Review and Outlook
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
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 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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