Review and Outlook
U.S. stock markets were unusually volatile during the three months ended September 30, 2015. Most indexes fell sharply, with small caps performing worse than large and mid cap stocks. The small cap Russell 2000 Growth Index lost 13.06% in the third quarter.
Baron Discovery Fund declined by 19.80% in the third quarter. Materials was the only sector to contribute to performance. Health Care, Information Technology (IT), and Industrials were the largest detracting sectors in the quarter. Materials gained on an increase in the share price of Flotek Industries, Inc., which was the Fund’s top contributor in the quarter. The Health Care sector experienced a broad-based decline late in the quarter, led by the health care supplies and biotech sub-industries. Biotech plunged after Hillary Clinton released a proposal to lower drug costs. Comments from the Federal Reserve suggesting it would raise interest rates by year end and concerns over possible cuts or delays in government spending on health care also negatively impacted the sector. IT also experienced a broad-based decline as investors exited high-growth, high-multiple stocks for more defensive sectors and asset classes. The decline of the Industrials sector was led by the third biggest detractor from performance, CaesarStone Sdot-Yam Ltd.
We continue to see a choppy macro environment which is something we have been calling out since Q3 of last year. While we had hoped to see more improvement in the economy by this point, the reality is that the economic data has not meaningfully improved. That being said, while we are mindful of the macro-economic landscape, we are primarily driven by the prospects of the individual companies that we own in the portfolio. On that front, we remain more upbeat based on the conversations we have had with our companies. We believe that many of our companies have the potential to grow through economic choppiness.
While the year-to-date performance has been disappointing, we continue to stay focused on “discovering” the next great growth company. We do not think that the more recent performance of the Fund is indicative of our potential to accomplish that goal over the longer 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 declined 19.80% in the third quarter and trailed the Russell 2000 Growth Index by 674 basis points. During the quarter, stock selection was the primary driver of underperformance due mostly to companies that missed earnings expectations. While we are disappointed in the results, we believe the majority of these earnings misses are temporary and not reflective of the long-term fundamentals and growth prospects of these businesses.
Materials and Financials investments and average cash exposure of 5.7% in a down market were the largest contributors to relative performance. Strength in Materials was mostly attributable to the outperformance of Flotek Industries, Inc., the largest contributor on an absolute basis. Within Financials, larger exposure to REITs, which rose 3.7% in the index after the Federal Reserve decided to leave interest rates unchanged, added the most value. Hotel & resort REIT Strategic Hotels & Resorts, Inc. also lifted relative performance after Blackstone agreed to acquire the company. Energy investments also added value after outperforming their index counterparts by 10.0%, but this positive effect was mostly offset by slightly larger exposure to this lagging sector.
Underperformance of Health Care, Information Technology (IT), and Industrials investments detracted the most from relative performance. Weakness in Health Care was mainly due to the underperformance of health care supplies holdings, which fell 50.8%, led by The Spectranetics Corporation and Sientra, Inc. These holdings were the two largest detractors from absolute and relative performance. AAC Holdings, Inc. and BioScrip, Inc. also hurt relative performance before the Fund exited both positions. Biotechnology holdings also weighed on relative performance, but this negative effect was mostly offset by meaningfully lower exposure to this lagging sub-industry. Within IT, systems software holdings underperformed after falling 37.0%, with Barracuda Networks, Inc. and Varonis Systems, Inc. leading the decline. Shares of Barracuda, a security and storage software company, fell after management again failed to meet internal growth targets due to slower growth and intensifying competition. We exited our position. Underperformance of Internet software & services holdings, led by Amber Road, Inc., and lack of exposure to better performing application software and data processing & outsourced services sub-industries also hampered relative performance. Shares of Amber, a trade management software company, fell after management again cut guidance for 2015. We believe revenue growth has the potential to get back on track. Within Industrials, underperformance of CaesarStone Sdot-Yam Ltd. and DigitalGlobe, Inc. detracted the most from relative results. CaesarStone was the third largest detractor on an absolute basis, while shares of satellite imagery provider Digital Globe declined due to concerns about potential competitors.
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