Review and Outlook
After the initial shock of the Brexit vote in late June, the U.S. stock markets settled down in the third quarter, experiencing significantly less volatility than in the first half of 2016. Stable economic data, monetary policy rates that remained relatively unchanged, and the lack of a major disruptive event allayed investor concerns and drove a broad-based rebound during the three-month period ending September 30, 2016.
Investor appetite for risk increased, and stocks (particularly small-cap stocks) rose more or less steadily throughout the quarter. Lower quality stocks outperformed their higher quality counterparts. After mostly underperforming in the first half of the year, risk-on categories such as biotechnology and semiconductors outperformed. On the other hand, defensive sectors retreated after strong performance in the first half of 2016.
Baron Partners Fund increased in the quarter. Holdings in Financials, Consumer Discretionary, and Health Care were the top contributors. Financials advanced primarily on the strength of contributor The Charles Schwab Corp. Arch Capital Group Ltd. also added to sector performance. The share price of this specialty insurance and reinsurance company performed well during Q3 on solid quarterly results, with profitable underwriting, modest catastrophe losses, and favorable reserve development. Although the Consumer Discretionary sector had a somewhat mixed quarter, contributors outweighed detractors. Positive performance was led by third largest contributor Vail Resorts, Inc. Health Care advanced primarily on the strength of top contributor IDEXX Laboratories, Inc.
Information Technology investments detracted. Zillow Group, Inc. and Gartner, Inc., respectively the third and fourth largest detractors from Fund performance, led the decline in the sector. Shares of Gartner, a provider of syndicated IT research, relinquished some gains due to tougher comparisons and slightly more challenging macro conditions. We believe Gartner’s key metrics are solid and that, over time, the company will generate accelerating top-line growth, significant growth in earnings and free cash flow, and persistent return of capital.
The U.S. economy showed signs of acceleration in the third quarter. Historically, the U.S. stock market has been closely aligned with GDP. In 1960, GDP was $520 billion and the Dow Jones Industrial Average was 600. In 2007, GDP was $14 trillion and the Dow was 14,000. In 2015, GDP was $17.9 trillion and the Dow was 17,000. We think the U.S. economy and the stock market are closely intertwined. Over the past half century or so, our economy and stock market have grown at a compound annual rate between 6-7% in nominal terms. Factoring in annual dividends of about 2-3%, stock prices have approximately doubled every 10 years during the same period. We think our nation’s economy and stock markets will continue to achieve similarly strong results over the long term.
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 increased 3.72% in the third quarter, yet trailed the Russell Midcap Growth Index by 87 basis points due to stock selection.
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, 2016, Baron Partners Fund had 136.3% of its net assets invested in securities, and this use of leverage in an up market contributed 170 basis points to relative performance.
Aside from leverage, Financials investments and lack of exposure to the underperforming Consumer Staples sector, which fell 4.6% in the index, contributed the most to relative results. Within Financials, significantly larger exposure to this strong performing sector and outperformance of The Charles Schwab Corp. and Arch Capital Group Ltd. added value. Schwab was the second largest contributor on an absolute basis, while Arch’s shares performed well after reporting solid quarterly results, driven by profitable underwriting, modest catastrophe losses, and favorable reserve development.
Underperformance of investments in Information Technology (IT) and Industrials weighed the most on relative results. IT investments detracted 329 basis points from relative performance after falling 3.2%, with the Fund’s two largest holdings in the sector, Zillow Group, Inc. and CoStar Group, Inc., driving the decline. Zillow was the third largest detractor from absolute results, while shares of CoStar, a real estate information and marketing services company, fell slightly on modest multiple compression after outperforming in Q2. Another detractor from relative performance was syndicated IT research provider Gartner, Inc., whose shares declined due to tougher comparisons and slightly more challenging macro conditions. Weakness in Industrials was mainly due to the underperformance of Fastenal Co., a leading distributor of industrial supplies, and Verisk Analytics, Inc., which provides information about risk to companies in the insurance, financial services, and energy industries. Both of these stocks underperformed after reporting disappointing financial results.
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