Review and Outlook
U.S. stock markets experienced significant volatility in the first quarter. Driving the volatility: concerns over interest rates, the strong dollar, declining oil prices, mixed domestic economic data, and corporate earnings disappointments. While gains were moderate overall, small and mid caps did better than large caps. The Russell 2500 Growth Index gained 7.44%, while large cap indexes were flat to slightly up.
After declining more than 40% in the fourth quarter, oil prices dipped another 11%, ending the first quarter at $48 per barrel. The decline in the price of oil since June 2014 has translated to significant savings for the U.S. economy.
On March 18, the Federal Open Market Committee removed forward guidance that they would be “patient” on hiking rates. Analysts are now predicting the first rate hike sometime later this year. Elsewhere, banks moved in the opposite direction. This divergence caused the U.S. dollar to surge.
Domestic economic reports were mixed. The unemployment rate dropped to 5.5%, a post-recession low. GDP growth remained subdued at 2.2% in the fourth quarter. Corporate profits were also mixed. While foreign profits declined 5.3% in 2014, domestic profits rose slightly, reaching a record high in the fourth quarter. This trend favored domestically focused smaller cap companies.
Baron Focused Growth Fund increased in the quarter. Information Technology (IT), Consumer Discretionary, and Financials contributed the most. Industrials and, to a lesser degree, Telecommunication Services detracted. IT gained on the strong performances of the Fund’s four sector holdings, including the second biggest contributor to performance, FactSet Research Systems Inc. Consumer Discretionary advanced on gains in Vail Resorts, Inc., and Choice Hotels International, Inc., the Fund’s biggest and third biggest contributors to performance. Financials had a strong quarter with increases in the Fund’s three sector holdings, including top five contributor Financial Engines, Inc. Shares of Financial Engines, a service provider to defined contribution plans and individual investors, increased on reports of advancement in its product offerings, outreach/marketing, and client base; and the addition of a $150 billion plan provider in Q4. Weakness in Colfax Corp. and Fastenal Company, the second and third biggest detractors from performance, pressured the Industrials sector. Both companies grappled with headwinds from declining oil prices and a stronger dollar.
We think the trend in the past two quarters favoring small and mid cap companies will continue, in part due to the persistence of low oil prices and a strong dollar. We believe conditions will also favor our style of fundamental investing, as well as companies in sectors and sub-industries such as airlines, cruise lines, automotive companies, and hotels & resorts.
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 (Institutional Shares) increased 3.48% in the first quarter, yet underperformed the Russell 2500 Growth Index by 396 basis points. During the quarter, the Fund’s relative sector weights and, to a lesser extent, stock selection detracted from relative performance.
The Fund’s investments within Information Technology (IT) and Financials were the largest contributors to relative performance. Within IT, the Fund’s two Internet software & services holdings, Benefitfocus, Inc. and CoStar Group, Inc., outperformed their peers in the index by 917 basis points. Shares of Benefitfocus, a leading provider of cloud-based benefits software, increased double-digits due to robust financial results, a strong 2015 outlook, and a strategic investment from Mercer, which acquired a 10% stake in the company. Shares of CoStar Group, Inc., an information and marketing services provider to the commercial real estate industry, rose as a result of solid financial results and strong synergy potential from the acquisition of Apartments.com. Another key contributor on an absolute and relative basis in the sector was FactSet Research Systems, Inc. Strength in Financials was mainly due to the outperformance of Financial Engines, Inc., a service provider to defined contribution plans and individual investors. Shares of Financial Engines increased after the company continued to show advancement in its product offerings, outreach/marketing and client base.
Underperformance of the Fund’s investments within the Consumer Discretionary and Industrials sectors, its lack of exposure to Health Care, which was the top performing sector in the index during the quarter, together detracted 420 basis points from relative results. Weakness in Consumer Discretionary was largely attributable to the underperformance of the Fund’s largest holdings in the sector, Tesla Motors, Inc. and Hyatt Hotels Corp. Tesla was the Fund’s largest detractor from absolute performance, while shares of Hyatt fell slightly as the company generated lower-than-expected unit growth in its fiscal fourth quarter. Supply concerns at two of its international hotels also hurt margins and EBITDA at its owned properties. Manchester United plc was another detractor from relative performance in the sector; its shares remained unchanged due to uncertainty around the club’s ability to qualify for Champions League in the 2015/2016 season. Within Industrials, underperformance of Colfax Corp. and Fastenal Co. detracted the most from relative performance. These companies were also the Fund’s second and third largest detractors on an absolute basis.
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