Review and Outlook
Last year’s volatility continued into 2016, with the U.S. equity markets plunging dramatically during the first six weeks of 2016 before executing an about-face to recover much of their losses, although small cap stocks fared worse than their larger cap counterparts. Concerns around the implications of a tightening credit market in the face of a possible U.S. recession, signs of slowing global growth, China and the RMB, and continued low oil prices drove the U.S. equity markets into correction territory by early February. During the quarter, oil prices declined at one point to near 15-year lows of $26/barrel, before rebounding to near $40/barrel by quarter end. In addition, slowed global growth and deflationary pressure early in the quarter prompted the central banks in Europe and Japan to ease monetary policy, including several that pushed interest rates into negative territory. As global concerns subsided, oil prices ticked up, and domestic job numbers improved, stock markets rallied strongly. In March, the U.S. Federal Reserve boosted equity markets even further with its suggestion that it would defer interest rate hikes that it earlier had been contemplating for 2016.
Baron Partners Fund declined in the first quarter. Investments in the Consumer Discretionary and Industrials sectors contributed to performance. Information Technology (IT), Financials, and Utilities were the top sector detractors. Consumer Discretionary had a solid quarter, with the top two contributors within the sector. Top five contributor Vail Resorts, Inc. also added to sector performance. Shares rose on strong earnings results as good ski conditions drove visitation to, and increased spend at, its resorts. Gains in the Industrials sector were driven primarily by Fastenal Company, the third largest contributor to performance. The IT sector experienced losses in all five of the portfolio’s sector holdings, led by third largest detractor CoStar Group, Inc., as high-growth, high-multiple stocks sold off in the volatile market. Top detractor The Charles Schwab Corp. was the primary driver behind the weak performance of the Financials sector. Utilities lost ground as a result of a sharp decline in the stock price of TerraForm Global, Inc., an owner of renewable energy plants in emerging markets, due to uncertainty related to the implications of a potential bankruptcy of parent company SunEdison. We exited our position.
Overall, we think the U.S. economy is doing well. Wages have increased somewhat. Income growth and low prices at the gas pump are providing consumers with more money for discretionary spending. Until now, much of the savings from low energy prices was being used to pay down debt, as consumers and businesses were not convinced that prices would stay low. With the extended low oil price environment, we believe assets previously allocated to energy costs will soon start to be redeployed to other parts of the economy.
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 decreased 2.66% in the first quarter and trailed the Russell Midcap Growth Index by 324 basis points. During the quarter, the Fund’s relative sector weights added value, but were outweighed the negative effect of 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 March 31, 2016, Baron Partners Fund had 125.2% of its net assets invested in securities, and this use of leverage in a volatile market detracted 86 basis points to relative performance.
Utilities and Health Care investments contributed the most to relative results. Within Utilities, outperformance of, and larger exposure to, ITC Holdings Corp. during the period held added the most value. ITC was sold in mid-February after Fortis, Inc. announced it would acquire the company. Strength in Health Care was partly due to the outperformance of veterinary diagnostics leader IDEXX Laboratories, Inc. and health care data and analytics vendor Inovalon Holdings, Inc. IDEXX’s shares rallied on strong financial results, while Inovalon’s shares rebounded as investors purchased shares at a discounted valuation. Lack of exposure to lagging biotechnology and pharmaceutical stocks, which declined 28.4% and 15.1%, respectively, within the index, contributed 125 basis points to relative performance.
Aside from leverage, investments in the Information Technology (IT), Consumer Discretionary, and Financials sectors were the primary detractors from relative results. Within IT, underperformance of CoStar Group, Inc., the third largest detractor on an absolute basis, and Mobileye N.V., which develops vision-based advanced driver assistance systems, detracted the most from relative results. Mobileye’s shares declined on short seller allegations that its high valuation and competitive position are unsustainable. We believe Mobileye has a dominant market position due to its solid technology and evidenced by its wins with top car manufacturers. Meaningfully larger exposure to Internet software & services, the poorest performing sub-industry in the benchmark’s IT sector, also detracted from relative results. Weakness in Consumer Discretionary was mostly attributable to the underperformance of Manchester United plc and Tesla Motors, Inc., although this was somewhat offset by meaningfully larger exposure to this strong performing sector. Manchester United was the second largest detractor from absolute results, while shares of electric vehicle company Tesla fell due to concerns around the impact of a possible recession on sales and the potential need for more financing. Within Financials, underperformance of The Charles Schwab Corp. and FactSet Research Systems, Inc. weighed the most on relative results. Schwab was the largest detractor from absolute performance, while shares of FactSet, a leading provider of investment management tools, fell as investors contemplated headcount reductions in its sell side business. Significantly larger exposure to this lagging sector, which fell slightly in the index, also hurt relative performance.
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