Review and Outlook
U.S. stock markets were unusually volatile during the three months ended September 30, 2015. Most indexes fell sharply, with small and mid-cap stocks performing worse than large caps. The small cap Russell 2000 Growth Index lost 13.06% in the third quarter.
The markets were pressured by several disruptive events in the period. China growth slowed, and the China A shares market fell sharply. Oil prices remained depressed, and the share prices of energy businesses and companies that supply or service the energy industry fell sharply in the quarter. High yield spreads increased by almost 200 basis points. This market was negatively impacted by impending financial problems of leveraged energy companies and downgrades of Volkswagen and Glencore debt. Interest rates, however, did not change. It is now nine years since the last time the Fed raised rates. This decision was attributed to slower-than-expected growth, market turmoil, and lower-than-desired inflation. The Fed also considered developments in China and economies overseas.
Baron Growth Fund declined by 8.66% in the quarter. Utilities was a modest contributor. Sub-industries that materially contributed to performance included apparel accessories & luxury goods, property & casualty insurance, and health care equipment. Industrials, Health Care, and Financials were the top detracting sectors to performance.
Utilities contributed on a stock rise by electric transmission company ITC Holdings Corp., which benefited from risk-off investment into the defensive Utilities sector. Apparel accessories & luxury goods was boosted by the strong performance of top contributor Under Armour, Inc. The second biggest contributor, Arch Capital Group, Inc., added to performance of the property & casualty insurance sub-industry. Gains by veterinary diagnostics company IDEXX Laboratories, Inc. drove contribution of the health care equipment sub-industry. Industrials had a challenging quarter with declines in 13 of 14 holdings led by top detractor CaesarStone Sdot-Yam Ltd. Health Care detracted as investors exited higher growth stocks for presumed safer havens. Financials was negatively impacted by weak performance among the Fund’s asset management & custody banks holdings.
The decline in the profitability of oil companies and their industrial suppliers has resulted in slower-than-desired economic growth and subdued inflation. We think the short-term slowdown caused by the decline in the profits of energy businesses will soon be offset by faster growth in the rest of the economy in part spurred by the lower cost of energy.
The U.S. stock market is closely aligned with GDP. Median stock values are presently 15X earnings, below the median for the last 55 years. Individual stock prices reflect growth of value in business. When earnings grow significantly and stock prices decline or remain steady, we think this creates investment opportunities. This is presently 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.
Baron Growth Fund declined 8.66% in the third quarter, yet meaningfully outperformed the Russell 2000 Growth Index by 440 basis points due to a combination of stock selection and relative sector weights.
Holdings in Consumer Discretionary, Health Care, and Information Technology (IT) and larger exposure to the outperforming Financials sector contributed the most to relative results. Within Consumer Discretionary, outperformance of Under Armour, Inc. and larger exposure to the better performing education services sub-industry, led by Bright Horizons Family Solutions, Inc., added the most value. Under Armour was the largest contributor on an absolute basis, while shares of corporate-sponsored childcare provider Bright Horizons rose more than 11%. Bright Horizons reported solid results for a third straight quarter, helped by rising center count, a mix shift to higher margin consortium centers, greater capacity utilization, and international expansion. Fast casual dining operator Panera Bread Co. and sporting goods retailer Dick's Sporting Goods, Inc. also aided relative performance. Panera’s same store sales improved, driven by the company’s ongoing conversion to a new store format. Shares of Dick’s fell slightly in the quarter, yet meaningfully outperformed other specialty stores stocks in the index. Dick’s reported better-than-expected quarterly results, highlighted by solid new store productivity and sales momentum with key suppliers like Under Armour and Nike. Within Health Care, significantly lower exposure to lagging biotechnology and pharmaceutical stocks, which fell 23.5% and 25.0%, respectively, within the index, contributed 180 basis points to relative performance. Sector strength was also due to the outperformance of IDEXX Laboratories, Inc., the leading provider of diagnostics to the veterinary industry. IDEXX reported strong quarterly results that demonstrated gains in instruments and reference labs, and assuaged concerns regarding its competitive position in rapid assays. Within IT, outperformance of application software holdings, led by SS&C Technologies, Inc. and FactSet Research Systems, Inc., and larger exposure to this sub-industry contributed the most to relative results. SS&C was the third largest contributor to absolute performance, while FactSet’s shares benefited from accelerating organic revenue growth and enhanced seat count additions. Within Financials, larger exposure to insurance and REITs, which were the sector’s best performing sub-industries, contributed to relative performance.
The Industrials sector was the primary detractor from relative performance. Sector weakness was mostly attributable to the underperformance of CaesarStone Sdot-Yam Ltd., the largest detractor on an absolute basis, and Colfax Corp., an industrial machinery company focused on infrastructure. Colfax’s underperformance resulted from exposure to commodity oriented capital expenditures and slowing emerging market economies.
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