Review and Outlook
It was a volatile third quarter, marked by geopolitical crises and concerns about the pace of global economic growth, especially in Europe and China; the end of quantitative easing in the U.S.; and the possibility that the U.S. Federal Reserve would raise interest rates sooner than expected.
The barrage of negative news appeared to be behind an ongoing "flight to safety" that started with the March/April selloff, with investors reallocating assets out of smaller cap companies and into larger cap companies and money market funds.
Domestically, economic news was good. U.S. manufacturing continued on its strong growth path, as factories settled into a more sustainable expansion that should spur the economy. Housing data remained solid, with home prices continuing to rise at two to three times the rate of inflation. Unemployment fell, ending the quarter at 6.1%, almost four percentage points lower than its Great Recession high of 10%.
Baron Partners Fund declined in the third quarter. No sector contributed, although, several sub-industries contributed. Industrials, Energy, and Financials were the top three sector detractors.The application software sub-industry was boosted by the performance of the Fund’s two sub-industry holdings, driver assistance software developer Mobileye N.V., and financial data and analytics company FactSet Research Systems Inc. The Fund’s Industrials holdings had a mixed quarter, with top detractor Air Lease Corp. weighing heavily on the sector. Energy, which included two of the top three detractors in the quarter, lost ground as falling oil prices pressured sector stocks. Financials had a mixed quarter. Within the sector, interest rate concerns drove down stock prices of REITs, and many asset managers were hit with equity fund outflows.
Looking forward, we think the U.S. economy will slowly but steadily continue on its path to recovery. Unemployment is on the decline and company financials are improving. Second quarter earnings hit a record high in S&P 500 operating earnings per share, with growth of 12.6% year over year and a 130% increase over the past five years. With interest rates still at record lows, credit remains available on attractive terms. The expense of servicing business debt as a percentage of earnings has fallen from 44% to 13% since the 2008-09 financial crisis. Low energy prices in the U.S. should help drive a rebirth in manufacturing, transportation and other industries in which the cost of energy plays a significant role. Housing starts are still less than half of the peak of eight years ago, which suggests there is still a considerable runway for growth in residential real estate.
Stock prices remain at about 15.2 times earnings, which is around the median levels of the past hundred years, meaning there are plenty of good stocks at attractive prices to be found, in our opinion. With the rotation out of high-growth stocks over the past six to seven months, many of these stocks are now at what we believe are attractive valuations.
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) declined 4.76% in the third quarter and underperformed the Russell Midcap Growth Index by 403 basis points. During the quarter, the Fund’s stock selection and, to a lesser extent, relative sector weights detracted from relative performance.
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, 2014, Baron Partners Fund had 122.8% of its net assets invested in securities. The Fund’s lack of exposure to the underperforming Materials sector added slightly to relative performance.
The Fund’s investments within the Industrials, Health Care, and Energy sectors were the largest detractors from relative results. Weakness in Industrials was mainly due to the underperformance of Air Lease Corp., the Fund’s largest detractor from absolute performance, SolarCity Corp., the nation’s largest residential solar installer, and Fastenal Co., a leading distributor of industrial supplies. The Fund sold its position in SolarCity during the quarter after the company’s shares experienced significant valuation compression as the stock market severely penalized high growth companies. Despite strong sales, shares of Fastenal fell due to depressed gross margins from higher sales to larger accounts and a shift in sales to lower margin products.
Within Health Care, the Fund’s lack of exposure to biotechnology stocks, which rose 11.8% as a group in the index, and underperformance of its two largest holdings in the sector, IDEXX Laboratories, Inc. and Illumina, Inc., hurt relative performance. Shares of IDEXX, the leader in veterinary diagnostics, fell from all-time highs in the quarter. In our opinion, investors took profits following management’s decision to migrate its U.S. commercial operations from a hybrid sales model to a direct sales model. Shares of Illumina, the leading provider of next generation DNA sequencing instruments and consumables, declined after rising significantly over the past year, driven by momentum from new products.
Within Energy, the Fund’s larger exposure to the worst performing sector in the index and underperformance of its two holdings in the sector, Concho Resources, Inc. and Helmerich & Payne, Inc., hampered relative results. These stocks fell 13.2% and 15.1 %, respectively, in response to the sharp decline in oil prices during the quarter and were two of the Fund’s largest detractors from absolute performance.
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