Baron Discovery Fund (BDFIX)

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

Latest Fact Sheets

Standard Fact Sheet

1Q16 Quarterly Letter

Portfolio Commentary

Institutional Performance

Review and Outlook (for quarter ended 3/31/2016)

The first quarter of 2016 was marked by heightened volatility. From the start of the new year, the Russell 2000 Growth Index went in one direction – straight down. By the time the index bottomed on February 11, it had vaporized 18.92% of its value. The rebound that followed left the index down “only” 4.68%. Our portfolio of smaller, earlier stage companies, with a weighted average market capitalization of about $1.4 billion, modestly outperformed the benchmark, with a weighted average market capitalization of about $2.0 billion. We believe this result is a testament to the portfolio’s reconfiguration last year, including larger position sizes geared to more established companies with higher cash flow and less revenue volatility balanced against positions in exciting earlier stage growth companies. We think this is the right mix in the current environment.

Baron Discovery Fund declined in the first quarter. Information Technology (IT) and Financials contributed to performance. Health Care, Materials, and Consumer Discretionary were the top detracting sectors. Contribution of the IT sector was driven primarily by semiconductor companies Mellanox Technologies, Ltd. and M/A-COM Technology Solutions Holdings, Inc., as well as electronic manufacturing services company Mercury Systems, Inc. Mercury, Mellanox and M/A COM were the second, third, and fourth largest contributors, respectively. College housing REIT Education Realty Trust, Inc. was the primary driver of positive performance of the Financials sector. The Health Care sector detracted due to sharp declines among the Fund’s investments in the pharmaceuticals and biotechnology sub-industries, including Pacira Pharmaceuticals, Inc., the second largest detractor in the quarter. Materials lost ground due to a sharp decline in the Fund’s only sector holding, Flotek Industries, Inc., which supplies chemical additives to the oil & gas industry. The Consumer Discretionary sector had a mixed quarter, although detractors outweighed contributors. ClubCorp Holdings, Inc., the third largest detractor in the quarter, led the decline in the sector.

We believe that going forward, we will be able to continue to perform well against the index in most environments, though our smaller capitalization bias favors up markets versus severe down markets. We continue to target companies that we believe can provide at least a 15% annualized return over time. Of course, there are no guarantees.

Top Contributors/Detractors to Performance

Contributors (for quarter ended 3/31/2016)
  • Shares of regional casino operator Pinnacle Entertainment, Inc. rose in Q1 on the increasing likelihood that it would close on the sale of its real estate assets to Gaming and Leisure Properties. Given the pending sale, shares benefited from a shift in investor focus to the pro-forma company, including likely strong free cash flow generation and enhanced growth prospects once the sale closes.

  • Mercury Systems, Inc. provides complex electronic subsystems to major defense contractors. In March, Mercury acquired a defense unit from Microsemi Corporation that added “embedded protection” capabilities that are like military cybersecurity and solid state storage. The market rewarded Mercury for this highly strategic, accretive acquisition by bidding shares up. We retain conviction as Mercury has a large and visible backlog and, we believe, has the potential to grow at more than double the rate of its peers and is an attractive takeout target.

  • Mellanox Technologies Ltd. supplies semiconductor-based interconnect solutions and services. Strong Q4 results re-instilled investor confidence in Mellanox’s ability to grow profitably. In addition, the completion of its EZchip acquisition and adjusted guidance laid out a strong financial case for this combination. We view Mellanox’s Ethernet business as a significant open ended opportunity. We expect Mellanox to be a high-end market leader and protect its high margin business model with strong innovation and product leadership.

Detractors (for quarter ended 3/31/2016)
  • Shares of JUST EAT plc, the leading online food takeout marketplace in Europe, Latin America, and Canada, were down in Q1 despite reporting second half of 2015 results that beat analyst estimates. Potential entry by Uber into restaurant delivery in the U.K., JUST EAT’s largest market, is driving heightened competitive concerns. We believe JUST EAT competes in a different market segment from Uber and other delivery-oriented companies. We think JUST EAT is the leader in a winner-take-most/all business that will not be meaningfully disrupted by new competitors.

  • Pacira Pharmaceuticals, Inc. is a specialty pharmaceutical company that sells a drug for local surgical analgesia (an anesthetic) called EXPAREL. At the end of the third quarter of 2015, Pacira received a favorable resolution of certain FDA issues, and we re-established our investment at the lower levels caused by the prior regulatory uncertainty. In our opinion, shares were down in Q1 due to the general negative industry dynamics around pharmaceutical companies.

  • Shares of ClubCorp Holdings, Inc., an operator and manager of golf courses across the U.S., declined in Q1 due to concerns that lower oil prices would hurt business at its golf clubs that serve Texas, which comprise 35% of its EBITDA. However, other than a slight impact on its Houston clubs, ClubCorp has seen no impact from lower oil prices on either member churn rate or spend to date, and we retain conviction. ClubCorp also initiated a buyback program on its shares.

Quarterly Attribution Analysis (for quarter ended 3/31/2016)

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 Discovery Fund fell 4.23% in the first quarter, yet outperformed the Russell 2000 Growth Index by 45 basis points due to stock selection.

Health Care, Information Technology (IT), and Financials investments were the largest contributors to relative performance. Within Health Care, outperformance of the Fund's biotechnology holdings, led by TESARO, Inc., and lower exposure to this lagging sub-industry contributed 269 basis points to relative results. Oncology company TESARO outperformed after being added early in the quarter. Investments in ExamWorks Group, Inc. and Inogen, Inc. also added value after their stock prices increased by double digits. Strength in IT was partly attributable to outperformance of semiconductor holdings M/A-COM Technology Solutions Holdings, Inc. and Mellanox Technologies, Ltd. and larger exposure to this better performing sub-industry. Mellanox was the third largest contributor on an absolute basis, while MA-COM’s shares rose as the company executed its strategy to gain share in key markets. Mercury Systems, Inc., the second largest contributor to absolute results, and laser manufacturer Coherent, Inc. also contributed to relative performance in the IT sector. Coherent’s shares performed well after announcing large orders for flat panel display equipment, and the acquisition of a competitor to help strengthen its position in the $1.25 billion fiber laser market. The Fund's Financials holdings consisted mostly of REITs; and several of these investments outperformed, led by Education Realty Trust, Inc., Rexford Industrial Realty, Inc., and American Assets Trust, Inc. All three were bolstered by solid earnings results. Larger exposure to REITs, which rose 10.9% in the index, also lifted relative results.

Investments within the Industrials, Materials, and Consumer Discretionary sectors were the primary detractors from relative performance. Weakness in Industrials was partly attributable to the underperformance of CaesarStone Sdot-Yam Ltd. and industrial machinery holdings, led by NN, Inc. We exited our position in quartz countertop manufacturer CaesarStone on concerns around delays in the production ramp of a new manufacturing facility. We sold out of NN due to the company’s elevated leverage, high debt costs, and uncertainty surrounding the integration of a large acquisition. Lack of exposure to transportation-related stocks, which were up double-digits in the index, also hampered relative performance. Underperformance of the Fund's sole Materials holding, Flotek Industries, Inc., and its lower exposure to this outperforming sector hurt relative results. Shares of Flotek, which supplies chemical additives to the global oil & gas industry, fell due to the sharp decline in drilling and completions activity. Within Consumer Discretionary, underperformance of Habit Restaurants, Inc. and ClubCorp Holdings, Inc. detracted the most from relative results, but this negative impact was somewhat offset by larger exposure to this outperforming sector. ClubCorp was the third largest detractor from absolute results. Shares of restaurant operator Habit fell due to heightened concerns around promotional activity.

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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.