Baron Discovery Fund (BDFIX)

Portfolio Management

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

3Q16 Quarterly Letter

Portfolio Commentary

Institutional Performance

Review and Outlook (for quarter ended 9/30/2016)

We were pleased with the performance of Baron Discovery Fund in the third quarter and year to date. We have been pleased with our performance during both up and down markets, although we still believe our smaller cap bias will tend to perform relatively better in up markets versus severe down markets. We balance the portfolio between higher growth, earlier-stage businesses and companies that are more established, predictable, and stable, with solid cash flow.

We saw some trends that carried over from the prior quarter. First the merger and acquisition environment has picked up. Three of the Fund’s companies agreed to be acquired in the quarter: Press Ganey, Cepheid, and Isle of Capri Casinos. We believe many of our companies make ideal acquisition targets for the same reasons we invest in them – they are fast growing companies with long-term competitive advantages. Second, multiples for the Fund’s faster growing companies have remained at the upper end of historical norms due to the scarcity of growth in a stagnant U.S. economy. Finally, we are still benefiting from the salutary effects of balancing the portfolio with a combination of established but still growing businesses with cash flow and exciting, earlier stage, high growth companies with large opportunities.

Information Technology (IT), Health Care, and Consumer Discretionary were the top sector contributors. Consumer Staples was a minor detractor as investors exited defensive sectors in the quarter. IT had a strong quarter. The sector included the top three contributors to Fund performance: Impinj, Inc.; MACOM Technology Solutions Holdings, Inc.; and Qualys, Inc. Ten IT holdings experienced double-digit increases in share price and one holding (Impinj) increased by triple digits in the quarter. Despite having the top three detractors in the quarter, Health Care contributed as double-digit increases in 14 holdings significantly outweighed declines elsewhere within the sector. Positive performance was led by Cepheid, which agreed to be acquired by Danaher in early September. With share prices increases in 10 out of 13 investments, Consumer Discretionary contributed in the quarter. Wingstop Inc., operator and franchisor of the Wingstop chain of fast casual restaurants, led positive performance. Shares rose on an earnings beat, an increase in full-year guidance, and operating outperformance relative to most peers experiencing declines in traffic.

September 30 marked the Fund’s three-year anniversary. We would like to reiterate the core principles as set out when we first launched the Fund and continue to guide and inform us in managing the Fund:  We use the investment process used in all Baron Funds – we seek high growth companies with terrific managers and long-term competitive advantages. We also seek to purchase these companies at what we believe are reasonable stock prices. We also take a longer-term view than most other investment managers. We believe that by analyzing the investment over a longer term horizon, we can gain an advantage over most market participants who are focused only on the short term.

Top Contributors/Detractors to Performance

Contributors (for quarter ended 9/30/2016)
  • Impinj, Inc. is the global leader in radio-frequency identification devices used to connect physical items to the digital world, helping customers increase sales, reduce costs, and improve efficiency. Impinj had a strong Q3 as a result of accelerating adoption across industries and use cases. We retain conviction because we believe Impinj has a long runway for growth, accelerating adoption, and significant barriers to entry given the high cost and complexity of designing and building a comparable chip.

  • MACOM Technology Solutions Holdings, Inc. designs and manufactures analog semiconductors for industrial, military, and communications end markets. Shares were up in Q3 as the company continued to execute on its strategy to expand in a number of large target markets, including optical networking, which is starting to accelerate as the technology penetrates metro and datacenter markets; radar technology, including upgrades to F-16 fighters and civilian weather and air traffic control systems; and cellular base station power amplifiers.

  • Shares of cloud security company Qualys, Inc. contributed in Q3 as the company continued to execute on its growth plan and reported good growth and profitability in Q2. Increasing investor confidence around its new CFO also helped lift the share price. We view Qualys as a stable growth company with a sustainable and profitable business model. We like the balanced approach management has been taking to growth and profitability and view new product opportunities as a potential for expansion of its market opportunity.

Detractors (for quarter ended 9/30/2016)
  • TherapeuticsMD, Inc. is developing drugs that address the multi-billion dollar hormone replacement market. Shares dropped in Q3, although we believe that this dip was entirely related to trading, as its fundamentals remain strong. During the quarter the company made substantial progress on the commercialization of its first drug, Yuvexxy, which is slated for potential approval in May 2017. We believe the company is developing unique drugs for a massive potential market, and expect its second drug for menopause will be approved in 2018.

  • Neos Therapeutics, Inc. is a specialty pharmaceutical company developing orally dissolving extended release versions of ADHD medications (Adderall and Ritalin). Its first product is launching and prescriptions are ramping nicely, but slow news flow and lack of booked revenue (a typical dynamic early in a drug launch) weighed on the stock price in Q3. We expect this dynamic to improve in coming months where efforts should be bolstered by Neos’s second launch, and we added to our shares on weakness.

  • Shares of American Renal Associates Holdings, Inc., a provider of kidney dialysis services, declined in Q3. A lawsuit alleging that American Renal was attempting to maximize reimbursement by counseling patients out of government health plans and into higher paying commercial insurance pressured the stock price in the quarter. The Department of Health and Human Services announced an investigation into the practice as well. We decided to exit our position.

Quarterly Attribution Analysis (for quarter ended 9/30/2016)

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 rose 15.38% in the third quarter and outperformed the Russell 2000 Growth Index by 616 basis points, mainly due to stock selection.

Outperformance of investments in Information Technology (IT), Consumer Discretionary, Health Care, and Financials contributed the most to relative results. Within IT, outperformance of semiconductors holdings Impinj, Inc. and MACOM Technology Solutions Holdings, Inc. and larger exposure to this strong performing sub-industry added the most value. Impinj and MACOM were the two largest contributors to absolute performance. Outperformance of Internet software & services investments, led by Amber Road, Inc. and The Trade Desk, and larger exposure to this better performing sub-industry lifted relative results. Shares of Amber Road, a software-as-a-service company that streamlines the import/export processes of goods, increased as management continued to build orders in excess of expectations. Shares of Trade Desk, which operates a self-service platform that enables ad buyers to purchase and manage data-driven digital ad campaigns, rose sharply after the company’s September IPO. Greater exposure to the outperforming systems software sub-industry through investments in Qualys, Inc. and Varonis Systems, Inc. aided relative results. Strength in Consumer Discretionary was mostly attributable to the outperformance of media holding company Liberty Media Group and fast casual restaurant franchisor Wingstop Inc. Liberty Media’s shares rose on news of the company’s plan to purchase a stake in Formula One Group, while Wingstop’s shares were up on earnings ahead of Street consensus, an increase in full-year guidance, and operating outperformance relative to peers. Within Health Care, outperformance of health care equipment holdings, led by Nevro Corp. and Glaukos Corporation, and larger exposure to this outperforming sub-industry contributed to relative results. Shares of Nevro, which sells an implantable spinal cord stimulation device called Senza, rose after the company beat Street estimates and raised revenue guidance. Shares of Glaukos, the leader in the field of minimally invasive glaucoma surgery, increased after clinical trial results showed improving outcomes as doctors become more skilled with the iStent. Outperformance of investments in the health care supplies, life sciences tools & services, and biotechnology sub-industries also added value, led by Sientra, Inc., Medpace Holdings, Inc., and Cepheid, respectively. Within Financials, outperformance of the Fund’s only sector holding, Kinsale Capital Group, Inc., lifted relative results. Shares of this specialty insurance company focused on the excess and surplus lines (E&S) market, rose following the company’s July IPO.

Larger exposure to the Real Estate sector, which was hurt by the poor performance of REITs, detracted the most from relative results.

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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.