Review and Outlook
The market environment for Baron Opportunity Fund - a strategy focused on investing in higher growth, innovative businesses - remained unfavorable in the third quarter of 2014. High growth and smaller cap stocks have significantly trailed their large cap, value, and even GARP (growth at a reasonable price) peers this year. The reasons include concerns about global economic growth (weakening economies in Europe and China); the end of QE3 (quantitative easing, the Federal Reserve’s bond buying program); uncertainty around when the Fed will begin to raise interest rates; and geopolitical events, such as the Ukraine conflict, the threat of ISIS and, most recently, the spread of the Ebola virus.
We have carefully analyzed the Fund’s historical performance – both this year and further back – and are convinced that our strategy of focusing on big secular trends and innovation is sound and when well executed, should yield superior long-term performance versus generalized market indexes. We remain confident that the Baron investment philosophy and process, and our talented research team, provide differentiation versus the short-term, trading mindset that dominates Wall Street today. At the same time, with the clarity of hindsight, we have to acknowledge that we made some mistakes in the context of the market backdrop just described. Our mistakes have been ones of execution. We have made enhancements to our research and portfolio management processes to enforce even more rigor and discipline around executing our “playbook.” At bottom, we intend to be laser-focused on investing in powerful, longer term secular trends and in differentiated and special businesses – companies with significant and durable competitive advantages and high quality business models.
The Telecommunication Services and Industrials sectors contributed to Fund performance in the third quarter, while Energy, Information Technology (IT), and Health Care were the top three detractors. Shares of the Fund’s sole Telecommunication Services holding, SBA Communications Corp., rose on reports of solid Q2 results. Industrials gained largely on the performance of food equipment manufacturer The Middleby Corp., whose shares were helped by strong Q2 results. Energy had a challenging quarter due to falling commodity prices. Performance of the Fund's IT holdings was mixed. Although the sector included the Fund’s top five individual contributors, this positive was outweighed by the weak performance of other detractors within the sector.
As any student of the market knows, changes in market sentiment and direction are almost impossible to predict. Today’s headwind becomes tomorrow’s tailwind. Reversion to the mean is inescapable. We cannot predict when the market environment will do its next about-face and become more favorable for higher growth, innovative businesses. But we believe it will. We remain steadfast in our belief that the innovative, secular growth businesses in which we are invested have the potential to double in size within four to five years, with many having the further opportunity to double again after that. And long-term valuations are far more attractive than they were earlier in the year.
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 Opportunity Fund (Retail Shares) declined 4.37% in the third quarter and underperformed the Russell Midcap Growth Index by 364 basis points. During the quarter, the positive effect from portfolio weightings was more than offset by stock selection.
The Fund’s investments within Industrials and its larger exposure to the more defensive Telecommunication Services sector, which was the top performing sector in the index during the quarter, contributed the most to relative results. Within Industrials, a combination of stock selection and the Fund’s lower exposure to this lagging sector aided relative performance. Strength in the sector was mostly attributable to the outperformance of The Middleby Corp., a leading food equipment manufacturer, and Verisk Analytics, Inc., a provider of information about risk to companies in the insurance, health care, and mortgage industries. Shares of Middleby increased after reporting solid quarterly results, allaying investors’ last quarter concerns over restaurant spending and the adverse impact of distributor acquisitions on subsidiary Viking Range’s margins. Shares of Verisk rose on slightly better-than-expected financial results and improved investor confidence in the company’s health care segment.
The Fund’s investments within the Health Care, IT, and Energy sectors were the largest detractors from relative results. Weakness in Health Care was mainly due to the underperformance of Illumina, Inc., the leading provider of next generation DNA sequencing instruments and consumables. Illumina’s shares declined in the quarter after nearly doubling over the last year on the strength of several new product introductions. The Fund’s biotechnology holdings also hurt relative performance after falling 14.3% as a group, led by Foundation Medicine, Inc., which markets a sequencing-based cancer test. The Fund exited its position in Foundation Medicine late in the quarter after the company’s shares moved sharply lower on concerns about reimbursements from third-party payors and an evolving competitive landscape. Within IT, the Fund’s Internet software & services holdings fell 9.1% as a group, with Benefitfocus, Inc. and Marchex, Inc. driving the decline. These companies were also two of the Fund’s largest detractors from absolute performance. Another detractor in the sector was Acxiom Corp., the leading provider of database marketing solutions and IT outsourcing services to large enterprise customers. Shares of Acxiom were down in the quarter due to slower customer adoption of the company’s new Audience Operating System platform. Within Energy, CARBO Ceramics, Inc. was the Fund’s second largest detractor on a relative and absolute basis due to company-specific issues, while the sharp drop in commodity prices during the quarter weighed on exploration & production holdings Oasis Petroleum, Inc. and Concho Resources, Inc.
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