Baron Small Cap Fund (BSCFX)

Portfolio Commentary

Review and Outlook (for quarter ended 3/31/2013)

The market was strong in the first quarter, as investors returned to equities. Despite all the worries about global macro issues such as European debt, Chinese growth, Middle East tensions, and austerity measures passed to deal with the U.S.’s fiscal cliff, surprisingly, the economy accelerated. Retail sales were firm, auto and industrial production rose, the housing market continued to strengthen, and employment reports beat consensus estimates by wide margins. Corporate earnings, which we contend are most important in determining stock prices, were solid. Corporate executives reported an improved tone to business and more optimism concerning their outlooks for the near future. Stocks rode the optimism to all-time highs. The upswing in stocks is four years old, yet this quarter it felt like a distinct change in attitude to us, with increased money flowing into equities, and the Fund. Still, there were some anomalies, in our view, in that defensive sectors such as Health Care led the rally, energy and commodity prices fell, and bonds weakened. These are all unusual occurrences for a rally based upon a firming economy.

The Fund’s strong returns were broad-based, with about a quarter of the Fund’s positions appreciating 20% or more in the quarter.

Consumer Discretionary stocks, which represented about 23% of the portfolio at quarter end, contributed the most based on fundamental factors. HomeAway, Inc. reported improved organic growth and positive trends with its expanded service offerings. Starz Liberty Capital, Inc., the pay cable service operator, was spun out from Liberty Media and its strategy to focus on developing original programming was well received. Shares of The Madison Square Garden Co. rose with the success of the Knicks, the end of the NHL strike, and strong returns from the capital invested in the Garden.
Other stocks which were strong in the quarter include holdings from the Information Technology sector, such as FleetCor Technologies, Inc., which had terrific earnings and continued to make strategic and accretive acquisitions.

The portfolio had less than 10% of its assets invested in Health Care, the best performing sector in the benchmark. Two of the portfolio’s Health Care investments, Masimo Corp. and IDEXX Laboratories, Inc., declined in the quarter and dampened overall performance of our stocks in this sector.

With the market rally and growth stocks trading at higher multiples, our new purchases focused on special situations and initial public offerings. Our largest purchase was DigitalGlobe, Inc., the operator of a constellation of high resolution satellites. We also bought stakes in IPOs Tesoro Logistics, an MLP, and Artisan Partners, an asset manager.

Subsequent to the end of the quarter, the positive trend in employment reversed. In the last three years, both the economy and stock markets cooled after March. We have been impressed by the economy’s and markets’ resiliency in the face of what should have been significant headwinds. On the other hand, bears think the economy will contract, earnings will disappoint and the market will fall, especially since stocks have been bought with impunity fueled by excessive liquidity provided by central banks. Though stocks have risen, valuations are still reasonable on an absolute basis and stocks are attractive relative to alternatives. If earnings don’t disappoint, it would not surprise us if the rotation back to equities could last longer than many expect.

Top Contributors/Detractors to Performance

Contributors (for quarter ended 3/31/2013)

• FleetCor Technologies, Inc. provides payment processing services to the vehicle fleet industry. The stock rose during Q1 due to better than expected earnings results and guidance. Organic growth continues to be strong, and management is aggressively seeking to grow outside the U.S. through acquisitions.

• HomeAway, Inc. was up 47.7% in Q1. HomeAway is the #1 firm in online vacation rentals with over 700,000 paid listings. Performance in Q1 was due to strong Q4 results, where the company beat Street expectations and showed an acceleration in its revenue-per-listing metric.

• Shares of Gartner, Inc., the leading independent provider of research and analysis on the information technology industry, outperformed in Q1, driven by solid financial results among uneven end markets. The company continued to generate record bookings in its research business, with contract value trending up 14%.

Detractors (for quarter ended 3/31/2013)

• Shares of Polypore International, Inc. partially retreated from their Q4 run up of 31.5%. Although the lead-acid battery separator business (about 50% of revenues) did well in Q4, sales of separators for lithium-ion (LiON) batteries were lower than expected for both consumer and vehicle applications. We believe the revenue decline associated with LiON battery separators has troughed, and with its capacity expansion, the company should see significant upside earnings leverage as electric vehicles gain penetration.

• Shares of United Natural Foods, Inc., the largest distributor of natural and organic products in North America, detracted from Q1 performance despite continued strong fundamentals. The company’s largest customer is Whole Foods, which is experiencing robust, though moderating, growth in the face of tough comparisons. We believe United Natural Foods will continue to benefit from a greater focus on health, growth of organics from less than 10% of grocery today, and conventional supermarkets devoting more space to the category.

• Mercury Systems, Inc. was hit particularly hard in the months just prior to the implementation of the federal sequestration process. While Mercury Systems is incredibly well positioned as an outsourcer of high-end defense electronics components for critical programs (missile defense, electronic warfare, and advanced surveillance applications), it suffered as large contractors focused on their own cash flows by delaying quick-turn orders to subcontractors. We believe that once program priorities are firmly established at the Department of Defense, revenues will rebound quickly.

Quarterly Attribution Analysis (for quarter ended 3/31/2013)

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 Small Cap Fund (Retail Shares) gained 12.59% in the first quarter, yet slightly underperformed the Russell 2000 Growth Index by 62 basis points. During the period, stock selection was favorable, yet the Fund’s sector weightings detracted from relative performance.

The Fund's investments within the Consumer Discretionary, Energy, and Information Technology (IT) sectors were the primary contributors to relative performance. Within Consumer Discretionary, more than half of the Fund's investments outperformed, led by HomeAway, Inc., the leading online vacation rentals company, and Starz Liberty Capital, Inc., a premium subscription video programming service. Shares of HomeAway rose 47.7% in the quarter after the company reported better than expected quarterly results and showed acceleration in its revenue-per-listing metric. Shares of Starz increased sharply in the quarter after Liberty Media Corp. spun-off the company in early January. Other contributors in the sector were Krispy Kreme Doughnuts, Inc., which operates as a branded retailer and wholesaler of doughnuts, beverages, and packaged sweets worldwide, and The Madison Square Garden Co., which operates sports teams, venues, and cable networks. Within Energy, the majority of the Fund's investments outperformed, led by Core Laboratories N.V. and Susser Petroleum Partners LP. Favorable stock selection within the IT sector was mainly the result of outperformance of FleetCor Technologies, Inc., a provider of payment processing services to the vehicle fleet industry. Strong organic growth and accretive acquisitions led to better than expected earnings and guidance.

Underperformance of the Fund’s investments within the Industrials and Health Care sectors and the Fund’s larger exposure to Telecommunication Services, one of the worst performing sectors in the benchmark, were the largest detractors from relative performance. Weakness within Industrials was mainly attributable to underperformance of Polypore International, Inc. Polypore’s shares declined after their run up last quarter as a result of lower than expected sales of lithium-ion battery separators. Within Health Care, a combination of unfavorable stock selection and the Fund’s lower exposure to the outperforming sector, and to biotechnology stocks in particular, hurt relative results. The Fund’s largest detractor from relative results in the sector was IDEXX Laboratories, Inc., the leading provider of diagnostics to the veterinary industry. Shares of IDEXX retreated from all-time highs reached late last year as investors analyzed the impact of a change in the company’s relationship with one of its distributors.

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