Review and Outlook
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
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 Discovery Fund (Institutional Shares) declined 9.51% in the third quarter and trailed the Russell 2000 Growth Index by 338 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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