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 6/30/2016)

After a volatile first quarter, much of the second quarter was relatively uneventful until late June, when the U.K. voted to exit the European Union. Even with the volatility that followed “Brexit,” U.S. equity markets ended the quarter mostly higher. Positive momentum was helped by a steady increase in oil prices. Although we are still in the midst of an oil glut, production has begun to fall as tight credit markets are forcing oil companies to cancel or delay exploration and new production projects.

Persistent low oil prices over the last two years have resulted in an energy depression and industrial recession in the U.S. Corporate earnings have now declined for four consecutive quarters, largely due to declines in energy company earnings. Outside of energy and energy-related industries, we believe the U.S. economy is improving. Bank loans are up. In accord with Federal Reserve Chairman Janet Yellen’s recent commentary, we think interest rates will remain low for an extended period. Employment is strong and wages are climbing. Housing prices are increasing. Retail sales improved in the second half of the quarter and consumer confidence rose. With weak conditions abroad, international investors are turning to U.S. equity markets.

Baron Focused Growth Fund increased in the quarter. Holdings in Information Technology (IT), Telecommunication Services, and Consumer Staples contributed the most to performance. Consumer Discretionary, Financials, and Industrials were the top sector detractors. IT increased on strong performances of top contributors CoStar Group, Inc. and Benefitfocus, Inc. Telecommunication Services benefited from a strong showing by the Fund's only sector holding, satellite communications company Iridium Communications Inc. Consumer products company Church & Dwight Co., Inc. lifted performance of the Consumer Staples sector. While performance was mixed among Consumer Discretionary investments, detractors outweighed contributors. The sector include two top detractors:  Tesla Motors, Inc. and Choice Hotels International, Inc. Financials lost ground due largely to the weak performance of Financial Engines, Inc., the second biggest detractor in the quarter. A stock drop in industrial supplies distributor Fastenal Company weighed on performance of the Industrials sector.  

While we think the domestic economy is strengthening, “Brexit,” terrorism, China’s economy, and other events abroad, as well as recent civil unrest in the U.S., are creating uncertainty. Investing for growth is investing in the future, and when the future seems uncertain, investors tend to exit growth stocks. Subdued IPO activity and negative interest rates on sovereign debt is further evidence of uncertainty. Investor flight to the perceived safety of value stocks has caused the recent contraction in the stock prices of many growth stocks, despite the strong fundamentals and continued growth of these companies. Value stocks outperformed growth in the period and growth stocks now have earnings multiples below 20-year averages while value stocks in all categories have multiples above 20-year averages. For growth investors like us, this creates investment opportunities.

Top Contributors/Detractors to Performance

Contributors (for quarter ended 6/30/2016)
  • Shares of CoStar Group, Inc., a real estate information and marketing services company, increased on outstanding financial results. Revenue growth accelerated to 25%, margins expanded 14% year over year, and earnings almost tripled. CoStar grew in its core commercial real estate market and captured share in the multifamily space. We believe CoStar is poised to generate accelerating organic revenue growth and significant margin expansion as it leverages recent investments in sales headcount, product expansion, and multifamily marketing.

  • Shares of benefits software vendor Benefitfocus, Inc. contributed to second quarter performance, driven by outstanding financial results. The company generated traction in new logo acquisition and cross-sales of new modules, including BenefitStore. Profitability also continues to scale ahead of expectations, and the company now expects to reach EBITDA breakeven in 4Q16. We believe Benefitfocus can continue to compound revenue at a low-to-mid 30% rate and generate substantial profitability over time.

  • Shares of FactSet Research Systems, Inc., a leading provider of investment management tools, rose in Q2 on favorable investor reaction to stronger equity markets. FactSet’s financial results demonstrated consistent and accelerating market share gains. The company grew its annual subscription value by 9.5% and user base by more than 10.6%, well ahead of average market growth rates. The company also aggressively returned capital to shareholders, repurchasing almost $250 million in stock over the last year.

