Review and Outlook
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 Growth Fund increased in the quarter. Holdings in Financials, Information Technology (IT), and Health Care contributed the most to performance. Consumer Discretionary investments detracted. The Financials sector had a strong quarter. Performance was led by Primerica, Inc., the top contributor in the quarter. Office REIT Douglas Emmett, Inc. was a top five contributor after its shares rose on Q1 earnings that beat Street expectations and an increase in full year guidance. IT benefited from the strong performance of CoStar Group, Inc., the second biggest contributor to performance. Syndicated IT research provider Gartner, Inc. also boosted sector performance on solid financial results. IDEXX Laboratories, Inc., the third biggest contributor in the quarter, led performance of the Fund's Health Care holdings. While results among Consumer Discretionary investments were mixed, detractors outweighed contributors. The sector included the top and third biggest detractor from performance in the quarter.
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
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 Growth Fund rose 3.38% in the second quarter and performed in line with the Russell 2000 Growth Index. During the quarter, stock selection added value, but this positive result was mostly offset by the negative effect of the Fund’s differences in sector weights relative to the index.
Financials and Information Technology (IT) holdings were the largest contributors to relative results. Within Financials, outperformance of Primerica, Inc. and REIT holdings, led by Douglas Emmett, Inc. and Gaming and Leisure Properties, Inc., added the most value. Primerica was the largest contributor on an absolute basis, while shares of office REIT Douglas Emmett rose after the company reported Q1 earnings that beat Street expectations and raised full year guidance based on improving fundamentals across its markets. Shares of gaming REIT Gaming and Leisure increased as the company closed on the acquisition of Pinnacle Entertainment’s real estate assets and improved its balance sheet through an upsizing of the equity offering used to finance the deal. Favorable stock selection in Financials was somewhat offset by larger exposure to the lagging asset management & custody banks sub-industry, which declined 7.7% in the index. Strength in IT was partly attributable to the outperformance of Internet software & services holdings CoStar Group, Inc., the second largest contributor to absolute results, and Benefitfocus, Inc., a provider of cloud-based benefits software. Shares of Benefitfocus rose after reporting outstanding financial results as the company generated traction in new logo acquisition and cross-sales of new modules, including BenefitStore. Outperformance of syndicated IT research provider Gartner, Inc. and lack of exposure to poor performing semiconductor stocks, which fell 6.9% within the index, also aided relative performance. Shares of Gartner increased on strong financial results. We believe the company’s key forward-looking metrics look strong.
Consumer Discretionary holdings and lack of exposure to the outperforming Materials sector, which rose 7.2% in the index, detracted the most from relative results. Weakness in Consumer Discretionary was mainly due to the underperformance of Under Armour, Inc. and hotels, resorts & cruise lines investments, led by Choice Hotels International, Inc. Under Armour and Choice were two of the largest detractors from absolute performance during the quarter. The Fund’s investment in Penn National Gaming, Inc., a U.S. regional gaming company, also hurt relative performance. Penn’s stock price fell as a result of investor concerns over subdued consumer spending and leverage on the company’s balance sheet, which could become an issue in the event of an economic downturn. We believe the domestic economy and consumer spending are stable, and the company’s balance sheet is strong enough to withstand a potential downturn in the economy.
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