Baron Discovery Fund (BDFFX)

Portfolio Management

RandolphGwirtzman
Randolph Gwirtzman

Fund Manager since 2013

View All Commentary by Randolph LairdBieger
Laird Bieger

Fund Manager since 2013

View All Commentary by Laird

Fund Description

Baron Discovery Fund invests primarily in small growth companies.
 

Fund Resources

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Portfolio Commentary

Retail Performance

Review and Outlook (for quarter ended 9/30/2014)

The quarter was punctuated by geopolitical strife in the Middle East, a weakening economy in Europe and fears of contagious disease spreading to the U.S. from Africa. In the wake of these events, the yield on the ten-year Treasury has dropped, and the U.S. dollar has strengthened. Large cap stocks also dramatically outperformed small cap stocks.

Baron Discovery Fund decreased in the quarter. While Health Care detracted, the sector included the Fund’s top three performing stocks, reflecting the generally acyclical nature of Health Care stocks, as well as positive fundamentals of our top performers. Two non-Health Care companies also performed well:  Farmer Bros. Co., a nationwide coffee distributor, and Tallgrass Energy Partners, LP, a fast growing midstream MLP. Tallgrass had a solid quarter despite a weak showing by the Energy sector due to declining commodity prices.

Information Technology detracted the most, with weak performers that included E2open, Inc. (lost three customers that were acquired) and Marchex, Inc. (which we sold after we determined that the company’s product didn’t provide as much value to customers as we had originally expected). We got unlucky with Revance Therapeutics, Inc., when an FDA division questioned a clinical trial program already approved by another FDA division. We believe this issue will be resolved favorably, and that Revance has a blockbuster cosmetic drug.

We were buyers of The Spectranetics Corporation, and were rewarded when the company received a key FDA device approval. We initiated a position in American Assets Trust, Inc., a top shelf hotel ownership/management company with strong assets. A new investment is ExamWorks Group, Inc., which provides independent medical exam services to U.S., U.K. and Australian insurers. The company has been rapidly consolidating the industry and has stable, growing cash flow characteristics and a solid management team. We added small positions in two specialty pharmaceutical companies which we believe have blockbuster potential: Esperion Therapeutics, Inc. (LDL cholesterol lowering drugs) and Aerie Pharmaceuticals, Inc. (glaucoma drugs that reduce intra-ocular pressure).

We sold a chunk of Pacira Pharmaceuticals, Inc. for purely valuation-related reasons as we still like the company and its opportunity. We also sold eHealth, Inc. and Tesco Corp. (where there was a key management change).

While we were disappointed in the performance of the Fund in the quarter, we continue to adhere to our investment philosophy of finding growth stocks with terrific management teams, protected markets, and solid business plans. Our process hasn’t changed, and we spent more time than usual performing due diligence on our investments this quarter. We have been speaking with our management teams, their competitors, and industry experts. We are confident that over time our philosophy and process will lead to market-beating returns.

Top Contributors/Detractors to Performance

Contributors (for quarter ended 9/30/2014)
  • Shares of The Spectranetics Corporation, a provider of medical devices for removing arterial plaque and the leads of old heart regulating devices, were up in Q3. As we expected, management rebounded from a Q1 misstep in sales execution, and the issuance of $230 million in convertible debt related to a strategic acquisition. In July, Spectranetics received approval of a major product indication, which we believe could triple its current market opportunity.

  • Shares of Intersect ENT, Inc. increased in Q3 on reports of solid Q2 results, as well as positive clinical trial data related to its pipeline product, Resolve. Intersect sells implants that deliver localized anti-inflammatory medication in patients who have had surgery to relieve chronic sinusitis. The company's technology is unique, and we believe the target market will expand over the next several years as Intersect introduces follow-on products designed to address different stages in the chronic sinusitis treatment paradigm.

  • Pacira Pharmaceuticals, Inc., a specialty pharmaceutical company, was a solid performer in the quarter. Sales of its injectable, long-lasting pain medication EXPAREL continued to grow rapidly (up 195% in Q2), driven by increasing hospital adoption and usage in surgical procedures. Run rate sales of EXPAREL are now about $180 million, and we believe the market could be worth billions.

