Review and Outlook
It was a volatile third quarter, marked by geopolitical crises and concerns about the pace of global economic growth, especially in Europe and China; the end of quantitative easing in the U.S.; and the possibility that the U.S. Federal Reserve would raise interest rates sooner than expected.
The barrage of negative news appeared to be behind an ongoing "flight to safety" that started with the March/April selloff, with investors reallocating assets out of smaller cap companies and into larger cap companies and money market funds.
Domestically, economic news was good. U.S. manufacturing continued on its strong growth path, as factories settled into a more sustainable expansion that should spur the economy. Housing data remained solid, with home prices continuing to rise at two to three times the rate of inflation. Unemployment fell, ending the quarter at 6.1%, almost four percentage points lower than its Great Recession high of 10%.
Despite improvements, the economic recovery still has a ways to go. Household debt is still over 100%, well above the historical average. Job creation has improved, but wages are flat. We take the Fed at its word that it will keep interest rates low for a substantial period of time going forward.
Baron Growth Fund declined in the third quarter. Health Care, and to a lesser extent, Telecommunication Services and Materials, contributed the most to performance, while the top three sector detractors were Industrials, Energy, and Financials. Health Care contributed largely on the strength of the Fund's second largest contributor, Community Health Systems, Inc., with mixed performance among other sector individual holdings. Industrials had a weak quarter, with just three of the Fund’s 15 sector holdings increasing. The sector included top detractor Colfax Corp., as well as three other individual detractors in the top 10. Energy lost ground as falling oil prices pressured stocks in this sector. Financials also lost ground as interest rate concerns drove down REIT stock prices, and asset managers were hit with equity fund outflows.
Looking forward, we think the U.S. economy will slowly but steadily continue on its path to recovery. Unemployment is on the decline and company financials are improving. Second quarter earnings hit a record high in S&P 500 operating earnings per share, with growth of 12.6% year over year and a 130% increase over the past five years. With interest rates still at record lows, credit remains available on attractive terms. The expense of servicing business debt as a percentage of earnings has fallen from 44% to 13% since the 2008-09 financial crisis. Low energy prices in the U.S. should help drive a rebirth in manufacturing, transportation and other industries in which the cost of energy plays a significant role. Housing starts are still less than half of the peak of eight years ago, which suggests there is still a considerable runway for growth in residential real estate.
Stock prices remain at about 15.2 times earnings, which is around the median levels of the past hundred years, meaning there are plenty of good stocks at attractive prices to be found, in our opinion. With the rotation out of high-growth stocks over the past six to seven months, many of these stocks are now at what we believe are attractive valuations.
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) declined 3.33% in the third quarter, yet outperformed the Russell 2000 Growth Index by 280 basis points, primarily due to stock selection.
The Fund’s investments within the Consumer Discretionary, Information Technology (IT), and Health Care sectors were the largest contributors to relative performance. As a group, the Fund’s Consumer Discretionary holdings finished the quarter roughly unchanged, while Consumer Discretionary stocks in the index fell more than 8%. Under Armour, Inc. was the Fund’s largest contributor to absolute and relative performance during the quarter. Vail Resorts, Inc., the Fund’s largest holding within leisure facilities, as well as Choice Hotels International, Inc. and Marriott Vacations Worldwide Corp., its largest holdings in hotels, resorts & cruise lines, also aided relative performance. Shares of Vail, the largest ski resort operator in the U.S., increased in the quarter after the company resolved litigation with the owners of Park City and purchased the Park City resort at what we believe is an attractive price. Shares of Choice Hotels, the largest domestic hotel franchisor, rose on the strength of strong second quarter revenue per available room and a positive outlook through year-end. Strength in IT was mostly attributable to the outperformance of Concur Technologies, Inc., which rallied after SAP announced an agreement to acquire the company. Concur was also the third largest contributor to the Fund’s absolute performance. Other key contributors in the sector were Gartner, Inc., the leading provider of research and analysis on the IT industry, and Booz Allen Hamilton Holding Corp., a provider of IT consulting services to the federal government and commercial customers. Shares of Gartner rose on better-than-expected financial results and continued share repurchases, and shares of Booz Allen increased as investors grew more comfortable with defense industry spending given an established U.S. government fiscal 2014 budget. As measured by average weight, more than half of the Fund’s investments in the Heath Care sector outperformed, led by Community Health Systems, Inc., which was also the second largest contributor to absolute performance. Favorable stock selection in the sector was partly offset by the Fund’s meaningfully lower exposure to biotechnology stocks, which, despite a slight decline, outperformed as a group in the index.
Underperformance of the Fund’s investments within the Industrials sector detracted from relative performance. Weakness in the sector was mainly due to the underperformance of Colfax Corp., the Fund’s largest detractor from absolute performance, and Badger Daylighting Ltd., a leading provider of non-destructive hydrovac excavation services. Badger’s second quarter earnings were negatively impacted by lower drilling activity in the Canadian oil sands and staffing-related growing pains in the U.S. Additionally, the company announced that it would slow its truck build rate from five trucks per week to four to better manage fleet utilization.
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