Review and Outlook
During a period marked by increased volatility, the U.S. stock market ended the fourth quarter higher. In a reversal of the prior three quarters, small cap stocks outperformed mid and large cap stocks. We are confident that stocks of smaller, faster growing companies once again will return to favor – and we think the results of the fourth quarter may indicate that time is approaching, although we cannot predict exactly when, how, or if it will happen. In addition, in the wake of an underperforming year, during which many small cap stocks nevertheless had strong growth, we believe these companies offer unusually attractive values at this time.
The freefall in oil prices dominated business headlines. Domestic (WTI) oil prices fell over 40%, driven down by slower global demand and rising oversupply. The price of crude oil dropped to $53 per barrel as of year-end, down almost 50% from its June high and at its lowest level since May 2009.
Domestically, generally positive economic reports supported the view that the U.S. economy is accelerating, outpacing much of the rest of the developed world. Unemployment was down, average hourly earnings increased, and consumer confidence rose. Higher-than-expected automobile sales and construction spending bolstered the recovery narrative.
Baron Growth Fund increased in the fourth quarter. Information Technology (IT), Consumer Discretionary, and Financials contributed the most. Only Energy detracted. IT performance was driven by increases in 12 of 15 sector holdings, including the two top individual contributors, MAXIMUS Inc. and SS&C Technologies, Inc., in the context of a rebound in high-growth technology stocks. Consumer Discretionary performance was boosted by investments in hotels, resorts & cruise lines, as travel-related businesses benefited from falling oil prices. The Fund’s REIT holdings, which increased in the continued low interest rate environment, helped drive up performance of the Financials sector. The steep drop in oil prices weighed heavily on the Energy sector, with the top five detractors to performance all in the Energy sector. The sector currently comprises less than 3% of the Fund.
We think oil prices may remain relatively low in the near term and possibly longer. In our view, this is a positive for the U.S. economy and non-energy U.S. stocks. Energy-intensive businesses will have lower energy costs, resulting in higher cash flow, and consumers will have more disposable income.
We view the current low price of oil as an opportunity to explore new and additional investments in companies affected by the price of oil. We are studying companies in energy-intensive industries, such as airlines, cruise lines, and automotive companies, as well as businesses that benefit from increased activity in those industries, such as travel-related businesses. Given the anticipated increase in disposable income, we are also researching additional businesses in the Consumer Discretionary sector, which has historically been a major focus for us. We see these and many more opportunities for 2015, especially in what we believe to be a favorable investment environment.
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 (Institutional Shares) gained 7.28% in the fourth quarter, yet underperformed the Russell 2000 Growth Index by 278 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 the Information Technology (IT), Materials, and Consumer Staples sectors were the largest contributors to relative performance. Strength within IT was largely attributable to the outperformance of MAXIMUS, Inc., a leading provider of government health and human services program management, and SS&C Technologies Holdings, Inc., a provider of mission-critical software products and services to the financial industry, which were also the Fund’s two largest contributors to absolute performance in the quarter. Other contributors in the sector were FactSet Research Systems, Inc., a provider of financial information to the global investment community, and two Internet software & services holdings, CoStar Group, Inc. and Benefitfocus, Inc. FactSet’s shares rose after the company’s organic growth rate accelerated and its customer and seat count additions exceeded expectations. Within Materials, the Fund’s lower exposure to this lagging sector and outperformance of CaesarStone Sdot-Yam Ltd. aided relative results. Shares of CaesarStone, a leading manufacturer of engineered quartz surfaces used for kitchen and bathroom countertops, increased by close to 17% after the company reported impressive quarterly results and raised fiscal year 2014 guidance for the third consecutive quarter. Within Consumer Staples, the outperformance of United Natural Foods, Inc., one of the Fund’s largest contributors on an absolute basis, and The Boston Beer Company, Inc., the largest craft brewer in the U.S., added the most value. Shares of Boston Beer were up sharply after reporting stellar quarterly results, with sales growth in excess of 25%.
