Review and Outlook
The market trended higher for most of the quarter as fear of a slump in global growth abated. Oil held to around $50 a barrel, stabilizing international economies. The U.S. economy chugged along, with statistics supporting 2% domestic growth. A surprisingly weak employment report for May stirred worries about the health of the seven-year expansion. However, it backed off expectations for a Federal Reserve rate increase, which the market favored. At the end of the quarter the market suffered a sudden drop when British citizens voted to leave the European Union.
The market has acted more normal this year, meaning stocks have broadly reacted to earnings results, news flows and valuation considerations, as opposed to momentum, sector rotation/factors and speculation. Our best performing stocks were companies who announced strong results and incrementally positive outlooks.
The U.S. and global economies have proven to be resilient, though we are not sure what will come of Brexit. Leading indicators in the U.S. have improved; and risk, measured by credit spreads and financial conditions, has moderated.
A good portion of our holdings are seeing growth accelerate; are growing earnings by double digits organically; and are increasing shareholder value through acquisitions, debt paydown, and/or share buy backs. After an exceptionally strong 2013, Baron Small Cap Fund has been marking time, but our holdings have been constantly growing their earnings and value. We believe valuations, which were high in retrospect, are now reasonable and are either stable or rising, especially for the visible and consistent growth that our “high quality” holdings are providing.
We believe a market environment that is so skittish is good for stocks. The Fund’s strong second quarter performance underscores just how hard it is to time when we will make our returns, which often come when least expected. It also highlights the futility of trying to predict the unpredictable and the virtue of ignoring the noise and focusing on business fundamentals. Our goal is to build and invest in a winning portfolio and “be in it to win it.”
We continue to focus on investing in a diversified portfolio of what we consider to be well-managed special growth businesses that can continue to compound growth at high rates for an extended period. This is what we have always done. We are heartened by the fact that our approach is coming back into favor after what we believe was an abnormal period where momentum, volatility, and high-multiple stocks outperformed.
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 Small Cap Fund increased 5.00% in the second quarter and outperformed the Russell 2000 Growth Index by 176 basis points, primarily due to stock selection.
Outperformance of Industrials, Health Care, and Information Technology (IT) investments added the most to relative performance. In Industrials, outperformance of aerospace & defense holdings, led by TransDigm Group, Inc., added the most value. TransDigm was the largest contributor on an absolute basis. Investments in Acuity Brands, Inc., the leading U.S. provider of lighting solutions, and Waste Connections, Inc., an integrated solid waste services company, also lifted relative results. Acuity’s shares rose after the company reported strong financial results. Shares of Waste Connections rose after the company’s legacy waste business grew +5% in Q1 while generating strong free cash flows. The company also completed its acquisition of Progressive Waste Solutions, which we believe will be beneficial for shareholders given the immediate synergies and cash flow benefits. Strength in Health Care was mainly due to the outperformance of Press Ganey Holdings, Inc., and health care equipment holdings IDEXX Laboratories, Inc. and DexCom, Inc. Press Ganey and IDEXX were two of the largest contributors to absolute performance, while shares of DexCom rose after reporting solid financial results. Within IT, outperformance of Gartner, Inc. and lack of exposure to lagging semiconductor stocks, which fell 6.9% within the index, added the most value. Shares of syndicated IT research provider Gartner increased on strong financial results. We believe Gartner’s key forward-looking metrics continue to look strong, with productivity trends approaching levels sufficient to drive margin expansion. Outperformance of application software holdings Guidewire Software, Inc. and The Ultimate Software Group, Inc. and electronic equipment & instruments investments FEI Company and Cognex Corp. also aided relative performance.
Consumer Discretionary and Consumer Staples investments were the primary detractors from relative results. In Consumer Discretionary, underperformance of education services holdings, led by Houghton Mifflin Harcourt Company, and larger exposure to this lagging sub-industry detracted the most from relative results. Houghton Mifflin was the second largest detractor from absolute results. Weakness in the sector was also attributable to the underperformance of Penn National Gaming, Inc., a U.S. regional gaming company, and Mattress Firm Holding Corp., the third largest detractor from absolute performance. Penn’s stock price fell as a result of investor concerns over subdued consumer spending and leverage on the company’s balance sheet. Within Consumer Staples, underperformance of The Chefs' Warehouse, Inc., the largest detractor on an absolute basis, hurt relative results.
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