On August 19, 2020, Litman Gregory senior research analyst Rajat Jain, CFA, interviewed Michael Kass, portfolio manager of Baron Emerging Markets (BEXIX) and Baron International Growth (BINIX). Their conversation focused on emerging markets. Specifically, they discussed the prospect of increased productivity for emerging-market (EM) businesses, the ongoing U.S.-China trade conflict, and the potential for a deepening of EM capital markets. In this report, we share excerpts from the interview and conclude by reiterating our high conviction in Kass and the international funds he manages:
The Productivity Case for Emerging Markets: Q&A with Michael Kass
People often refer to the demographic dividend when making the case in favor of emerging markets. Is a productivity boom, aided by technology and other trends we are seeing, finally going to get unleashed? Do you see a shift in the earnings growth and productivity for EM stocks?
Kass: I think it might be the failure of the demographic dividend to actually play out that is driving this next phase of bringing more focus to productivity-driven and policy reforms. Because global growth is slowing and because the China-investment super-cycle has peaked—because the demographic dividend is really not translating into accelerating growth or the idea of sustaining per-capita income growth … [we saw] a slowing down of the organic growth, a compression of return on invested capital within EM countries. That became clearer over the past five to seven years.
In India, there have been major reforms. But those things often are two steps forward, one step back. It takes time to really see the benefits. I’d say if you look at our portfolios where we’re most excited and have the greatest concentration: it’s India, China, and Brazil. Those are making up some 70% of our total allocation [in Baron Emerging Markets]. Those are the areas where we see the greatest opportunity in this idea of some form of reorientation toward a higher-productivity economy.
Reforms in India. Reforms and privatizations in Brazil. In China, it’s really this massive shift of emphasis away from cyclical capital-and-labor-intensive, low-value-added economic activity, [away from] infrastructure and commodity-based activity, to going after capturing a greater share of value-added economic activity that has historically been dominated by Western multinationals within China. Basically, if you’re a Western multinational corporation, the biggest driver of your earnings growth for the last decade or 15 years or so is probably access to a growth-and-premiumization in the China market.
That’s going to change in the next 10 to 20 years. Instead of having Western companies that create manufacturing joint ventures on the ground, you’re going to have domestic Chinese companies fully controlling the supply chain from lithium to selling electric vehicles [EVs], servicing EVs, and developing charging stations and all of that.
Semiconductor is clearly another one. China consumes about 30% of the world’s semiconductor content. Historically, only 5% of that was self-manufacturing. I’d say within five to 10 years, China will reach some form of self-sufficiency in semiconductor design and manufacturing. They will for another 10 or 15 years likely capture greater and greater share of their own consumption.
We’re talking about the productivity gains where within China they’re going from manufacturing, labor-and-capital-intensive, low-margin, low-value products … shifting the emphasis to the highest-margin, highest-value products in end-markets in the world. That’s EVs and semiconductors; it’s cloud; Internet platforms, which they already dominate as domestic platforms. But the economy is shifting toward digitization, which drives productivity. But it’s also their own datacenters and cloud software. For example, software is nearly ubiquitous [within] China, and probably 95% of the software being used in China is not currently being paid for. It’s a legacy-pirated software. There’s very little monetization. You look at a company we own, Kingsoft. Kingsoft owns 52% of Kingsoft Cloud WPS: That’s the equivalent of Microsoft Office in China.
There is a major initiative [in China] to emphasize local players in value-added industries that extend from semiconductors and software, electronic vehicles to automation and robotics. There are areas that Internet platforms [have] already roped off, but there is obviously opportunity there as you push further digitization.
There are companies that you would not want to own. You’d not want to own major exporters. You’d not want to own major companies where there’s a supply chain with 100% reliance on China.
We are emphasizing higher-quality growth companies. I’d say it’s not shown up as being of benefit in recent years because the risk premium [has been] widening from early 2018 through 2020, at least through the COVID-19 crisis. If you look back over three years, mega-cap index stocks have outperformed all others by somewhere between 1,000 and 2,500 basis points on average.
