Review and Outlook
Baron Energy and Resources Fund posted strong performance again during the third quarter. Following the greater than 17% gain in the second quarter, the Fund rose by another 9.9% and outpaced its benchmark – the S&P North American Natural Resources Sector Index – by 566 basis points. Following the Fund’s gains for the quarter, we are now within less than 100 basis points of our benchmark on a year-to-date basis, a big change from the Fund’s greater than 1,000 basis point relative deficit that we had at the end of the first quarter of this year.
Through the second quarter, the recovery in the Fund’s performance had largely coincided with the recovery in oil prices. However, in the third quarter, oil prices were essentially flat and yet the Fund’s Energy holdings generated a total return of 11.24% and outperformed the Energy holdings in our benchmark by 644 basis points. It is our view that because of our focus on growth oriented small-cap and mid-cap energy and resource companies, our Fund is structured to perform better in flat or rising oil and gas price environments than falling price environments, and this has clearly been borne out over the past several years. This is what we saw in the third quarter as it became increasingly clear that Energy’s two-year long recession had come to an end. While sharply rising oil prices in the second quarter provided a tailwind for the Fund, prices were flat in the third quarter and our Energy investments still posted solid gains and outperformed the benchmark as noted above.
Based on a combination of industry indicators such as oil and gas inventories, oil and gas supply and demand trends, commodity prices, and drilling rig and well completion activity, we believe that the first half of 2016 will be seen as the bottom of the recession for this industry, and that conditions are in place for fundamental longer-term recovery. We believe that such a recovery will result in a return to more normalized oil and gas prices, which we view as the price level necessary for industry participants to earn returns that are close to the cost of capital and are higher than current futures prices. A return toward normalized price levels should allow many of the companies in our portfolio to realize both cyclical and secular growth in earnings and cash flows over the next several years.
Despite the clear signs that the Energy sector’s recession has come to an end, investor surveys continue to show that institutional investors remain underweight relative to historical norms. We think this means that there is still a significant amount of capital remaining on the sidelines that could be put to work in the areas in which the Fund invests.
We continue to be positive on the outlook for investing in the Energy sector, which is the dominant portion of the Fund’s holdings (80.5% at quarter end).
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 Energy and Resources Fund rose 9.89% in the third quarter and outperformed the S&P North American Natural Resources Sector Index by 566 basis points, due to a combination of stock selection and relative sector/sub-industry weights. Smaller cap energy stocks outperformed for a second consecutive quarter, and the Fund’s bias towards these companies also aided relative performance.
Energy and Materials investments added the most value, while no sectors materially detracted from relative performance. Within Energy, outperformance of oil & gas exploration & production (E&P) holdings, led by Parsley Energy, Inc., Encana Corp., Concho Resources, Inc., and Rice Energy Inc., and larger exposure to this strong performing sub-industry contributed 309 basis points to relative results. Parsley, Encana, and Concho were the three largest contributors to absolute results, while shares of Rice, an independent E&P company focused on the Marcellus and Utica shales in Pennsylvania and Ohio, rose after the company raised production guidance, significantly lowered cash costs, and increased drilling activity without changing its capital budget. Lack of exposure to poor performing large-cap stocks in the integrated oil & gas sub-industry and outperformance of U.S. Silica Holdings, Inc. in the oil & gas equipment & services sub-industry also added value in the Energy sector. Shares of U.S. Silica, one of the largest low-cost suppliers of sand used as a proppant for the hydraulic fracturing of oil and gas wells, outperformed following the announcement of two strategic acquisitions. The overall uptick in drilling activity during the quarter also bolstered U.S. Silica’s stock price. Within Materials, outperformance of specialty chemicals holdings Flotek Industries, Inc. and Kraton Corporation and lower exposure to lagging gold stocks, which fell 8.4% as a group within the index, lifted relative results. Flotek’s shares rallied sharply following strong sales of the company’s proprietary product, complex nano-fluid, while shares of Kraton rose after investors reacted favorably to management’s long-term plan to achieve cost reductions and synergies from the Arizona Chemical acquisition.
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