Baron Real Estate Fund (BREIX)

Portfolio Management

JeffreyKolitch
Jeffrey Kolitch

Fund Manager since 2009

View All Commentary by Jeffrey

Fund Description

Baron Real Estate Fund invests in securities of real estate and real estate related companies of all sizes.

  

Portfolio Commentary

Institutional Performance

Review and Outlook (for quarter ended 12/31/2015)

Despite the strong performance of Baron Real Estate Fund for the six years since inception, we are disappointed with its 2015 performance, in which we made a few key investment mistakes (particularly in senior housing and hotel investments). We have spent considerable time reviewing 2015 and documenting “lessons learned,” and believe we are well positioned to avoid these missteps in the future.

We have been taking advantage of the recent, largely indiscriminate market sell-off to upgrade the quality of the holdings and overall structure of the Fund.

  • We are buying what we view as best in class companies that are now “on sale” (e.g., CBRE Group, Inc., Mohawk Industries Inc., Boston Properties, Inc.)
  • We have lowered overall leverage by trimming or exiting positions in companies with more highly leveraged balance sheets.
  • We are minimizing our exposure to smaller and less liquid companies.
  • We are de-emphasizing complex companies that may have a narrower investor audience and are less likely to receive full credit for intrinsic value.
  • We are trimming exposure to geographic markets that may face headwinds due to low oil prices (Houston), elevated real estate construction activity (e.g., New York City hotels), or unfavorable international exposure (e.g., Brazil).
  • We are increasing exposure to REITs. Near-term prospects for REITs appear relatively attractive. Most REITs are largely domestic, have average dividend yields of about 4%, may continue to benefit from low interest rates, should benefit from occupancy growth and increased rents at a time of limited new construction activity, and have stronger balance sheets and access to low cost capital and accretive investment opportunities, in our view. We are also positioning the Fund with a larger yield and a defensive orientation. Our view is that targeting a 30-40% REIT allocation is prudent, given current economic and market conditions.
  • Other real estate categories we are prioritizing include commercial real estate service companies, cruise line operators, data center companies, and building product/services companies. We are de-emphasizing hotels, timeshare operators, international gaming companies, and senior housing operators.

While the near-term outlook for real estate is a bit more cautious than a few years ago, we maintain a favorable bias because we believe the positive considerations outweigh the negative ones. We believe the factors that have fueled the real estate recovery largely remain in place. Demand continues to outstrip supply in many markets, most balances sheets are in solid shape, and credit remains available at low interest rates. Absent a recession, our sense is that business prospects for many categories of real estate will remain positive.

We recognize that in the months ahead, there may be periods of continuing market weakness. Nevertheless, we believe that the overall prospects for real estate and the Fund remain promising.

Top Contributors/Detractors to Performance

Contributors (for quarter ended 12/31/2015)
  • Shares of quartz countertop manufacturer CaesarStone Sdot-Yam Ltd. contributed in Q4, recapturing some of the ground it lost in Q3 that resulted from Q2 financial results that, while impressive, fell short of Street expectations. A negative report by a short seller also pressured the stock in Q3. We remain positive on our investment in CaesarStone, as earnings growth continues to accelerate from successful new product launches and quartz market share gains over other countertop materials such as granite and marble.

  • Shares of MGM Resorts International, an operator of casinos mainly in Las Vegas and Macau, increased in Q4 as the company generated strong Las Vegas Strip revenue per available room and indicated robust forward bookings for conventions, especially at its new Mandalay convention space. In addition, the announcement that MGM will be spinning off some assets into a REIT and issuing an IPO for the REIT in early 2016 boosted the stock price as investors viewed the spin off as a smart way to reduce balance sheet leverage for the holding company.

  • Equinix, Inc. is a carrier-neutral data center and Internet exchange provider. Share prices rose in Q4 after Equinix announced the closing of its acquisition in Japan and the approval of its Telecity acquisition in Europe. We expect both deals to strengthen Equinix’s leading global position. We like Equinix's growth prospects and think it has a clear and sensible plan to keep growing at a higher pace than its peers while improving business efficiencies and demonstrating margin leverage.

Detractors (for quarter ended 12/31/2015)
  • Despite earnings that met Street expectations, shares of global hotelier Hilton Worldwide Holdings, Inc. decreased in Q4 as revenue per available room decelerated, raising concerns that the current lodging cycle was ending. Concerns that Airbnb was taking away pricing power during peak times also affected sentiment on the stock. The company continues to consider spinning off its owned assets into a REIT and spinning off or selling its timeshare business, all of which could create more value in the stock, in our view.

  • Shares of Builders FirstSource, Inc. fell in Q4. Builders FirstSource is a leading distributor of building products, mostly for the new residential construction industry in the U.S. Despite impressive financial results for Q3, shares declined as a result of relatively high debt levels amidst concerns that macroeconomic growth is slowing. Following its merger with ProBuild, we retain conviction, as residential construction levels are still depressed, the company is gaining market share, and management’s merger synergy targets appear conservative.

  • Shares of ClubCorp Holdings, Inc., an operator of golf courses and business clubs across the U.S., declined in Q4 due to concerns over the effect of slumping oil prices on the Texas economy, where 26 of its 150 golf clubs are located. In addition, a decline in the number of golf rounds played in Q4 as a result of bad Texas weather affected sentiment. However, golf rounds played comprise just 15% of the revenue and retention rates have not been affected, nor do we expect them to be, since members historically stay on 85% of the time.

