Review and Outlook
The global economy is gradually improving and central banks, mainly the Federal Reserve, the European Central Bank, and the Bank of Japan, are maintaining easy monetary policies. In the U.S., market indexes continued their strong advance during September, as the Federal Reserve delayed its tapering efforts. This resulted in a drop in interest rates, which was viewed favorably by the equity markets. In addition, the prospect of deeper U.S. entanglement in the Middle East, which concerned the market during the month, receded.
We regard ourselves as investors in businesses for the long term, not simply in stocks. As a result, we are less influenced by current news and its daily impact on stock prices. We make investments based on what we think the value of businesses will become years from now, not only on a static estimate of what they are worth today.
The year-to-date trend, in which “lower quality” stocks advanced more rapidly than more stable and higher quality firms, continued in the third quarter. The Fund attempts to avoid the former and, instead, invests in stable businesses that typically possess higher profit margins, higher credit quality, higher returns on capital, and wide moats and those that can thrive under a variety of economic conditions.
This marked another good quarter for the Fund’s Consumer Discretionary businesses, as well as for those in Information Technology (IT) and Energy. IT performance was driven by the Fund's two information services companies. Retention rates for these companies have largely recovered to pre-recession levels. Energy sector performance was led by our oil & gas exploration & production holding. While valuations rose in the quarter, they remain attractive, especially when we look at potential earnings and cash flow over the next two to three years.
While the large majority of the Fund's holdings increased during the quarter and there were no sectors that in aggregate detracted on absolute basis, several holdings in Financials and Industrials had a negative impact on the portfolio.
We believe there are several reasons to expect continued expansion in equity valuations. These include the persistent low interest rate environment and tame levels of inflation. In addition, we believe that our Firm’s long investment horizon and intensive research process enable us to purchase shares in what we think are great companies at unusually attractive prices. We remain confident in the management teams, stewards of capital, and leaders of the firms in which we are invested.
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 Partners Fund (Institutional Shares) gained 11.07% in the third quarter, outperforming the Russell Midcap Growth Index by 173 basis from its use of 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, 2013, Baron Partners Fund had 134.9% of its net assets invested in securities, and this use of leverage in an up market contributed approximately 343 basis points to relative performance.
Outperformance of the Fund’s investments in the Energy and Information Technology (IT) sectors, and its lack of exposure to Consumer Staples, which was the worst performing sector in the benchmark, contributed the most to relative results. Strength in Energy was attributable to the outperformance of the Fund’s two holdings in the sector, Concho Resources, Inc., an independent exploration & production company focused on the Permian Basin in West Texas, and Helmerich & Payne, Inc., a leading U.S. contract drilling company. Shares of Helmerich rose in the quarter after reporting better than expected quarterly earnings results driven by strength in the company’s U.S. land and offshore operating segments. Outperformance of CoStar Group, Inc., the leading provider of commercial real estate data in the U.S. and U.K, added value within IT. The company’s shares benefited from outstanding financial results, accelerating business momentum, and growing synergies from its LoopNet acquisition.
The Fund’s investments within the Financials, Utilities, and Industrials sectors were the largest detractors from relative performance. Within Financials, the Fund’s larger exposure to this lagging sector combined with underperformance of asset managers, Windy City Investments Holdings, L.L.C. and The Carlyle Group, hurt relative results. Another detractor in the sector was The Charles Schwab Corp., a premier discount brokerage firm. Shares of Schwab declined significantly towards the end of the quarter after the Federal Reserve’s taper was postponed, leaving interest rates low for the near term. This decision was viewed as unfavorable for Schwab given that higher interest rates would meaningfully improve earnings from its money market fund business and banking assets. Weakness in Utilities was the result of underperformance of the Fund’s only holding in the sector, ITC Holdings Corp., the nation’s largest independent electric transmission company. Shares of ITC declined in mid-August after the company decided to withdraw its application in Texas for the Entergy transaction. While ITC plans to re-file in Texas, the delay introduced additional uncertainty regarding the prospects of closing a deal that could fuel future growth. Stock selection in Utilities, which detracted from relative performance, was partially offset by the Fund’s larger exposure to this top performing sector. Within Industrials, the largest detractor from relative results was Ryanair Holdings plc, the lowest-cost short-haul airline in Europe. Shares of Ryanair came under pressure in early September after the company cautioned that near-term demand is expected to be weaker than previously expected.
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