Review and Outlook
Following a year of exceptional returns, U.S. stocks remained nearly unchanged in Q1. We believe that three main events weighed on the market: profit taking deferred for tax purposes until the first quarter of 2014, the resumption of "The Cold War" with Russia when that nation annexed Crimea in March, and Congressional testimony by Federal Reserve Chair Janet Yellen regarding the Fed's intent to reduce large scale asset purchases of fixed income securities. We believe the gradual ending of these purchases is an indication that the Fed believes our economy will soon be able to grow at attractive and sustainable rates without its help. This is obviously a good thing.
Several important positive factors in our view offset the negative impact of profit taking and negative news. Most important is the strengthening U.S. economy, with improving housing sales and prices, improving auto sales, expectation of increased domestic energy supplies with resultant lower energy prices, and continued available credit at a historically attractive cost.
Baron Growth Fund's performance was largely flat in the quarter. The best performing sectors on an absolute and relative basis were Industrials, Energy and Utilities, as investors shifted assets into these defensive sectors that are viewed as being comprised largely of more stable, slower growing companies.
The two main sector detractors in the quarter were Information Technology (IT) and Consumer Discretionary. IT was driven down by broad contraction of multiples across the software category, as well as other areas within the sector. The Consumer Discretionary sector saw a volatile quarter as an unusually harsh winter weighed on consumer spending on products and travel and leisure, and a number of our holdings experienced moderate declines.
We initiated a position in The Container Store Group, Inc., a leading specialty retailer of storage and organizational products; and added to our positions in Manchester United plc, an English Premier League professional sports team; and Marriott Vacations Worldwide Corp., a leading timeshare company.
The Big Picture: Stocks remain attractively priced when compared to long-term historical median valuations. In our view, stock prices hedge against loss of purchasing power due to inflation. We think stocks will continue the historic economic growth trend to double in price over the next decade and double again in the following decade. Our goal is to do better. Of course, we cannot guarantee that will be the case.
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 Growth Fund (Retail Shares) increased 0.19% in the first quarter and performed in line with the Russell 2000 Growth Index. During the quarter, the Fund’s stock selection added value, but this positive effect was offset by differences in sector weights relative to the benchmark.
The Fund’s investments within the Industrials, Energy, and Utilities sectors were the largest contributors to relative performance. The majority of the Fund’s investments in the Industrials sector outperformed, led by industrial machinery investments Colfax Corp. and The Middleby Corp. Shares of Colfax increased in the quarter as investors reacted favorably to the company’s $947 million acquisition of Victor Technologies, Inc., a U.S.-based welding company. This purchase expands the product portfolio of Colfax’s existing welding business and increases exposure to the higher margin U.S. market. Another key contributor in the sector was Air Lease Corp., which purchases and leases commercial aircraft to airlines worldwide. Within Energy, the outperformance of Helmerich & Payne, Inc., a leading U.S. contract drilling company, added the most value. Shares of Helmerich & Payne rose after the company reported another solid quarter, highlighted by the announcement of nine additional FlexRig newbuild contracts and management commentary noting signs of improvement in the U.S. market. RSP Permian, Inc. also contributed to relative performance in the sector after the company’s shares rose significantly following its IPO in mid-January. RSP is an independent exploration & production company whose sole assets are located in the Midland Basin portion of the Permian Basin in West Texas. Strength in Utilities was attributable to the outperformance of the Fund’s only holding in the sector, ITC Holdings Corp.
Underperformance of the Fund’s investments within the Health Care and Information Technology (IT) sectors detracted the most from relative results. Within Health Care, a combination of the Fund’s meaningfully lower exposure to biotechnology stocks, which rose 8.2% as a group during the quarter, and stock selection, hurt relative performance. Weakness within the sector was mainly due to the underperformance of CFR Pharmaceuticals SA, a leading Latin American pharmaceutical company, which specializes in the manufacture and sale of branded generic drugs, and TECHNE Corp., a provider of innovative bioactive tools and resources for the research and clinical diagnostic communities. Shares of CFR Pharmaceuticals declined as investors anticipated that foreign currency devaluation in Latin American markets and expenses associated with the company’s unsuccessful effort to acquire a South African pharmaceutical company would negatively impact quarterly results. About 50% of the Fund’s IT exposure is in application software businesses and these stocks fell 9.6%, driven by broad multiple contraction among software stocks during the quarter. ANSYS, Inc., the leading global provider of simulation software, and Pegasystems, Inc., which is the developer of a software tool used to automate manual business processes, led the decline.
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