coupled with an order of magnitude enhance in provide of U.S. Treasuries/{dollars}, suggests a greenback bear market awaits. A greenback bear market has traditionally favored EM and worldwide property on a relative foundation.

We’re inspired by the latest efficiency of EM equities, and the relative efficiency of our consumer portfolios, and as at all times, we stay assured that we’ve got invested in a group of well-positioned and well-managed corporations with substantial long-term funding return potential.

Thanks for investing within the Baron Rising Markets Fund.

Sincerely,

Michael Kass, Portfolio Supervisor

Authentic Put up

Editor’s Word: The abstract bullets for this text had been chosen by Searching for Alpha editors.