Detractors (for quarter ended 9/30/2014)
  • Shares of E2open, Inc., a provider of cloud-based software that helps some of the world’s largest companies manage their complex manufacturing supply chains, decreased in Q3. In September, the company pre-released Q3 earnings. While the quarter was good, E2open took down full year guidance due to the loss of three customers who were acquired (and in two cases, shut down operations). We continue to believe that E2open’s solution is sticky, valuable to customers, and difficult to replicate.

  • Shares of online health insurance broker eHealth, Inc. fell in Q3 on news that the Affordable Care Act had translated into far fewer commissions to eHealth than expected. We also learned from management’s discussion of Q2 results that the influx of new insurers servicing state exchanges significantly muddled commission reporting and thereby the key transmission mechanism of eHealth’s revenue stream.

  • Shares of Foundation Medicine, Inc. declined in Q3 as a result of concerns regarding the timing and amount of reimbursement by third-party payors for the company’s product and the evolving competitive landscape. Foundation Medicine markets a sequencing-based cancer test that identifies genetic alterations and allows physicians to match the genetic alterations with therapies.

Quarterly Attribution Analysis (for quarter ended 9/30/2014)

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 Discovery Fund (Retail Shares) declined 9.60% in the third quarter and underperformed the Russell 2000 Growth Index by 347 basis points, primarily due to stock selection. During the quarter, the Fund’s larger exposure to micro cap stocks also detracted from relative performance.

Outperformance of the Fund’s investments within the Energy and Consumer Staples sectors and its average cash exposure of 8.2% in a difficult period for small cap stocks contributed the most to relative performance. Despite the sharp decline in energy stocks, the outperformance of the Fund’s MLP investments and larger exposure to these stocks aided relative results within the Energy sector. Shares of RoseRock Midstream, L.P. rose on the strength of better-than-expected second quarter results, including revenue that was up 80% on a year-over-year basis, while shares of Tallgrass Energy Partners, LP increased after the company closed on its first equity stake in the Pony Express pipeline. Strength in Consumer Staples was mostly attributable to the outperformance of the Fund’s largest holding in the sector, Farmer Brothers Co., a roaster and wholesale distributor of coffee and related products. Shares of Farmer Brothers jumped 34% after the company’s earnings call alerted the market to its ongoing turnaround story and intermediate-term earnings growth potential.

The Fund’s investments within the Information Technology (IT), Financials, and Materials sectors were the largest detractors from relative performance in the quarter. Within IT, the Fund’s Internet software & services holdings fell 27.4% as a group, with E2open, Inc., Marchex, Inc., and Benefitfocus, Inc. driving the decline. E2open was the Fund’s largest detractor from absolute performance. The Fund exited its position in Marchex after the company lost a substantial piece of business from one of its largest customers. Shares of Benefitfocus were hurt by a secondary offering that increased the public float by more than 30%, as well as broad multiple contraction among high growth companies. Another detractor in the sector was PDF Solutions, Inc., a provider of yield management services to the semiconductor industry. Shares of PDF Solutions traded down in the quarter after the company announced that a meaningful contract might not be signed. Weakness in the Financials sector was mainly due to the underperformance of eHealth, Inc., which was also one of the Fund’s largest detractors on an absolute basis. Within Materials, underperformance of the Fund’s largest holding in the sector, Flotek Industries, Inc., detracted the most from relative results. Shares of Flotek, a leading supplier of specialized chemicals to the oil & gas industry, fell over concerns that the increasing use of sand in well completions would displace usage of its main product.

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The prospective performance of the companies discussed herein is based on our internal analysis and reflect our opinions only. We cannot promise future returns and our opinions are a reflection of our best judgement at the time of publication. Our views are not intended as recommendations or investment advise to any person and are subject to chage at any time based on market and other conditions and Baron has no obligation to update them. Investing in the stock market is always risky. Current and future portfolio holdings in the Fund are subject to risk.

Source: FactSet PA.