Review and Outlook
U.S. stock markets made little progress during the three months ended June 30, 2015. Most indexes achieved modest gains. The Russell 2500 Growth Index gained 0.61%.
Numerous cross currents impacted the economy and markets during the second quarter of 2015. The U.S. economy continued to steadily improve. Consumer and business confidence rose, unemployment fell, wages increased at an accelerating pace, housing prices continued to rise, automobile sales remained strong, and central banks worldwide implemented “easy” monetary policies to stimulate their economies. With our economy growing and reported inflation increasing in the U.S., interest rates, while still quite low, began to increase. This impacted interest-sensitive stocks, including REITs, MLPs and utilities. Continued strength in the dollar negatively impacted U.S. industrial and export-dependent businesses, whose stocks lagged in the period. Stocks in transport companies, whose results are closely correlated to industrial businesses, also lagged. Energy prices stayed low, to the benefit of consumers and energy-dependent businesses. A cutback in capital expenditures by energy companies partially offset the favorable impact of lower energy prices.
Baron Focused Growth Fund increased in Q2. Consumer Discretionary, Information Technology (IT), and Financials contributed the most in the quarter. Utilities, Industrials, and Telecommunication Services were the top detractors. Consumer Discretionary included three of the top five contributors in Q2, including top contributor Tesla Motors, Inc., whose stock rose more than 40% during the quarter, and third biggest contributor Manchester United plc. Ski resort owner Vail Resorts, Inc. also showed strength, driven largely by stronger-than-expected season pass sales. These positive results more than outweighed declines elsewhere in Consumer Discretionary, including the hotels, resorts & cruise lines, specialty stores, and automotive retail sub-industries. IT’s contribution was primarily driven by a stock price increase in Benefitfocus, Inc., the Fund’s second biggest contributor. All four of the Fund’s Financials holdings increased in the quarter, as rising interest rates helped boost performance. Utilities lagged due to a drop in the stock price of ITC Holdings Corp., the third biggest detractor in the quarter. Industrials lost ground primarily as a result of weak performance by the biggest detractor in Q2, Genesee & Wyoming, Inc. A decline in the stock price of the Fund’s only Telecommunications Services investment, Iridium Communications Inc. hurt performance of that sector.
While it is not possible to predict stock markets over the short term, over the long term, stock prices and our economy are inextricably linked. For the past 55 years, GDP has grown 6.6% a year and stock prices have grown 6.6% a year. Taking dividends into account, stocks have doubled every 10 years. We have every reason to believe that our economy and stock markets will continue to achieve these historic results over the long term. We see many opportunities.
Top Contributors/Detractors to Performance
Quarterly Attribution Analysis
When reviewing performance attribution on our portfolio, please be aware that we construct the portfolio from the bottom up, one stock at a time. Each stock is included in the portfolio if it meets our rigorous investment criteria. To help manage risk, we are aware of our sector and security weights, but we do not include a holding to achieve a target sector allocation or to approximate an index. Our exposure to any given sector is purely a result of our stock selection process.
Baron Focused Growth Fund gained 3.06% in the second quarter and outperformed the Russell 2500 Growth Index by 245 basis points. During the quarter, the Fund’s stock selection added value, but this positive effect was partly offset by differences in sector weights relative to the index.
Outperformance of investments within the Consumer Discretionary, Financials, and Information Technology (IT) sectors were the largest contributors to relative results. Within Consumer Discretionary, outperformance of Tesla Motors, Inc., Manchester United plc, and Vail Resorts, Inc. added the most value. Tesla and Manchester United were two of the largest contributors to absolute performance, while shares of ski resort operator Vail increased due to stronger-than-expected season pass sales for the upcoming season despite last season's poor snow in Utah and Lake Tahoe. Vail’s recent acquisition of Perisher in Australia also lifted the stock price as season pass sales at that resort increased 68% since the deal was announced. We believe this acquisition bodes well for the upcoming season as Vail now has an opportunity to directly market to Australians, who are among its largest international customer bases. Within Financials, outperformance of Arch Capital Group Ltd. and The Carlyle Group and lack of exposure to REITs, which suffered due to interest rate concerns, contributed the most to relative results. Shares of Arch, a specialty insurance and reinsurance company, rose on reports of solid quarterly financial results with 15% growth in book value per share. Despite a soft reinsurance pricing environment, Arch’s underwriting profitability remained strong, catastrophe losses remained benign, and the company continued to experience favorable reserve development. Shares of alternative asset manager Carlyle Group increased after the company rebounded from poor performance at one of its hedge funds as investors realized it was a contained issue and not a broader problem among other products. Strength in IT was mostly attributable to the outperformance of Benefitfocus, Inc., the Fund’s second largest contributor on an absolute basis, and FactSet Research Systems Inc., which provides financial information to the global investment community. FactSet’s shares rose after reporting better than expected quarterly results, driven by accelerating annual subscription value, improved retention rates, and doubled-digit organic user count growth.
Lack of exposure to the top performing Health Care sector and larger exposure to Utilities through investments in ITC Holdings Corp. and TerraForm Power, Inc. detracted the most from relative results. Within Health Care, lack of exposure to biotechnology stocks, which rose 9.5% in the index, detracted approximately 77 basis points from relative performance.
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