Detractors (for quarter ended 6/30/2016)
  • Shares of electric vehicle company Tesla Motors, Inc. fell during Q2, driven down by concerns over dilution from recent equity financing and the complex Model X ramp and execution risk. The market also appeared skeptical of Tesla’s announced intent to buy Solar City. We feel good about the brand Tesla has built and its execution on two top-of-the-line cars. Tesla has received over 370,000 reservations for the Model 3, representing nearly $18 billion in backlog. We are still evaluating the potential implications of a Tesla/Solar City deal.

  • Shares of Financial Engines, Inc., a service provider to retirement plan participants, declined in Q2. The company has seen a slowdown in new assets under contract and has yet to see successful results from its revamped marketing campaign and increased advisor hours. Additionally, investors appear skeptical that the acquisition of The Mutual Fund Store will materially impact enrollment rates. We believe the acquisition is only now being integrated and will add to assets under management and double the addressable market over time.

  • Shares of Choice Hotels International, Inc., the largest hotel franchisor in the U.S., fell in Q2 due to slowed growth in revenue per available room (RevPAR) and unit growth that slightly missed Street estimates. While we agree RevPAR trends are a concern, Choice’s revenue is fee-driven and therefore less impacted by RevPAR than franchisees. We believe Choice will continue to generate strong cash flow and use it to repurchase shares, issue dividends, and invest in its new higher-end Cambria brand and vacation rental business.

Quarterly Attribution Analysis (for quarter ended 6/30/2016)

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 1.37% in the second quarter, yet trailed the Russell 2500 Growth Index by 133 basis points, primarily due to relative sector weights.

Information Technology (IT) and Consumer Staples investments and larger exposure to the outperforming Telecommunication Services sector contributed the most to relative results. Within IT, outperformance of Internet software & services holdings CoStar Group, Inc. and Benefitfocus, Inc. and meaningfully larger exposure to this strong performing sub-industry added the most value. CoStar and Benefitfocus were the two largest contributors on an absolute basis. Lack of exposure to lagging semiconductor stocks and outperformance of Guidewire Software, Inc. also aided relative results. Shares of property and casualty insurance software vendor Guidewire increased as the company continued to enjoy near-perfect retention rates, a growing installed base, and accelerating adoption. Strength in Consumer Staples was due to the outperformance of the Fund’s only holding in the sector, Church & Dwight Co., Inc. The company experienced pricing and volume growth in many categories and continued to take market share. It was also rumored to be an acquisition candidate.

Consumer Discretionary, Financials, and Health Care investments were the largest detractors from relative results. Within Consumer Discretionary, meaningfully larger exposure to this poor performing sector and underperformance of Tesla Motors, Inc. and Choice Hotels International, Inc. detracted the most from relative results. Tesla and Choice were two top detractors from absolute performance. Investments in global hotelier Hyatt Hotels Corp. and sporting goods retailer Dick's Sporting Goods, Inc. also hampered relative performance. Hyatt shares declined due to industry-wide decelerations in revenue per available room and group bookings, which comprise 45% of Hyatt’s domestic revenue. Shares of Dick’s fell over investor concern that the liquidation of inventory by recently bankrupt competitors will put pressure on near-term sales and margins. We exited our position. Weakness in Financials was mainly due to the underperformance of Financial Engines, Inc., the second largest detractor on an absolute basis, and Virtu Financial, Inc., a leading electronic trading firm and market maker. Virtu’s shares fell after reporting weak Q1 financial results as the company faced a tough comparison against last year when high volatility from the Swiss Franc de-pegging caused higher volumes and wider spreads. Underperformance of the Fund’s only Health Care holding, Inovalon Holdings, Inc., and lack of exposure to the better performing health care equipment and services sub-industries hurt relative results. Shares of Inovalon, a health care data and analytics vendor, declined after financial results fell short of Street expectations.

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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.