Baron Focused Growth Fund (BFGIX)

Portfolio Management

RonBaron
Ron Baron

Fund Manager since 1996

View All Commentary by Ron

Fund Description

Baron Focused Growth Fund invests in a focused portfolio of small and mid-size growth companies.

    

  

Portfolio Commentary

Institutional Performance

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

After the initial shock of the Brexit vote in late June, the U.S. stock markets settled down in the third quarter, experiencing significantly less volatility than in the first half of 2016. Stable economic data, monetary policy rates that remained relatively unchanged, and the lack of a major disruptive event allayed investor concerns and drove a broad-based rebound during the three-month period ended September 30, 2016.

Investor appetite for risk increased, and stocks (particularly small-cap stocks) rose more or less steadily throughout the quarter. Lower quality stocks outperformed their higher quality counterparts. After mostly underperforming in the first half of the year, risk-on categories such as biotechnology and semiconductors outperformed. On the other hand, defensive sectors retreated after strong performance in the first half of 2016.

Baron Focused Growth Fund increased in the quarter. Holdings in Consumer Discretionary, Financials, and Industrials were the top contributors. Although Consumer Discretionary had a somewhat mixed quarter, contributors outweighed detractors. Positive performance was led by top contributor Vail Resorts, Inc. Professional sports team Manchester United plc also boosted sector performance after shares rose on enthusiasm over the hiring of a new coach and addition of marquee players to the roster. Financials advanced on the strength of second largest contributor Arch Capital Group Ltd. Financial Engines, Inc. also added to sector performance. Shares of this retirement account manager increased on reports of improving metrics across all categories. The Industrials sector benefited from a strong showing by quartz countertop manufacturer Caesarstone Ltd.

Health Care, Telecommunication Services, and Consumer Staples investments detracted. Health Care performance was hampered by top detractor Inovalon Holdings, Inc. Telecommunication Services and Consumer Staples lost ground as investors exited defensive stocks. The Fund’s sole Telecommunication Services investment, Iridium Communications, Inc., was the third largest detractor. Shares of the Fund’s only Consumer Staples company, consumer products company Church & Dwight Co., Inc., fell on reports of decelerations in certain key categories. We believe in the company’s steady growth, cash flow generation, and ability to make accretive acquisitions in new business lines with higher margins and growth rates.

The U.S. economy showed signs of acceleration in the third quarter. Historically, the U.S. stock market has been closely aligned with GDP. In 1960, GDP was $520 billion and the Dow Jones Industrial Average was 600. In 2007, GDP was $14 trillion and the Dow was 14,000. In 2015, GDP was $17.9 trillion and the Dow was 17,000. We think the U.S. economy and the stock market are closely intertwined. Over the past half century or so, our economy and stock market have grown at a compound annual rate between 6-7% in nominal terms. Factoring in annual dividends of about 2-3%, stock prices have approximately doubled every 10 years during the same period. We think our nation’s economy and stock markets will continue to achieve similarly strong results over the long term.

Top Contributors/Detractors to Performance

Contributors (for quarter ended 9/30/2016)
  • Shares of ski resort company Vail Resorts, Inc. increased in Q3 on news that the company had entered into an agreement to acquire Whistler Blackcomb in Canada. Vail owns some of the best ski resorts across North America, including Vail, Beaver Creek, Park City, and now Whistler. The deal gives the company even greater scale, which we think it will be able to leverage in its bid to continue to grow its season pass sales.

  • Arch Capital Group Ltd. is a specialty insurance and reinsurance company. The stock performed well during Q3 on solid quarterly results, with profitable underwriting, modest catastrophe losses, and favorable reserve development. The market also reacted favorably to Arch’s agreement to acquire mortgage insurance company United Guaranty from AIG. This acquisition will make Arch the largest provider of mortgage insurance, a market that we believe has attractive profitability and growth characteristics.

