Baron Small Cap Fund (BSCFX)

Portfolio Management

Cliff Greenberg

Fund Manager since 1997

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Fund Description

Baron Small Cap Fund invests primarily in small growth companies.



Fund Resources

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Cliff Greenberg seeks long-term growth from small companies.

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Portfolio Commentary

Retail Performance

Review and Outlook (for quarter ended 9/30/2015)

The third quarter was a challenging one. Concerns arose that growth in China was significantly slowing. The Chinese devalued their currency by 2%, which fueled the fire. Emerging market equities and currencies declined, and their economies entered recession. Fears were stoked that developed economies would suffer in conjunction. The U.S. market experienced its first correction in four years.

The tenor of the small cap market changed. Psychology turned negative. The down draft in prices spread from companies with big foreign exposures to engulf many of the sectors that had been the leaders for the previous year. Biotechnology, pharmaceuticals and high multiple technology stocks rolled over. Health Care stocks got spooked by comments by politicians that drug cost inflation needed to be better controlled. Investors sold “winners” to protect gains. Concern about a possible interest rate hike contributed to the weak market.

In all this negativity, there are some positive observations. If rates stay low, that would be good for stocks. The U.S. dollar was rising in anticipation of higher domestic interest rates, which was hurting our economy and reducing reported earnings of companies with international operations. This, too, is on hold. Investment sentiment quickly became negative. . . this is good for stocks. Stock multiples have contracted to a point where they seemed reasonable, even cheap in many cases, against our expectations of future earnings.

We believe earnings will be the key to the market and it is what we are most focused on. It has been a market where struggling companies that miss earnings expectations have been blasted, no questions asked, and the stocks have gone down more and stayed down longer than in normal market environments. Many performing companies have become market darlings, trading up to hefty valuation levels we feel uncomfortable with. Many of these companies are not yet profitable and trade at revenue multiples or other concoctions, which do not hold up well in corrections.

We are hoping to invest somewhere in the middle. We seek to invest in businesses that are able to show significant organic revenue growth (usually 5-20%), which can increase margins so profits are growing faster than revenues, that can supplement this with accretive acquisitions, debt repayment or share repurchase, so that per share earnings grow even faster; and where trading multiples can (ideally) expand or stay around present levels.

Going forward, the bull case for stocks is that the economy will continue to expand at a modest, yet self-sustaining rate. Monetary policy will be friendly, meaning when rates do rise that it will be gradual and will not choke off growth. We think stock valuations will remain reasonable and inexpensive relative to low levels of interest rates and inflation. The bear case is that a recession is in the offing or the market will be gripped by contagion. The bull case seems more likely to us, and we are generally positive about the U.S. economy and underlying fundamentals. But we are hearing of weakening conditions from some of our portfolio companies so we are watching carefully.

Top Contributors/Detractors to Performance

Contributors (for quarter ended 9/30/2015)
  • Shares of Bright Horizon Family Solutions, Inc., a leading provider of high quality corporate sponsored childcare in the U.S. and parts of Europe, rose in Q3. Management continued its exceptional execution. Growth was driven by additional centers, a mix shift to higher margin consortium centers, greater center utilization, accretive acquisitions in a highly fragmented market, international expansion and the rollout of new higher margin services, including backup care and educational counseling.

  • Shares of veterinary diagnostics manufacturer IDEXX Laboratories, Inc. contributed to Q3 performance. The company reported strong Q2 results that demonstrated share gains in instruments and reference labs, and assuaged concerns regarding its competitive position in rapid assays. Catalyst placements grew 44% in the quarter, driven by the launch of CatalystOne in the U.S. and Europe. Premium hematology placements grew 30% in Q3, a meaningful increase from 14% last quarter. Reference lab results were also strong, growing 12.1% in Q3.

  • Shares of The Ultimate Software Group, Inc. contributed to performance in Q3. Ultimate Software is a leading provider of cloud-based payroll and human resources software. The company reported good financial results during Q3, and management noted that it had the best overall bookings quarter in company history. We continue to believe the company is well positioned for market share gains and strong revenue growth for years to come.

Detractors (for quarter ended 9/30/2015)
  • Shares of senior housing company Brookdale Senior Living Inc. fell in Q3 on concerns over the integration with Emeritus, lagging occupancy, and a possible increase in senior housing supply. Investors appear less optimistic that management will pursue actions to unlock shareholder value, such as the sale of the company or a spin-off of owned real estate. Absent such a transaction, we still believe Brookdale will benefit from positive demographics, deeper senior housing penetration, and favorable supply/demand balance.

  • Shares of mattress retailer Mattress Firm Holding Corp. fell in Q3. The company lowered earnings expectations in the face of a challenging economic environment in many of its Texas and energy-dependent markets due to low oil prices and their associated economic impact. We retain conviction in Mattress Firm’s long-term growth strategy and are willing to wait out the recent economic malaise.

  • Shares of Financial Engines, Inc., a service provider to 401k plan participants, declined in the quarter. The company missed street expectations. While an enhanced marketing program helped boost enrollment rates and assets under contract rose modestly, the company was not successful in converting assets to profits due to downward pressure on revenue yield and increased costs. We maintain conviction as we believe Financial Engines will continue to expand its prospects as it adds new record keepers to its client base.

Quarterly Attribution Analysis (for quarter ended 9/30/2015)

The Quarterly Attribution Analysis for period ending September 30, 2015 is not yet available

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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 advise to any person and are subject to chage 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.