Who has the upper hand in the U.S.-China Trade War?
We could argue it would be wrong for China to use state resources to subsidize and to support [particular] industries because we don’t do that here … We really have the private sector. But China was never really organized that way.
We could say, If you do that, we won’t buy your product, but I don’t think you can stop them from developing in these industries for their own domestic purposes. We can slow them down; we can’t stop them.
We can threaten to cut them out of the U.S.; we can threaten them that we will not repay or pay interest or principal on Treasury bonds that they hold, but [each] would have massive repercussions to the U.S., and would disqualify the U.S. as the world’s reserve currency. It would create European nations beginning to fall into the fold of the China-Middle East-Russia consortium that will ultimately present an alternative transaction or reserve currency or financial system. That’s already starting to happen.
What people in the U.S. are not thinking about when they say, We’re going to prevent them from accessing our capital markets, is that mainland China investors, until very recently through the Hong Kong Connect, had no access to invest in the leading Chinese technology value-added companies [because of capital controls and no full currency convertibility]. You have much more capital in China that wants to own these Chinese technology national champions.
How do you view de-listing risk for Chinese companies on U.S. exchanges?
[For] U.S.-listed ADRs in Chinese companies, that will have no impact. For $0.50 a share or something, we should be able to redenominate our ADR shares into Hong Kong shares. They should be available to trade there. Given that we are licensed and registered to trade in Hong Kong, we don’t care. There’s almost nothing we own that we wouldn’t [expect] within the next three months to be able to have a dual-listing in Hong Kong.
Are you seeing capital markets deepen further in EM? There is fintech, which makes it easier and faster to have money flow through the economy. There are financial reforms in India.
Absolutely. One of our themes is this transition away from politically motivated bank-directed lending. They tend to charge higher interest rates than markets because they don’t understand credit risk and are uncomfortable. Emerging markets have more of these digital/Internet platforms—artificial-intelligence driven platforms that are [relatively] better at assessing credit risk and allocating capital on a micro basis. The ability of these new entities, I’d call that capital market deepening.
Looking at the decline of interest rates around the world, the relative decline in rates in Brazil [for example] is much higher than it is in the Western world—U.S. and Europe. The rates in Brazil, just before [President] Dilma Rousseff [departed], were 14%. Now they’re 4% or lower. Inflation has come down. Maybe now it’s 2.5%. It might go a little higher.
Real rates have come down everywhere. When real rates are negative in the Western world, or zero to negative, then people are willing to take 2% in Brazil when they used to want 4%. All of that is opening up the opportunity for corporations to access bond markets … [more] bond issuance versus bank credit.
In addition, I’d say the big decline in interest rates across all these markets is causing an enormous opportunity to deleverage through equity funding. Now you have Brazil, China, India [having better] access to equity funding because of the decline of nominal rates from the low double digits to the mid to low single digits. It’s forcing capital to leave deposits in fixed-income markets and to seek equity alternatives. Because the yields are now so low. Real rates are so low, you’re not getting compensated. B3, a stock exchange in Brazil, would be a winner in this period of declining interest rates. Similarly, that phenomenon is happening in India, but the liquidity crisis temporarily overshadowed that.
On a forward-looking decade versus the trailing decade, I feel that the potential stimulus [and] the enhancement to the growth opportunity due to this capital market deepening and lower cost of capital is more substantial in EM.
These are all parts of the drivers of why we think relative-earnings growth outside the U.S. will be more attractive in the next decade on a relative basis than the last decade. The fact is that profit sharing is going to be migrating from Western multinationals to local players particularly in places like China and India. In fact, India is the most likely beneficiary in the supply-chain diversification out of China.
Investment Philosophy & Process
Kass believes the best way to compound wealth is to invest in businesses with long-term competitive advantages and substantial open-ended, long-term growth potential. Importantly, these businesses need to be run by entrepreneurs with the strategic vision and financial sophistication to sustain an above-average return on capital, and who have also instituted shareholder-friendly corporate governance.
