Review and Outlook
Baron Real Estate Fund declined in the second quarter, although it outperformed its benchmark, the MSCI USA IMI Extended Real Estate Index.
The growing likelihood that the U.S. Federal Reserve will increase interest rates in the second half of 2015 had a negative impact on real estate in the quarter, particularly because high-dividend yielding stocks like REITs usually become less attractive to investors when treasury yields climb.
We are aware of the impact that an increase in interest rates could have on some categories of real estate. However, we believe that the Fund, with its broader and more comprehensive investment approach than the typical REIT-dominated fund, could potentially generate solid results should interest rates increase in the next few years.
In addition to interest rates, other contributors to positive equity market performance in the last five years – namely, favorable valuations 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 the equity market and the Fund are attractive.
In our opinion, economic conditions are generally solid, and currently offer a rare and welcome combination of low interest rates, low inflation, cheap oil prices, solid job growth, and increased household formation.
Stocks, while generally not cheap, remain attractive versus bonds (especially factoring in longer-term inflation expectations of at least 2.0%).
Also, the backdrop for commercial and residential real estate remains appealing. 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, thus propelling growth.
It appears that, at long last, the pieces are falling in place for a normalized and growing housing market. Employment and household formation have improved. Credit conditions are easing, and mortgage rates remain near historical lows. In numerous markets, renting is more expensive than owning a home, thus fueling the preference to purchase. There are signs that the millennial generation (approximately 75 million people ages 18-34) is beginning to move out of their parents’ home. New home sales are increasing and construction levels remain below historical norms, creating a favorable ratio between demand and supply.
We remain optimistic. We are hopeful that the Fund’s investments will continue to report solid business results, favorable business outlooks, and perhaps additional initiatives to increase shareholder value such as strategic acquisitions or corporate reorganizations.
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
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 Real Estate Fund declined 3.66% in the second quarter, yet outperformed the MSCI USA IMI Extended Real Estate Index by 200 basis points due to differences in real estate category weights relative to the index.
The Fund’s significantly lower exposure to REITs, which fell more than 9% in the index due to concerns over rising interest rates, and outperformance of its investments within building products/services, data centers, and real estate operating companies contributed the most to relative results. Strength in building products/services was mostly attributable to the outperformance of Builders FirstSource, Inc. and CaesarStone Sdot-Yam Ltd., two of the largest contributors on an absolute basis. Other contributors to relative performance in this real estate category were Masonite International Corp., a vertically integrated manufacturer of interior and exterior doors, and Mohawk Industries, Inc., the largest player in the U.S. flooring industry. Both companies outperformed on better-than-expected quarterly results. Outperformance of the Fund’s only data centers real estate holding, Equinix, Inc., added value. The company was also the second largest contributor to absolute performance. Real estate operating companies outperformed their index counterparts by 10%, led by Kennedy Wilson Europe Real Estate plc, which owns a portfolio of real estate and property loans in the U.K., Ireland, and Spain. Shares of Kennedy Wilson Europe increased in the quarter, driven by continued acquisition activity, including the company’s first acquisition in Spain.
Underperformance of investments within the senior housing and casinos & gaming real estate categories detracted the most from relative results. The Fund's investment in senior housing company Brookdale Senior Living, Inc. was negatively impacted by disappointing business results, lower earnings guidance, and the challenging integration with Emeritus. Weakness in shares of Capital Senior Living Corp. was due to modestly disappointing quarterly results. The Fund’s three casinos & gaming investments, MGM Resorts International, Las Vegas Sands Corp., and Wynn Resorts Ltd., were hurt by the slowdown in Macau. We increased our position in MGM because we believe the current stock price does not accurately reflect improving Las Vegas Strip trends as well as the company’s pipeline of new casinos in Massachusetts and Maryland. We sold Las Vegas Sands and Wynn during the quarter due to consistently weak business conditions in Macau and Wynn’s decision to slash its dividend by 67%.
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