The Fund’s investments within the Health Care, Consumer Discretionary, and Industrials sectors were the largest detractors from relative performance. Within Health Care, the Fund’s meaningfully lower exposure to biotechnology stocks, which rose 21.9% as a group within the index, and underperformance of Community Health Systems, Inc. detracted the most from relative results. Community Health’s shares stalled in the quarter as investors grew more cautious after the Republicans swept Congress and the Supreme Court surprisingly decided to hear a case brought by critics of the Affordable Care Act. Many of the Fund’s Consumer Discretionary investments underperformed, led by its largest holding in the sector, Under Armour, Inc. After rising significantly early in the year as the company continued to demonstrate strong brand momentum with sales growing faster than 30% in nearly all categories, Under Armour’s stock underperformed in the quarter. Other detractors from relative performance in the sector were DreamWorks Animation SKG, Inc., a leading developer, producer, and marketer of animated films, TV shows, and home entertainment, and Manchester United plc, an English Premier League professional sports team. Shares of DreamWorks lagged due to disappointing feature film results, while shares of Manchester United were down due to a secondary offering. Weakness in Industrials was mainly due to the underperformance of Genesee & Wyoming, Inc., a leading short-line railroad, and Colfax Corp., an industrial machinery company focused on infrastructure. Shares of Genesee & Wyoming declined in the quarter due to commodity-related issues and rail congestion across the U.S. rail network, both of which we believe will be temporary. Shares of Colfax fell after the company reported weaker than expected quarterly earnings and issued below consensus 2015 guidance at its analyst day.
Yearly Attribution Analysis
The Baron Growth Fund (Institutional Shares) increased 4.66% for the year, yet trailed the Russell 2000 Growth Index by 94 basis points. During the year, stock selection added value, but this positive effect was more than offset by the effect of its relative sector weights.
The Fund’s investments within the Utilities, Materials, and Energy sectors were the largest contributors to relative results. Within Utilities, the significant outperformance of the Fund’s only holding in the sector, ITC Holdings Corp., was partly offset by its larger exposure to this lagging sector, which declined 7.5% in the index. ITC was also one of the Fund’s largest contributors to absolute and relative performance during the year. Strength in Materials was largely attributable to the outperformance of CaesarStone Sdot-Yam Ltd., a leading manufacturer of engineered quartz surfaces used for kitchen and bathroom countertops. CaesarStone’s shares outperformed after regularly reporting better-than-expected results and raising full-year guidance. The Fund’s lower exposure to the underperforming Materials sector, which dropped 2.1% in the index, also aided relative results. The Fund’s Energy investments declined 19.7% as a group amid the sharp drop in oil prices in the latter half of the year, yet outperformed their counterparts in the index by 13.0%. Stock selection within the oil & gas drilling and equipment & services sub-industries, led by Helmerich & Payne, Inc. and CARBO Ceramics, Inc., respectively, were the largest contributors to relative performance in the sector. While Shares of Helmerich & Payne declined over the period, they held up relatively well after reporting solid results. Despite modestly outperforming, CARBO lost significant value and the portfolio manager exited his position at the end of the third quarter, avoiding further loses.
The Fund’s lower exposure to Health Care, which rose 19.6% in the index, and underperformance of its Industrials and Financials investments detracted the most from relative performance. Within Health Care, significant gains in the shares of CFR Pharmaceuticals SA, Community Health Systems, Inc., and IDEXX Laboratories, Inc. were more than offset by the Fund’s meaningfully lower exposure to biotechnology and pharmaceuticals stocks, which rose 29.5% and 27.2%, respectively, within the index. The Fund’s Industrials holdings fell 2.6% as a group and trailed their counterparts in the index by 359 basis points. The stocks that detracted the most were Colfax Corp., Badger Daylighting Ltd., and Generac Holdings, Inc. Shares of Colfax Corp. lagged during the year as the company missed earnings and revised guidance lower due to a weaker than expected macro environment and execution issues in its fluid handling business. Shares of Badger Daylighting, a leading provider of non-destructive hydrovac excavation services, declined after quarterly earnings were adversely impacted by lower revenues, higher costs due to bad weather, and lower oil prices, which hurt pipeline construction and hydrovac demand. Within Financials, the Fund’s larger exposure to the lagging asset management & custody banks sub-industry, which fell 20.8% in the index, and underperformance of Gaming and Leisure Properties, Inc. detracted the most from relative results. Shares of Gaming and Leisure, an owner and operator of regional casino assets, declined during the year as investors were disappointed with the pace of the company’s acquisitions.
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