Typically, companies with open-ended, long-term growth potential are benefiting from innovation (which may or may not be company specific) or some secular change, which may be regulatory, economic, or demographic in nature. In essence, these changes or themes may “lead to a step-function change” (i.e., significant or transformational) in the returns or profitability or return on capital a company can generate over a long period. Kass avoids excessively leveraged companies. To be confident that a company will be able to sustain high returns on capital, Kass wants to see a sustainable competitive advantage that will give it pricing power and allow it to maintain relatively high margins over a long period. He also wants to see a high degree of financial sophistication in management, meaning he wants to see companies manage cash needs prudently and invest the cash they generate in higher-return projects.
Kass tends to avoid deeply cyclical and commodity-oriented businesses as they often have volatile and unpredictable earnings streams and generally do not achieve returns on capital substantially above the companies’ cost of capital on a sustainable basis. That said, he may selectively add some if he sees strong inflexion in profitability and reasons why it can sustain beyond a shorter-term or cyclical horizon and if that view is severely underpriced by the market. It’s fair to say that Kass’s hurdle to investing in commodity and cyclical sectors is higher than in other areas. So, a relatively large subset of companies typically present in an EM stock index is generally not part of Kass’s investment opportunity set.
Kass and the analysts place emphasis on meeting company management teams, suppliers, customers, regulators on the ground, consultants and industry experts, and local sell-side analysts. Ultimately, the analysts build detailed models forecasting earnings and cash flows three to five years out. Models help identify key drivers or swing factors and are actively updated and utilized both prior to purchasing a stock and during ongoing monitoring. A stock becomes a candidate for purchase if Kass and his analyst team see upside of about 100% over three to five years. Typically, most of the upside in a stock stems from their view on how fast the company can grow its earnings or cash flows. An expectation of expansion in valuation multiples is seldom central to Kass’s purchase decision.
Performance & Team
Year to date ending August 31, 2020, Baron Emerging Markets is up 8.27% (versus 0.45% for the MSCI Emerging Market Index) and Baron International Growth is up 11.62% (versus a 4.44% decline for the MSCI World ex USA Index and an 8.22% gain for the MSCI ACWI ex USA Growth Index). The average EM fund in the Morningstar universe was flat during this period, while the average foreign large growth fund was up 9.06%.
Over longer periods, the performance of both funds has been strong. Since its inception on December 31, 2010, through August 31, 2020, Baron Emerging Markets has risen 5.44%, annualized, which compares to an MSCI EM return of 2.01% and the average EM peer’s return of 1.38%. Baron International Growth is up 11.56% since its inception date on December 31, 2008 (extending the strategy’s track record using the retail share class), while MSCI ACWI ex USA is up 7.10%, MSCI ex USA Growth is up 9.05%, and the average foreign growth fund peer is up 9.43%.
Both strategies have shown excellent consistency in beating their respective primary benchmarks and peers over longer periods. Over all possible rolling five-year periods, Baron Emerging Markets has beaten the MSCI EM benchmark and its average peer 88% and 100% of the time, respectively. Baron International Growth has beaten both MSCI ACWI ex USA and the average foreign-growth peer in 100% of all possible rolling five-year periods since inception.
This outperformance in the two funds has come with relatively lower risk. Baron Emerging Markets has captured only 75% of the downside relative to the broad index, while Baron International Growth has captured 90% of the downside since their respective inception dates.
Kass and his dedicated team of five analysts help manage both strategies. Anuj Agarwal, who joined Baron in 2012, was named Assistant Portfolio Manager in 2020 in recognition of his contributions.
Litman Gregory Opinion
We believe Baron Emerging Markets and Baron International Growth will beat their benchmarks over the long term. We continue to recommend the funds, and we own the EM fund in our active model portfolios published on AdvisorIntelligence.
Our confidence stems from Baron Capital’s disciplined long-term approach to growth investing and portfolio manager Kass’s superior understanding of long-term themes and business models. He also employs a prudent macro-risk overlay, which with regard to Baron Emerging Markets in particular we believe can mitigate downside risk.
—Rajat Jain, CFA
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