Quarterly Attribution Analysis (for quarter ended 12/31/2015)

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 Real Estate Fund rose 5.33% in the fourth quarter, yet trailed the MSCI USA IMI Extended Real Estate Index by 84 basis points. During the quarter, the Fund’s relative real estate category weights and, to a lesser extent, its average cash exposure of 3.5% in an up market hurt relative results.

The Fund’s investments within the senior housing operators & health care facilities, casinos & gaming, and REIT categories were the largest contributors to relative results. Within senior housing operators & health care facilities, the timely sale of Brookdale Senior Living, Inc., which fell sharply after the Fund exited its position in late October, and the Fund’s lower exposure to this poor performing category added value. Brookdale outperformed for the period held before being sold due to concerns surrounding the highly disruptive Emeritus integration, which resulted in disappointing performance and lowered estimates. Strength in casinos & gaming was due to outperformance of MGM Resorts International and the Fund’s larger exposure to this top performing category, which rose 16.6% in the index. MGM was the second largest contributor to absolute performance. Favorable stock selection in REITs, mostly owing to the outperformance of Equinix, Inc. and Douglas Emmett, Inc., was partly offset by the Fund’s meaningfully lower exposure to this strong performing category. Equinix was the third largest contributor on an absolute basis, while shares of Douglas Emmett rose after reporting Q3 results that highlighted the strong real estate fundamentals in the company’s key Los Angeles sub-markets.

The Fund’s hotels & leisure and building products/services investments were the primary detractors from relative performance. Within hotels & leisure, underperformance of Hilton Worldwide Holdings, Inc. and ClubCorp Holdings, Inc., two of the largest detractors on an absolute basis, hampered relative results. The Fund’s significantly larger exposure to this lagging category also hurt relative performance. Weakness in building products/services was partly due to the Fund’s notably lower exposure to strong performing home improvement retailers Home Depot, Inc. and Lowe's Companies, Inc., which account for nearly 14% of the index. Underperformance of Builders FirstSource, Inc., the second largest detractor from absolute results, and Masonite International Corp., a vertically integrated manufacturer of interior and exterior doors, also weighed on relative performance in the category. Masonite’s shares underperformed due to lingering concerns that pricing power is weakening in one of Masonite’s end markets. However, our channel checks indicate that the opposite holds true, and we remain excited about our investment in Masonite.

Yearly Attribution Analysis (for year ended 12/31/2015)

Baron Real Estate Fund declined 4.42% during the year and trailed the MSCI USA IMI Extended Real Estate Index by 669 basis points, primarily due to stock selection.

Investments within the REITs, data centers, and casinos & gaming categories contributed to relative performance. Within REITs, outperformance of Equinix, Inc. and Strategic Hotels & Resorts, Inc. and significantly lower exposure to the lagging health care, diversified, and mortgage REIT sub-industries added the most value. Equinix, which was moved from data centers to REITs in early July after it completed its REIT transformation, was the largest contributor on an absolute basis. Shares of Strategic Hotels, which owns and manages luxury hotels in North America and Europe, rose after Blackstone agreed to acquire the company. Strength in data centers was due to the outperformance of Equinix before it was reclassified as a REIT. Within casinos & gaming, MGM Resorts International contributed the most to relative performance after being added to the Fund early in the year.

Hotels & leisure, building products/services, senior housing operators & health care facilities, and tower operators & wireless telecommunication services investments were the largest detractors from relative results. Within hotels & leisure, cruise line investments added value, but this positive effect was more than offset by underperformance of hotels & timeshare companies, led by Hilton Worldwide Holdings, Inc., Hyatt Hotels Corp., Wyndham Worldwide Corp., and Starwood Hotels & Resorts Worldwide, Inc. Investor concerns surrounding decelerating revenue per available room and the potential end of the upswing in the lodging cycle weighed on these stocks. Fears about Airbnb taking market share and affecting pricing power also hurt sentiment. Within building products/services, meaningfully lower exposure to outperforming home improvement retailers Home Depot, Inc. and Lowe's Companies, Inc. and underperformance of CaesarStone Sdot-Yam Ltd. and Summit Materials, Inc. detracted the most from relative results. Shares of quartz manufacturer CaesarStone dropped after it reduced its full-year revenue guidance on its Q2 earnings call. Weighing further on the stock price was the publishing of a negative report by a short seller. Shares of building materials company Summit declined as a result of more tempered expectations around the pace of future acquisitions, exacerbated by higher-than-average leverage. Weakness in senior housing operators & health care facilities was due to the underperformance of Brookdale Senior Living, Inc. and Capital Senior Living Corp. Brookdale was the largest detractor on an absolute basis before being sold late in the year, while shares of Capital Senior fell on concerns about increasing development activity and the prospect of slowing business fundamentals. The primary detractor from relative performance in the tower operators & wireless telecommunication services category was Indonesian tower operator Tower Bersama Infrastructure Tbk PT. Tower Bersama’s shares fell sharply due to a weakened demand environment from carrier customers, a cancellation of the Mitratel acquisition, and rupiah depreciation.

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The prospective performance of the companies discussed herein is based on our internal analysis and reflect our opinions only. We cannot promise future returns and our opinions are a reflection of our best judgement at the time of publication. Our views are not intended as recommendations or investment advice to any person and are subject to change at any time based on market and other conditions and Baron has no obligation to update them. Investing in the stock market is always risky. Current and future portfolio holdings in the Fund are subject to risk.

Source: FactSet PA.