Review and Outlook
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
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 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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