Review and Outlook
The third quarter was full of unexpected challenges. Markets endured a late summer swoon in August and September as investors expressed concerns about global growth and reassessed the timing of the Fed’s long anticipated rate increase. The sell-off began with the unexpected devaluation of the Chinese RMB in mid-August. This coincided with disappointing Chinese economic data and led to a reduction in Chinese GDP growth expectations, which led to a significant decline in Chinese equity markets. Many developing economies are highly dependent on China, creating second order concerns about the health of emerging markets and how an emerging markets slowdown may ultimately impact developed nations. At the same time, investors debated the likelihood of the Fed raising interest rates given an uncertain global macroeconomic picture. That debate is continuing as of this writing, although we believe the probability of a 2015 rate increase is currently running close to zero. Finally, we believe that the unexpected resignation of House Speaker John Boehner added further uncertainty to the mix, a condition that is rarely good for markets.
Materials holdings contributed modestly to Baron Opportunity Fund in the period. Holdings in the specialized REITs, apparel accessories & luxury goods, and Internet retail sub-industries also contributed to performance. Information Technology (IT), Health Care, Utilities, and Industrials were the top detracting sectors. Materials gained from a significant increase in the stock price of Flotek Industries, Inc., which was the top contributor in the period. Under Armour, Inc. helped boost performance of apparel accessories, on the strength of another period of robust financial results driven by revenue growth and cost management. Internet retail had a relatively good quarter, with Amazon.com, Inc. and Netflix, Inc. noteworthy contributors. IT was negatively impacted by risk-off sentiment that dominated the quarter. Health Care similarly lost ground as investors exited high-growth, high-multiple stocks. Utilities was hurt by a sharp decline in the Fund’s renewable electricity holdings. The second largest detractor from performance, CaesarStone Sdot-Yam Ltd., led the decline in the Fund’s Industrials investments.
In our opinion, none of the recent macro events have impacted the secular trends or long-term drivers of business value for the companies in which we are invested. We remain steadfast in our view that a portfolio of well-managed, higher growth businesses capitalizing on innovative and longer-term secular growth themes could potentially outperform the broader market and passive indexes across market cycles. It is becoming increasingly clear to us that the world is changing fast, that legacy business models and technologies are being left behind, and that consumers and enterprises alike are quickly adopting new ways of doing things.
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 fell 12.09% in the third quarter and trailed the Russell 3000 Growth Index by 616 basis points, primarily due to stock selection. Larger exposure to poor performing style factors such as volatility, growth, and leverage when compared to the all-cap growth index also hurt relative performance.
Materials, Financials, and Consumer Discretionary investments and average cash exposure of 1.7% in a down market were the primary contributors to relative results. Within Materials, outperformance of Flotek Industries, Inc., the largest contributor on an absolute basis, and lower exposure to this lagging sector contributed to relative results. Strength in Financials was mainly due to the outperformance of Equinix, Inc., a network neutral global operator of data centers. Shares increased after Equinix completed its REIT transformation, reduced its cost of capital, and bid for a large European competitor. Within Consumer Discretionary, gains from Internet retailer Netflix, Inc. and athletic apparel company Under Armour, Inc., and larger exposure to Internet retail stocks, which rose 11.7% in the index, aided relative results. Netflix benefited from strong Q2 subscriber additions and a robust subscriber growth outlook for Q3, while Under Armour reported another period of strong financial results. Manchester United plc, a U.K. professional sports team, also added value after outperforming its peers in the movies & entertainment sub-industry by more than 10%.
Underperformance of Information Technology (IT), Utilities, and Industrials investments and lack of exposure to the defensive Consumer Staples sector detracted the most from relative performance. Weakness in IT was mostly attributable to the underperformance of SunEdison, Inc., a renewable energy company classified as semiconductor equipment, and Internet software & services holdings, led by Benefitfocus, Inc. and Shutterstock, Inc. SunEdison and Benefitfocus were the first and third largest detractors on an absolute basis, while shares of Shutterstock, a stock photo company, fell due to concerns around Adobe’s launch of a competitive offering. Cybersecurity vendor FireEye, Inc. also hurt relative performance after shares fell more than 35%. While FireEye reported a strong Q2 with a significant beat on profitability metrics, the stock fell on the news that its CFO was leaving and on disappointing (though robust) growth in product license numbers. Within Utilities, underperformance of SunEdison yieldcos TerraForm Power, Inc. and TerraForm Global, Inc. weighed on relative results. The Fund exited its position in TerraForm Power. TerraForm Global’s shares fell after the company went public at a lower-than-expected valuation. Industrials holdings trailed their index counterparts after falling 17.2%, with CaesarStone Sdot-Yam Ltd. and DigitalGlobe, Inc. driving the decline. CaesarStone was the second largest detractor from absolute performance, while shares of satellite company DigitalGlobe fell due to concerns around potential competitors.
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