Review and Outlook
It was a volatile third quarter, marked by geopolitical crises and concerns about the pace of global economic growth, especially in Europe and China; the end of quantitative easing in the U.S.; and the possibility that the U.S. Federal Reserve would raise interest rates sooner than expected.
The barrage of negative news appeared to be behind an ongoing "flight to safety" that started with the March/April selloff, with investors reallocating assets out of smaller cap companies and into larger cap companies and money market funds.
Domestically, economic news was good. U.S. manufacturing continued on its strong growth path, as factories settled into a more sustainable expansion that should spur the economy. Housing data remained solid, with home prices continuing to rise at two to three times the rate of inflation. Unemployment fell, ending the quarter at 6.1%, almost four percentage points lower than its Great Recession high of 10%.
Baron Focused Growth Fund declined in the third quarter. Telecommunication Services, Materials, and Consumer Staples contributed to performance, while Industrials, Energy, and Consumer Discretionary detracted the most in the quarter. Gains in the three contributing sectors were largely stock-specific, since the Fund has just one or two investments in each of these sectors. Industrials lost ground with decreases in four of five sector holdings, including top individual detractor Colfax Corporation. Energy had a challenging quarter as declining commodity prices weighed on performance. Consumer Discretionary holdings had a mixed quarter, and although the sector detracted overall, it also included three of the top five contributors: Vail Resorts, Inc., Mobileye N.V., and Choice Hotels International, Inc.
Looking forward, we think the U.S. economy will slowly but steadily continue on its path to recovery. Unemployment is on the decline and company financials are improving. Second quarter earnings hit a record high in S&P 500 operating earnings per share, with growth of 12.6% year over year and a 130% increase over the past five years. With interest rates still at record lows, credit remains available on attractive terms. The expense of servicing business debt as a percentage of earnings has fallen from 44% to 13% since the 2008-09 financial crisis. Low energy prices in the U.S. should help drive a rebirth in manufacturing, transportation and other industries in which the cost of energy plays a significant role. Housing starts are still less than half of the peak of eight years ago, which suggests there is still a considerable runway for growth in residential real estate.
Stock prices remain at about 15.2 times earnings, which is around the median levels of the past hundred years, meaning there are plenty of good stocks at attractive prices to be found, in our opinion. With the rotation out of high-growth stocks over the past six to seven months, many of these stocks are now at what we believe are attractive valuations.
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.
The Baron Focused Growth Fund (Retail Shares) declined 4.19% in the third quarter and performed roughly in line with the Russell 2500 Growth Index. During the quarter, stock selection added value, but this positive effect was offset by relative sector weights.
Outperformance of the Fund’s investments within the Consumer Discretionary, Information Technology (IT), and Materials sectors contributed the most to relative results. Within Consumer Discretionary, a combination of stock selection and the Fund’s larger exposure to this outperforming sector lifted relative results. The Fund’s holdings in the sector outperformed their counterparts in the index by 224 basis points, led by Vail Resorts, Inc. and Mobileye N.V. These companies were also two of the Fund’s largest contributors on an absolute basis. Choice Hotels International, Inc. and Hyatt Hotels Corp. aided relative performance after shares of both companies were bolstered by strong second quarter revenue per available room. The majority of the Fund’s exposure to the IT sector is in application software businesses, and these stocks rose 11.9% as a group, led by Concur Technologies, Inc. and Guidewire Software, Inc. Concur was the Fund’s largest contributor to absolute performance after SAP announced an agreement to acquire the company. Shares of Guidewire, a leading provider of core systems software to the global property & casualty insurance industry, increased in the quarter helped by wins at several major insurers. Strength in Materials was largely attributable to the outperformance of the Fund’s two holdings in the sector, CaesarStone Sdot-Yam Ltd. and Airgas, Inc. Shares of CaesarStone, a leading manufacturer of engineered quartz surfaces used for kitchen and bathroom countertops, performed well after the company reported better-than-expected quarterly results and raised full-year guidance. Investor concerns about Israel-based CaesarStone’s business being adversely impacted by harsh weather in the U.S. and the conflict in Gaza were unwarranted. Shares of Airgas, the largest distributor of industrial, medical, and specialty gases in the U.S., outperformed as the company’s volumes stabilized and margins improved.
The Fund’s investments within the Industrials sector and its lack of exposure to biotechnology and pharmaceuticals stocks, which rose 1.8% and 6.3%, respectively in the index, detracted the most from relative performance. Weakness in Industrials was mainly due to the underperformance of Colfax Corp., which was also the Fund’s largest detractor on an absolute basis. Other detractors in the sector were Genesee & Wyoming, Inc., a leading short-line railroad, and Fastenal Co., a leading distributor of industrial supplies. We believe shares of Genesee & Wyoming declined as a result of profit taking after the company reported solid earnings results. Despite strong sales, shares of Fastenal fell due to depressed gross margins from higher sales to larger accounts and a shift in sales to lower margin products.
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