Review and Outlook
During a period marked by increased volatility, the U.S. stock market ended the fourth quarter higher. In a reversal of the prior three quarters, small cap stocks outperformed mid and large cap stocks. We are confident that stocks of smaller, faster growing companies once again will return to favor, and we think the results of the fourth quarter may indicate that time is approaching, although we cannot predict exactly when, how, or if it will happen. In addition, in the wake of an underperforming year, during which many small cap stocks nevertheless had strong growth, we believe these companies offer unusually attractive values at this time.
The freefall in oil prices dominated business headlines. Domestic (WTI) oil prices fell over 40% in the quarter, driven down by slower global demand growth and rising oversupply. The price of crude oil dropped to $53 per barrel as of year-end, down almost 50% from its June high and the lowest level since May 2009.
Domestically, generally positive economic reports supported the view that the U.S. economy is accelerating, outpacing much of the rest of the developed world. Unemployment was down, average hourly earnings increased, and consumer confidence rose. Higher-than-expected automobile sales and construction spending bolstered the recovery narrative.
Baron Focused Growth Fund increased in the fourth quarter. Information Technology (IT), Consumer Discretionary, and Materials contributed the most. Industrials and Energy detracted. IT performance was led by CoStar Group, Inc. and FactSet Research Systems, Inc., in the general context of a rebound in high-growth technology stocks. Consumer Discretionary performance was boosted by CarMax, Inc. Sporting goods retailer Dick’s Sporting Goods, Inc., also had a strong quarter, rebounding after a weak start to the year. CaesarStone Sdot-Yam Ltd. lifted performance of the Materials sector. A strong earnings beat and management’s optimistic outlook drove up shares of this quartz countertop manufacturer. The pullback in Industrials was due primarily to the weak performance of Colfax Corp. The steep drop in oil prices weighed on the performance of the Fund’s sole Energy holding, Helmerich & Payne, Inc., which the Fund exited during the quarter.
We think oil prices may remain relatively low in the near term and possibly longer. In our view, this is a positive for the U.S. economy and non-energy U.S. stocks. Energy-intensive businesses will have lower energy costs, resulting in higher cash flow, and consumers will have more disposable income.
We view the current low price of oil as an opportunity to explore new and additional investments in companies affected by the price of oil. We are studying companies in energy-intensive industries, such as airlines, cruise lines, and automotive companies, as well as businesses that benefit from increased activity in those industries, such as travel-related businesses. Given the anticipated increase in disposable income, we are also researching additional businesses in the Consumer Discretionary sector, which has historically been a major focus for us. We see these and many more opportunities for 2015, especially in what we believe to be a favorable investment environment.
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.
The Baron Focused Growth Fund (Retail Shares) gained 4.51% in the fourth quarter, yet trailed the Russell 2500 Growth Index by 298 basis points due to stock selection.
Outperformance of the Fund’s investments within Information Technology (IT) and Materials, and its lower exposure to the lagging Energy sector, which tumbled 29.1% in the index amid declining oil prices, contributed the most to relative performance. The Fund’s IT holdings are exclusively invested in the Internet software & services and application software sub-industries; and these positions meaningfully outperformed in the quarter, led by CoStar Group, Inc., FactSet Research Systems, Inc., Benefitfocus, Inc., and Guidewire Software, Inc. CoStar and FactSet were two of the Fund’s largest contributors on an absolute basis. Shares of Benefitfocus, the leading provider of cloud-based benefits software, increased on strong financial results, confidence around the company’s cash requirements, and, we believe, recognition that its shares were undervalued. Shares of Guidewire, the gold standard of property & casualty systems, rose in the quarter, helped by strong financial performance and wins at top insurers. Within Materials, outperformance of the Fund’s largest holding in the sector, CaesarStone Sdot-Yam Ltd., added the most value. Shares of CaesarStone, a leading manufacturer of engineered quartz surfaces used for kitchen and bathroom countertops, increased by over 16%, driven by strong quarterly earnings that beat Street expectations and management’s positive outlook.
Underperformance of the Fund’s investments within the Consumer Discretionary, Industrials, and Financials sectors and its lack exposure to Health Care, which was the best performing sector in the index during the quarter, detracted the most from relative results. Tesla Motors, Inc. and Hyatt Hotels Corp detracted the most from relative results in the Consumer Discretionary. Tesla was also the largest detractor on an absolute basis. Hyatt’s shares fell slightly in the quarter due to lower margins at two Asian properties. Other detractors from relative performance in the sector were Pinnacle Entertainment, Inc., a regional casino company, and Manchester United plc, an English Premier League professional sports team. We believe shares of Pinnacle declined due to a proposed equity offering, the proceeds of which would be used to pay down debt, while shares of Manchester United were down due to a secondary offering. The Fund exited its position in Pinnacle during the quarter. Weakness in the Industrials sector was largely attributable to the underperformance of Colfax Corp., one of the Fund’s largest detractors on an absolute basis, and Genesee & Wyoming, Inc., a leading short-line railroad. Shares of Genesee & Wyoming were hurt by commodity-related issues and rail congestion, both of which we believe will be temporary. Within Financials, the underperformance of The Carlyle Group, an alternative asset manager, hurt relative results. Carlyle’s shares fell after lower investment realizations resulted in a lower dividend payout, and lower performance fees caused a sharp drop in distributable earnings.
Yearly Attribution Analysis
The Baron Focused Growth Fund (Retail Shares) increased 2.35% for the year, yet underperformed the Russell 2500 Growth Index by 470 basis points, due to a combination of stock selection and sector weightings.
The Fund’s lower exposure to the Energy sector, which dropped 25.7% in the index, and outperformance of its investments within Information Technology (IT) and Telecommunication Services contributed the most to relative results. Strength in IT was mostly attributable to the outperformance of the Fund’s application software holdings, which increased 31.1% as a group, led by Concur Technologies, Inc. and FactSet Research Systems, Inc. Concur’s shares rose sharply after SAP announced an agreement to acquire the company, and shares of FactSet increased after the company’s organic growth rate and customer and seat count additions accelerated. Another contributor to relative performance in the sector was Zillow, Inc., the leading U.S. online real estate site. Zillow’s shares were up as the company beat expectations each quarter, and spent more on building brand awareness. Within Telecommunication Services, outperformance of the Fund’s only holding in the sector, Iridium Communications, Inc., added value. The company was also one of the Fund’s largest contributors to absolute performance.
The Fund’s lower exposure to the top performing Health Care sector and underperformance of its investments within the Industrials, Consumer Discretionary, and Financials sectors detracted the most from relative results. Each of the Fund’s Industrial investments underperformed, led by Colfax Corp, which had a weak second half, and Genesee & Wyoming, Inc. Within Consumer Discretionary, a combination of stock selection and the Fund’s significantly larger exposure to this lagging sector hampered relative performance. The Fund’s Consumer Discretionary holdings trailed their counterparts in the index by 327 basis points, led by declines in the shares of Tesla Motors, Inc., AO World plc, and Dick's Sporting Goods, Inc. The Fund purchased shares of electric vehicle (EV) manufacturer Tesla late in the third quarter, and we believe the stock declined subsequently on investor views that significantly lower oil prices would make EVs less attractive. AO World was one of the Fund’s largest detractors from absolute performance during the year. Shares of Dick’s, a sporting goods retailer, declined as a result of weakness in its hunting and golf businesses. Within Financials, underperformance of the Fund’s largest holding in the sector, The Carlyle Group, detracted the most from relative results.
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