Review and Outlook
After a volatile first quarter, much of the second quarter was relatively uneventful until late June, when the U.K. voted to exit the European Union. Even with the volatility that followed “Brexit,” U.S. equity markets ended the quarter mostly higher. Positive momentum was helped by a steady increase in oil prices. Although we are still in the midst of an oil glut, production has begun to fall as tight credit markets are forcing oil companies to cancel or delay exploration and new production projects.
Persistent low oil prices over the last two years have resulted in an energy depression and industrial recession in the U.S. Corporate earnings have now declined for four consecutive quarters, largely due to declines in energy company earnings. Outside of energy and energy-related industries, we believe the U.S. economy is improving. Bank loans are up. In accord with Federal Reserve Chairman Janet Yellen’s recent commentary, we think interest rates will remain low for an extended period. Employment is strong and wages are climbing. Housing prices are increasing. Retail sales improved in the second half of the quarter and consumer confidence rose. With weak conditions abroad, international investors are turning to U.S. equity markets.
Baron Partners Fund increased in the quarter. Holdings in Information Technology (IT), Financials, and Health Care contributed the most to performance. Consumer Discretionary and Industrials investments detracted. IT benefited from the strong performances of Zillow Group, Inc. and CoStar Group, Inc., the two biggest contributors to performance in the quarter. Positive performance of the Financials sector was led by two top five contributors, Gaming and Leisure Properties, Inc. and FactSet Research Systems Inc. IDEXX Laboratories, Inc., the third biggest contributor in the quarter, led performance of the Fund's Health Care holdings. While results among Consumer Discretionary investments were mixed, detractors outweighed contributors. The sector included the top two detractors from performance in the quarter. Weak performance of the Industrials sector was led by aircraft leasing company Air Lease Corp. In the wake of “Brexit,” the stock traded lower over concerns that higher travel barriers will impact passenger demand.
While we think the domestic economy is strengthening, “Brexit,” terrorism, China’s economy, and other events abroad, as well as recent civil unrest in the U.S., are creating uncertainty. Investing for growth is investing in the future, and when the future seems uncertain, investors tend to exit growth stocks. Subdued IPO activity and negative interest rates on sovereign debt is further evidence of uncertainty. Investor flight to the perceived safety of value stocks has caused the recent contraction in the stock prices of many growth stocks, despite the strong fundamentals and continued growth of these companies. Value stocks outperformed growth in the period and growth stocks now have earnings multiples below 20-year averages while value stocks in all categories have multiples above 20-year averages. For growth investors like us, this creates investment opportunities.
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 gained 3.27% in the second quarter and outperformed the Russell Midcap Growth Index by 171 basis points. During the quarter, stock selection added value and overshadowed the negative effect of the Fund’s relative sector weights.
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 June 30, 2016, Baron Partners Fund had 129.6% of its net assets invested in securities, and this use of leverage in an up market contributed 52 basis points to relative performance.
Aside from leverage, outperformance of Information Technology (IT) investments and larger exposure to strong performing REIT and specialized finance stocks within the Financials sector contributed the most to relative results. Within IT, outperformance of Internet software & services holdings Zillow Group, Inc. and CoStar Group, Inc. and significantly larger exposure to this better performing sub-industry added the most value. Zillow and CoStar were the two largest contributors on an absolute basis. Strength in the sector was also attributable to the outperformance of Gartner, Inc., a provider of syndicated IT research, and Mobileye N.V., a vision-based advanced driver assistance systems software company. Gartner’s shares increased on strong financial results, while Mobileye recouped losses suffered in the first quarter after management allayed investor concerns regarding competitive threats by announcing two autonomous program wins.
Consumer Discretionary, Health Care, and Industrials investments, and lack of exposure to the outperforming Consumer Staples sector detracted the most from relative results. Favorable stock selection in the Consumer Discretionary sector resulting from the outperformance of Manchester United plc, Vail Resorts, Inc., and recently re-purchased Under Armour, Inc. was outweighed by the negative effect of significantly larger exposure to the poor performing hotels, restaurants & leisure sub-industry. Weakness in Health Care was mainly due to the underperformance of Illumina, Inc., the third largest detractor from absolute results, and Inovalon Holdings, Inc., a health care data and analytics vendor. Inovalon’s shares declined after the company’s financial results fell short of Street expectations. Within Industrials, underperformance of Air Lease Corp., which leases commercial aircraft to airlines around the world, and Fastenal Co., an industrial supplies distributor, hurt relative results. Shares of Air Lease traded lower on concerns that "Brexit" would result in higher travel barriers and negatively impact passenger demand. Fastenal’s stock price declined due to choppy monthly sales performance as a sharp decline in demand in oil and gas-impacted regions and the impact of a stronger dollar on multinational industrial customers weighed on results.
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