Review and Outlook
Baron Opportunity Fund performed well during the third quarter, continuing a steady improvement from a challenging start to the year. In January and February, investors appeared to put significant weight on macro downside risks: a sharp economic slowdown in China, the end of the U.S. economic recovery, persistent low and even negative sovereign interest rates, collapsing oil prices, etc. As we have progressed through the year, concerns over those fears have turned more optimistic and the market environment has been more favorable for the Fund. But macro uncertainties always exist. Today they involve such issues as whether the Federal Reserve will raise interest rates before the end of the year, the outcome of one of our nation’s most troubling presidential elections in recent history, the persistent challenges in the Middle East (Syria, Iraq, ISIS, etc.) and the seemingly ever-present threats of terrorist attacks, and, of course, what the next move in the stock market will be. While we try to stay abreast of all these issues, we remain focused on what we can control: our industry and company research and portfolio construction decisions.
The consistent strategy of the Fund has been to invest in high growth, innovative businesses capitalizing on powerful secular trends. This is how we strive to distinguish ourselves from a passive index or ETF, as well as generalized growth funds, and to provide our investors with what we believe is a unique investment vehicle in today’s increasingly passive, index-driven investment mindset. In a world and market concerned about where growth will come from, we aim to differentiate not by trying to figure out the next bend in the cyclical growth curve, but by identifying powerful secular trends–generational, paradigm or tectonic shifts across industries and society–that will drive robust long-term growth regardless of the short-term fluctuations of the underlying economy. These trends are visible, impactful, and persistent. They are where the world’s going, not where it’s been (paraphrasing the great hockey player Wayne Gretzky). We believe many of the businesses that emerge as winners will possess significant growth opportunities, considerable moats to sustain their leadership and capture large profit pools from the legacy way of doing things.
Some of the powerful secular themes in which we invest include 1) cloud computing and software-as-a-service, 2) mobile, 3) big data and analytics, 4) digital (internet-delivered) media, 5) e-commerce, 6) genetics, 7) electronic medical records, 8) immuno-oncology, 9) targeted digital advertising, 10) cybersecurity, 11) electric drive vehicles and autonomous driving, and 12) electronic payments.
We believe wholeheartedly in the strategy for the Fund: growth based on powerful, long-term, innovation-driven secular growth trends. In the highly uncertain world we live in, we believe non-cyclical, sustainable, and resilient growth should be part of investors’ portfolios.
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 Opportunity Fund increased 6.47% in the third quarter and outperformed the Russell 3000 Growth Index by 155 basis points due to relative sector weights. Larger exposure to outperforming small cap stocks, which rose more than 10% within the index, also added value.
Consumer Discretionary, Financials, and Health Care investments and lack of exposure to the lagging Consumer Staples sector, which fell 4.8% in the index, contributed the most to relative results. Within Consumer Discretionary, outperformance of internet & direct marketing retail holdings Amazon.com, Inc. and The Priceline Group, Inc. and larger exposure to this better performing sub-industry, which rose 15.5% in the index, added the most value. Amazon was the largest contributor to absolute results, while shares of online travel agency Priceline rose on solid Q2 results and a robust outlook for Q3. Strength in Financials was mainly due to the outperformance of brokerage firm The Charles Schwab Corp. and electronic trading platform company MarketAxess Holdings Inc. Schwab’s shares appreciated on strong asset growth, while shares of MarketAxess rose on robust trading activity as average daily volume grew 34% in Q3 compared to the year-ago period. MarketAxess also reported excellent Q2 results with 28% revenue growth and 36% EPS growth, both exceeding Street estimates. Within Health Care, outperformance of Illumina, Inc. and Sage Therapeutics, Inc. and lower exposure to poor performing pharmaceutical stocks, which fell 7.4% within the index, lifted relative results. Shares of DNA sequencing company Illumina increased after the company reported financial results that beat Street expectations and reiterated guidance for the year. Shares of Sage, which is developing treatments for central nervous system disorders, rose sharply after the company announced positive top-line results from its Phase II trial with SAGE-547 for the treatment of severe postpartum depression.
Underperformance of Information Technology (IT) investments detracted from relative results, but this negative effect was somewhat offset by significantly larger exposure to this strong performing sector, which increased double-digits in the index. Weakness in IT was mostly attributable to the underperformance of Gartner, Inc. and application software investments, led by Guidewire Software, Inc. and salesforce.com, inc. Gartner and salesforce were two of the largest detractors on an absolute basis, while shares of P&C insurance software vendor Guidewire fell on earnings guidance slightly below Street expectations due to an accounting-related deferral that we expect will reverse next year. Semiconductor holding Mellanox Technologies Ltd. also weighed on relative performance after the company reported disappointing Q2 results.
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