Review and Outlook
U.S. stock markets made little progress during the three months ended June 30, 2015. Most indexes achieved modest gains. The Russell 2000 Growth Index gained 1.98%.
Numerous cross currents impacted the economy and markets during the second quarter of 2015. The U.S. economy continued to steadily improve. Consumer and business confidence rose, unemployment fell, wages increased at an accelerating pace, housing prices continued to rise, automobile sales remained strong, and central banks worldwide implemented “easy” monetary policies to stimulate their economies. With our economy growing and reported inflation increasing in the U.S., interest rates, while still quite low, began to increase. This impacted interest-sensitive stocks, including REITs, MLPs and utilities. Continued strength in the dollar negatively impacted U.S. industrial and export-dependent businesses, whose stocks lagged in the period. Stocks in transport companies, whose results are closely correlated to industrial businesses, also lagged. Energy prices stayed low, to the benefit of consumers and energy-dependent businesses. A cutback in capital expenditures by energy companies partially offset the favorable impact of lower energy prices.
Baron Growth Fund declined in the quarter. Consumer Discretionary, Information Technology (IT), and Health Care were the top contributors. Consumer Staples, Industrials, and Utilities detracted the most. Contribution of the Consumer Discretionary sector was led by the Fund’s leisure facilities, education services, and casinos & gaming holdings. IT gained on strong performances by certain Internet software & services and application software holdings, including the fourth biggest contributor in the second quarter, Benefitfocus, Inc. The strong stock performance of top contributor Community Health Systems, Inc. drove performance of the Health Care sector. A drop in the stock price of United Natural Foods, Inc., the third biggest detractor in the quarter, negatively impacted the performance of the Consumer Staples sector. Low oil prices and a strong dollar weighed on the Industrials sector. Industrials holding Genesee & Wyoming, Inc., a leading short line railroad, was the Fund’s top detractor. ITC Holdings Corp., the second biggest detractor in the quarter, negatively impacted performance of the Utilities sector.
While it is not possible to predict stock markets over the short term, over the long term, stock prices and our economy are inextricably linked. For the past 55 years, GDP has grown 6.6% a year and stock prices have grown 6.6% a year. Taking dividends into account, stocks have doubled every 10 years. We have every reason to believe that our economy and stock markets will continue to achieve these historic results over the long term. We see many 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 declined 1.11% in the second quarter and trailed the Russell 2000 Growth Index by 309 basis points. During the quarter, the Fund’s stock selection and, to a lesser extent, relative sector weights detracted from relative performance.
The Fund’s lower exposure to the lagging Materials and Energy sectors and outperformance of its Consumer Discretionary investments contributed the most to relative results. Strength in Consumer Discretionary was partly attributable to the outperformance of the Fund’s education services holdings, led by Bright Horizons Family Solutions, Inc., a leading provider of corporate sponsored childcare. Shares of Bright Horizons increased on solid quarterly results, driven by rising center count, a mix shift to higher margin consortium centers, greater capacity utilization, and international expansion. Other contributors to relative performance in the sector were timeshare company Marriott Vacations Worldwide Corp. and regional casino operator Penn National Gaming, Inc. Shares of Marriott rose after strong sales led management to increase EBITDA and free cash flow guidance for fiscal year 2015, while Penn National’s shares increased on an upturn in visitation and spending levels boosted gaming revenue at its casinos.
The Health Care, Financials, and Consumer Staples sectors were the largest detractors from relative performance. Within Health Care, meaningfully lower exposure to biotechnology stocks, which rose 12.7%, detracted 119 basis points from relative results. Sector weakness was also due to the underperformance of IDEXX Laboratories, Inc., a leader in veterinary diagnostics. IDEXX’s stock price decline was partly attributable to greater-than-expected foreign exchange headwinds. Separately, the company noted increased competition and lower prices impacting around 3% of revenue. We believe that management will successfully react with pricing programs, creative diagnostic bundles, and an expanded inside sales force to better serve these customers in the future. Within Financials, larger exposure to REITs, which suffered in a rising interest rate environment during the quarter, and underperformance of Primerica, Inc. and Cohen & Steers, Inc. detracted the most from relative results. Shares of Primerica, a provider of term life insurance and third-party investment products, declined due to potential negative implications of the Department of Labor’s new fiduciary rules for advisers servicing Individual Retirement Accounts. Consumer Staples investments trailed their index counterparts, falling 7.8%, with United Natural Foods, Inc. and TreeHouse Foods, Inc. leading the decline. United Natural was the third largest detractor on an absolute basis, while shares of TreeHouse declined after the company lowered guidance for 2015 due to competitive challenges in single-serve coffee and customer delays in the roll-out of snack nut merchandising displays.
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