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 3/31/2015)

Baron Real Estate Fund generated solid returns in the first quarter, along with most REIT and real estate funds. Positive performance was driven by several categories, including REITs, hotel & leisure, building products/services companies, and senior housing operators.

Business conditions were generally strong for the Fund’s REIT companies; and we believe they may continue to benefit from limited new construction activity, accretive investment opportunities, and the possibility that interest rates remain low. We are mindful, however, that the valuations of many REITs have become pricey (with compressed dividend yields), and REITs may be more vulnerable to an eventual rise in interest rates.

We think the prospects for our investments in hotel & leisure companies remain attractive amid expectations of solid demand and low supply forecasts, as well as company-specific initiatives.

We believe that building products/services companies will continue to benefit from a multi-year recovery in housing.

Senior housing operators represented in the Fund are well positioned, in our opinion, to benefit from favorable demographic trends, industry consolidation, a cyclical recovery in their businesses, and, perhaps, initiatives that can unlock real estate value.

We are mindful that some of the contributors to positive equity market performance in the last few years such as favorable valuations, an accommodating Federal Reserve, and the undervalued U.S. dollar, are now somewhat less compelling. Consequently, the outsized equity returns of the last five years are unlikely to be repeated. Nevertheless, we continue to believe that the prospects for real estate and the Fund are attractive.

We believe stocks remain attractive versus bonds. Longer duration bonds are so expensive now that they carry a negative yield when adjusted for inflation. For example, the 10-year treasury yield has declined from 6.58% in January 2000 to 1.90% today despite a longer term inflation expectation of at least 2.0%.

The backdrop for commercial real estate remains strong while demand, in most cases, is outstripping new construction activity. Strong balance sheets, low interest rates, and wide access to cheap capital afford many companies the opportunity to develop and acquire real estate, and to propel growth.

In the housing market, it appears that, at long last, the pieces are falling in place for a normalized and growing residential market. Employment and household formation have improved. Credit conditions are easing and mortgage rates are near historical lows. In numerous markets, renting is more expensive than owning a home. New home sales are up 25% year-to-date.

In summary, business conditions for most of our companies are improving – both in commercial and residential real estate. The first quarter of 2015 was particularly encouraging, given the large number of the Fund’s portfolio of companies that reported strong business results, strategic acquisitions, corporate reorganizations, and/or favorable business outlooks.

We are pleased with the Fund’s holdings. We believe we have assembled a group of quality companies that are reasonably priced with good growth prospects, led by great management teams.

Top Contributors/Detractors to Performance

Contributors (for quarter ended 3/31/2015)
  • Shares of Mohawk Industries, Inc. contributed positively to performance during Q1, driven by better-than-expected Q4 results and the announcement of a sizable acquisition. Mohawk is a leading vertically integrated flooring manufacturer with a global footprint. Its product offerings include carpet, rugs, ceramic tile, laminate, wood, stone, and vinyl flooring.

  • Shares of timeshare company Diamond Resorts International, Inc. increased in Q1, driven by strong sales and improved margins as a result of innovative marketing programs. The uptick in revenue has generated significant free cash flow, which Diamond has started using to buy back shares and develop additional inventory. We believe Diamond will continue to use its cash to purchase inventory, buy back shares, and possibly initiate a dividend.

  • Shares of Norwegian Cruise Line Holdings, Ltd., an operator of cruise ships under the Norwegian, Regent, and Oceania brands, increased in Q1 on stronger-than-expected synergies from its recent Prestige acquisition and the continued decline in oil prices, which currently comprise 11% of its operating costs. We believe the company will benefit from six new ships coming online over the next five years. We believe this additional inventory, combined with lower industry supply, will improve yields and cash flow in the years to come.

Detractors (for quarter ended 3/31/2015)
  • Shares of Wynn Resorts Ltd., an operator of casinos in Macau and Las Vegas, declined in Q1 as a result of the Chinese government’s anti-corruption campaign, which has produced a slowdown in Macau and lower spend at the casinos. We believe that eventually comparisons will ease and new supply will draw visitors back to Macau. Wynn continues to generate strong cash flow which, in our view, supports its 5% dividend yield.

  • Shares of Las Vegas Sands Corp., which operates casinos in Macau, Singapore and Las Vegas, declined in Q1 as a result of the Chinese government’s ongoing anti-corruption campaign, which has discouraged visits to Macau and resulted in lower spend at the casinos. We believe that comparisons will eventually ease and new supply will bring visitors back to Macau. Las Vegas Sands continues to generate strong cash flow, which we think supports its 5% dividend yield.

  • Essent Group Ltd. provides credit protection on residential mortgages. Essent reported strong financial results during Q1, including growth in its book of business and expanding distribution. However, the stock fell as continued softness in the U.S. housing market recovery caused the company’s operating leverage to moderate. We expect Essent to show significant earnings growth as the housing market recovers and the government pulls back from the mortgage finance market.

Quarterly Attribution Analysis (for quarter ended 3/31/2015)

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.

The Baron Real Estate Fund (Institutional Shares) rose 4.55% in the first quarter, yet modestly underperformed the MSCI USA IMI Extended Real Estate Index by 57 basis points. During the quarter, the Fund’s relative real estate category weights added value, but this positive effect was more than offset by the effect of stock selection.

Outperformance of the Fund’s hotels & leisure investments and its significantly lower exposure to lagging REITs contributed the most to relative performance. Strength in hotels & leisure was mostly attributable to the outperformance of Diamond Resorts International, Inc. and Norwegian Cruise Line Holdings Ltd., which were also two of the Fund’s largest contributors on an absolute basis. An accretive transaction contributed to Hilton Worldwide Holdings, Inc.’s outperformance during the quarter. Hilton sold the Waldorf Astoria in New York for $1.95 billion or 32x EBITDA, and it redeployed the proceeds in five hotels in San Francisco and Florida at 13x EBITDA. The Fund’s larger exposure to hotels & leisure stocks, which rose 6.6% as a group within the index, also aided relative performance.

Underperformance of the Fund’s tower operators & wireless telecommunication services investments, its average cash exposure of 4.5% in an up market, and its lower exposure to outperforming building products & services stocks detracted the most from relative results. The Fund’s three tower holdings trailed their counterparts in the index after falling 2.4% as a group, with Tower Bersama Infrastructure Tbk PT and Sarana Menara Nusantara Tbk PT declining. These companies, which are the two largest operators of tower assets in Indonesia, were hurt when their management teams cautioned investors to expect a muted new-build outlook for key customers in 2015. Stock selection in the senior housing & health care service providers and casinos & gaming operators also detracted from relative results. Weakness in senior housing was mainly due to the underperformance of Brookdale Senior Living, Inc., which offers residents in its senior living communities a full continuum of services, including independent and assisted living, memory care, and skilled nursing. Brookdale’s shares lagged after the company preannounced weaker-than-expected quarterly earnings and lowered guidance for 2015. This was a big disappointment in the first full quarter since it combined operations with Emeritus. Within casinos & gaming, the underperformance of Wynn Resorts Ltd. and Las Vegas Sands Corp., which were also the Fund’s two largest detractors from absolute performance, hampered relative results.

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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.