Review and Outlook
During the three-month period ended December 31, 2015, market indexes rebounded sharply from their retreat during the previous quarter to end the year in modestly positive territory. The biggest news during the quarter was the Federal Reserve’s decision to increase short-term interest rates for the first time since the financial crisis. Although widely expected, the stock market appeared to accept the Fed’s view that the economy was now strong enough to continue growing in the face of moderately increasing rates.
Baron Asset Fund increased in the period. The Information Technology (IT), Financials, and Consumer Discretionary sectors were the top three contributors to performance. Consumer Staples was a material detractor in the quarter. IT’s gains were led by syndicated IT research provider Gartner, Inc. and Internet infrastructure service provider VeriSign, Inc. Financials benefited from strong performances by Willis Towers Watson Plc, the third largest contributor in the period, and brokerage firm Charles Schwab Corp. Performance of the Consumer Discretionary sector was driven in large part by Vail Resorts, Inc., which was the top contributor in the quarter. Both of the Fund’s Consumer Staples investments lost ground in the quarter, led by United Natural Foods, Inc. Shares of this leading natural foods distributor declined after the company reported disappointing financial results.
Despite the recent stock market volatility, we continue to believe that high-quality, mid-sized growth stocks represent an attractive long-term investment opportunity. The U.S. economy is among the world’s healthiest, and, particularly after the recent stock market correction, its equity market multiples are within the range of their long-term averages. Interest rates remain at historic lows, and we believe that equity markets often perform well, even after rates begin to increase. Employment and housing trends continue to improve, and energy prices remain meaningfully below their recent levels. We think that our portfolio of what we believe are well-managed, competitively advantaged, fast growing companies will continue to perform well in this environment, although we cannot guarantee that they will.
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 Asset Fund increased 4.70% in the fourth quarter and outperformed the Russell Midcap Growth Index by 58 basis points, mainly due to stock selection.
The Fund’s Consumer Discretionary, Information Technology (IT), and Energy investments were the largest contributors to relative results. Within Consumer Discretionary, outperformance of Vail Resorts, Inc. and the Fund’s lack of exposure to lagging restaurant and department store stocks contributed the most to relative results. Vail was the largest contributor on an absolute basis after the company’s stock price rose 23.6% in the quarter. Strength in IT was partly attributable to outperformance of the Fund’s Internet software & services holdings, led by VeriSign, Inc., which provides Internet infrastructure services worldwide. The company’s shares were up 23.8% in the quarter due to strong increases in new domain name additions in China. The Fund’s investments in Guidewire Software, Inc., a leading P&C insurance software vendor, and Gartner, Inc., a provider of syndicated IT research, also aided relative performance. Guidewire’s shares increased after reporting near-perfect retention rates, a growing installed base, and accelerating adoption of its complete product suite, while Gartner’s shares benefited from strong forward-looking metrics. Gartner’s contract value growth and productivity trends are approaching levels sufficient to drive margin expansion, retention rates are at all-time highs, and the company has significant financial flexibility. Within Energy, outperformance of Shell Midstream Partners, L.P. added value and more than offset the negative effect of the Fund’s larger exposure to this poor performing sector. Shares of Shell Midstream, a master limited partnership (MLP) formed by Royal Dutch Shell to own, operate, develop, and acquire midstream and logistics assets, rose sharply as it recovered from the broad sell-off of MLPs in the third quarter.
The Fund’s Health Care and Consumer Staples investments were the primary detractors from relative performance. Within Health Care, underperformance of Inovalon Holdings, Inc., IDEXX Laboratories, Inc., and The Cooper Companies, Inc. weighed the most on relative results. Inovalon and Cooper were two of the largest detractors from absolute performance, while IDEXX’s shares fell after issuing forward guidance that was modestly below Street expectations. Despite the recent pullback, we believe IDEXX’s competitive trends remain strong, highlighted by instrument placement growth of almost 100%, domestic lab growth more than twice that of its primary competitor, rising field sales productivity, and a rebound in rapid assays. Weakness in Health Care was somewhat offset by the Fund’s larger exposure to this outperforming sector, which increased 7.2% in the index. Within Consumer Staples, the Fund’s lower exposure to this top performing sector and underperformance of United Natural Foods, Inc. detracted the most from relative results. Shares of United Natural, the leading natural foods distributor, declined after reporting disappointing financial results.
Yearly Attribution Analysis
Baron Asset Fund finished roughly unchanged for the year and outperformed the Russell Midcap Growth Index by 40 basis points. During the period, the Fund’s stock selection added value, more than offsetting the negative effect of its relative sector weightings.
Information Technology (IT), Financials, and Industrials investments and lower exposure to the lagging Materials and Consumer Discretionary sectors contributed the most to relative performance. Within IT, outperformance of application software holdings, led by FactSet Research Systems, Inc. and Guidewire Software, Inc., and larger exposure to this strong performing sub-industry added the most value. Shares of FactSet, a leading provider of investment management tools, outperformed after the company’s financial results demonstrated consistent and accelerating market share gains. VeriSign, Inc. and Gartner, Inc. also lifted relative performance. Financials holdings outperformed their index counterparts, led by Arch Capital Group Ltd. and Towers Watson & Co. Shares of Arch, a specialty insurance and reinsurance company, increased on strong financial results. Shares of HR consultant Towers Watson & Co. rose after proposed merger partner Willis Group Holdings plc more than doubled the special dividend payable to Towers Watson shareholders. This was sufficient to achieve shareholder approval for the merger, which was completed in early 2016. Strength in Industrials was mainly due to the outperformance of Verisk Analytics, Inc., the third largest contributor on an absolute basis, and Roper Technologies, Inc., a manufacturer of industrials controls, fluid handling, and analytical instrumentation products. Roper’s shares rose after deploying over $1.7 billion in deals as part of an effort to move to an asset light model with superior profitability and less cyclicality. Lack of exposure to trucking stocks, which fell 28.9% within the index, also aided relative performance in the sector.
Health Care, Consumer Staples, and Utilities investments and slightly larger exposure to the poor performing Energy sector detracted the most from relative performance. Weakness in Health Care was mostly attributable to the underperformance of Inovalon Holdings, Inc. and The Cooper Companies, Inc., although this weakness was partly offset by larger exposure to this strong performing sector. Within Consumer Staples, lower exposure to this outperforming sector and a sharp decline in the shares of United Natural Foods, Inc. weighed the most on relative results. Within Utilities, underperformance of SunEdison yieldcos TerraForm Power, Inc. and TerraForm Global, Inc. and larger exposure to this lagging sector hurt relative results. These stocks underperformed during the year as a result of the increased cost of capital, which raised concerns regarding the yieldcos’ ability to grow and subsequently the entire business model. The Fund exited its position in TerraForm Power due to concerns regarding management execution as well as the liquidity position, while it continues to hold its restricted position in TerraForm Global.
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