Review and Outlook
U.S. stock markets were unusually volatile during the three months ended September 30, 2015. Most indexes fell sharply, with small and mid-cap stocks performing worse than large caps. The Russell Midcap Growth Index lost 7.99% in the third quarter.
The markets were pressured by several disruptive events in the period. China growth slowed, and the China A shares market fell sharply. Oil prices remained depressed, and the share prices of energy businesses and companies that supply or service the energy industry fell sharply in the quarter. High yield spreads increased by almost 200 basis points. This market was negatively impacted by impending financial problems of leveraged energy companies and downgrades of Volkswagen and Glencore debt. Interest rates, however, did not change. It is now nine years since the last time the Fed raised rates. This decision was attributed to slower-than-expected growth, market turmoil, and lower-than-desired inflation. The Fed also considered developments in China and economies overseas.
Baron Partners Fund declined by 10.51% in the quarter. No sectors contributed. Sub-industries that materially contributed to performance included property & casualty insurance, health care equipment, and electric utilities. Consumer Discretionary, Information Technology (IT), and Financials were the top detracting sectors to performance.
Top contributor Arch Capital Group, Inc. drove performance of the property & casualty insurance sub-industry. Gains by veterinary diagnostics company IDEXX Laboratories, Inc., which was the second largest contributor to the portfolio, helped boost performance of the health care equipment sub-industry. Electric utilities gained on a stock rise by electric transmission company ITC Holdings Corp., the third largest contributor to performance in the quarter. The weak performance of Hyatt Hotels Corp. negatively impacted the Consumer Discretionary sector. The Fund’s five IT holdings fell, led by CoStar Group, Inc., which was the second largest detractor in the quarter. While Financials had a mixed quarter, contributors were outweighed by detractors, led by top detractor The Carlyle Group L.P.
The decline in the profitability of oil companies and their industrial suppliers has resulted in slower-than-desired economic growth and subdued inflation. We think the short-term slowdown caused by the decline in the profits of energy businesses will soon be offset by faster growth in the rest of the economy in part spurred by the lower cost of energy.
The U.S. stock market is closely aligned with GDP. Median stock values are presently 15X earnings, below the median for the last 55 years. Individual stock prices reflect growth of value in business. When earnings grow significantly and stock prices decline or remain steady, we think this creates investment opportunities. This is presently the case.
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 Partners Fund declined 10.51% in the third quarter and underperformed the Russell Midcap Growth Index by 252 basis points due to stock selection and leverage.
The Fund may use leverage and is especially likely to do so when we believe prospects for businesses are favorable and stock prices of those businesses do not reflect those prospects. As of September 30, 2015, Baron Partners Fund had 124.7% of its net assets invested in securities, and this use of leverage in a down market detracted 177 basis points from relative performance.
Lack of exposure to the lagging Materials and Energy sectors, larger exposure to the outperforming Utilities sector, and investments in Health Care were the largest contributors to relative results. Within Health Care, outperformance of IDEXX Laboratories, Inc., the second largest contributor on an absolute basis, added the most value. Lack of exposure to lagging biotechnology and pharmaceutical stocks, which fell 20.7% and 19.3%, respectively, within the index, also aided relative performance.
Underperformance of the Fund’s Financials and Consumer Discretionary holdings and lack of exposure to the defensive Consumer Staples sector detracted the most from relative results. Weakness in Financials was mostly attributable to the underperformance of The Carlyle Group, which was also the largest detractor on an absolute basis. Specialized REIT Gaming and Leisure Properties, Inc. and investment brokerage firm The Charles Schwab Corp. also hurt relative performance. Shares of Gaming and Leisure declined as a result of uncertainty with regard to the company’s plans to finance the purchase of Pinnacle Entertainment’s real estate assets. Schwab’s shares fell as a result of investor concerns that market volatility will slow adoption of its trading platform. Within Consumer Discretionary, underperformance of Hyatt Hotels Corp. and CarMax, Inc. weighed on relative results, but this negative effect was somewhat offset by the Fund’s meaningfully larger exposure to this outperforming sector. Hyatt was the third largest detractor from absolute performance, while shares of used car retailer CarMax declined despite reporting healthy sales and earnings growth, as investors likely took profits in a company that performed well over the past year.
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