  • Shares of retirement account manager Financial Engines, Inc. increased in Q3. The company reported improving metrics across all categories. Shares also benefited from investor sentiment that the recent integration of its Mutual Fund Store acquisition will help improve the legacy business while allowing expansion into a new channel. New marketing campaigns and advisor seminars appear to be having an early impact as the company reported a drop in cancelations and a slight increase in enrollments.

Detractors (for quarter ended 9/30/2016)
  • Shares of health care data and analytics vendor Inovalon Holdings, Inc. fell in Q3 on weak financial results and reduced guidance through year-end. Management attributed the revenue shortfall to price reductions in its retrospective risk adjustment business, and the margin shortfall to investments aimed at long-term growth. We think the recent poor performance is temporary. Inovalon has high quality products that generate solid ROI for its customers, and we think it is well-positioned to capitalize on the need for robust data and analytics in health care.

  • Shares of electric vehicle company Tesla Motors, Inc. fell during Q3 as the market continued to evaluate the potential merger with SolarCity. An investigation into a fatal accident involving Tesla’s autopilot and the possibility of an additional equity round by year end also pressured the stock. We feel good about the brand Tesla has built and its ability to bring substantial innovation to its products. Tesla has received over 370,000 Model 3 reservations, representing close to $18 billion in backlog and the largest product launch in history.

  • Shares of satellite communications company Iridium Communications Inc. fell in Q3. While the company reported a strong Q2, delays in payments from a customer/subsidiary, Aireon, ignited concerns regarding financing and liquidity. In addition, the SpaceX explosion of a Falcon 9 missile increased the risk of a delayed launch schedule. We see potentially significant cash flows yield for the NEXT constellation launch in 2018 and beyond and look forward to launches later this year.

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 Focused Growth Fund increased 1.05% in the third quarter, yet underperformed the Russell 2500 Growth Index by 593 basis points. During the quarter, stock selection and, to a lesser degree, relative sector weights hurt relative performance.

Lack of exposure to the lagging Real Estate sector, which was hurt by the poor performance of REITs, and outperformance of Consumer Discretionary investments contributed the most to relative results. Strength in Consumer Discretionary, owing to the outperformance of Vail Resorts, Inc. and AO World plc, was overshadowed by significantly larger exposure to this underperforming sector. Vail was the largest contributor on an absolute basis, while shares of AO, the U.K.’s leading online retailer of major domestic appliances, increased double digits after being added to the Fund in July. AO continues to expand rapidly in its core U.K. market, while making further gains in the German market.

Aside from greater exposure to the underperforming Consumer Discretionary sector, investments in Information Technology (IT), Health Care, and Financials detracted the most from relative results. Within IT, underperformance of CoStar Group, Inc., a real estate information and marketing services company, and Guidewire Software, Inc., a leading provider of core systems software to the global P&C insurance industry, hampered relative results. Shares of CoStar fell slightly on modest multiple compression after outperforming in Q2, while Guidewire’s shares declined after earnings guidance was slightly below Street expectations due to an accounting-related deferral that we expect will reverse next year. Lack of exposure to the semiconductors and systems software sub-industries, which were both up more than 25% in the index, also hurt relative results. Within Health Care, underperformance of the Fund’s only position in the sector, Inovalon Holdings, Inc., and lack of exposure to strong performing biotechnology and health care equipment stocks weighed on relative results. Inovalon was the largest detractor from absolute performance. Weakness in Financials was mostly attributable to the underperformance of FactSet Research Systems, Inc., a financial information provider to investment firms, and The Carlyle Group, one of the largest diversified alternative asset managers with approximately $180 billion under management. FactSet’s shares lagged as growth moderated slightly due to choppy end markets, while Carlyle’s shares fell alongside other alternative asset managers as investor concerns about flows and fees pressured the share prices of these companies. Electronic trading firm and market maker Virtu Financial, Inc. also detracted from relative performance in the sector.

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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 advice to any person and are subject to change 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.