Review and Outlook
The current environment has been good for stocks. Inflation is low, interest rates are low, the dollar is strong, and the economy is expected to accelerate as the headwinds from the beginning of the year abate. We believe the main reason that the market has been so strong is because the economy is now on sound footing. Our economy is stable, and is back to normal, after going through a four-year, gut-wrenching restructuring process.
With this backdrop, investors have favored growth this quarter. Performance of U.S. small-cap stocks has outpaced larger company stocks, and U.S. stocks have decoupled from non-U.S. equities. The fastest growing technology, Internet, and biotech companies have been the market leaders. The smallest market caps have outperformed. Though much is written that the market trading multiples are inexpensive or are reasonable in historical context, after the move in the NASDAQ this last quarter, many of the market leaders now trade at fancy valuations, in our opinion.
Baron Small Cap Fund participated nicely in the rally, led by our highest growth holdings. The Fund did not keep pace with the Russell 2000 Growth Index, as one would expect because of the lower beta profile of the Fund. As usual, we have lower exposure to Health Care and Information Technology, which was a disadvantage this quarter since these were among the best performing sectors. Because of our long-stated approach to “water our flowers,” which means that we stuck with our winners as they got bigger if we believed they still offered attractive returns, the market caps of many of our holdings seem to be out of the sweet spot of the market. As a point of interest, last year the opposite was true, and our higher market cap holdings drove performance. Our detractors reported disappointing results or guidance, driven either by difficult macroeconomic conditions in their industries or company-specific issues.
We initiated five new positions and exited three. We trimmed some stocks that have experienced meaningful appreciation and added to positions in which we have our highest conviction or can take advantage of recent price weakness.
Going forward, an optimistic perspective is that cooler heads will prevail and a political compromise will avert a default on the U.S. government debt, the economy will strengthen, that the Federal Reserve will get back to a more normal monetary policy (Fed “tapering” will be a good thing) and that inflation will stay low. In this scenario, we believe stock multiples could continue to expand and propel stocks higher. Remember that P/E multiples declined for the last decade, and, as this reverses, stocks can gain nicely even without significant earnings growth.
The counterpoints are that the economic recovery has been tepid and trading multiples of high growth small stocks that are now in vogue are high. We are price sensitive, so we are sticking to our knitting – favoring well positioned growth businesses that we believe are still undervalued based on our realistic and conservative projections of future earnings and trading multiples.
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.
The Baron Small Cap Fund (Institutional Shares) gained 9.46% in the third quarter, yet underperformed the Russell 2000 Growth Index by 334 basis points. During the quarter, the Fund’s stock selection and, to a lesser extent, sector weights detracted from relative performance.
The Fund's investments within the Information Technology (IT) and Financials sectors were the primary contributors to relative performance. Within IT, outperformance of FleetCor Technologies, Inc., a payment processing provider to the vehicle fleet industry, and Cognex Corp., a leading provider of machine vision systems added the most value. By portfolio weight, more than a third of the Fund’s IT investments are application software companies, and these businesses also aided relative results, led by The Ultimate Software Group, Inc., a leading provider of cloud-based payroll and human resources software. Shares of Ultimate Software performed well following better than expected quarterly results in which recurring revenue grew almost 25%. Strength in Financials was mostly attributable to outperformance of Financial Engines, Inc., an independent provider of portfolio management and retirement income services to 401(k) plan participants, and the Fund’s specialized REIT investments. LaSalle Hotel Properties, a specialized REIT which engages in the buying, owning, redevelopment, and leasing of primarily upscale and luxury full service hotels, outperformed. Shares of LaSalle rose in the quarter helped by company’s recent acquisition of four high-quality, boutique-style hotels in the supply-constrained, top-tier markets of Key West and San Francisco. LaSalle’s performance is noteworthy because REITs in general lagged during the quarter due to concerns about rising interest rates.
Underperformance of the Fund’s investments within the Health Care, Consumer Discretionary, and Industrials sectors detracted the most from relative performance. Within Health Care, a combination of the Fund’s limited exposure to biotechnology companies, which rose more than 20% as a group in the quarter, and stock selection hurt relative results. Weakness in the sector was mainly due to underperformance of Intuitive Surgical, Inc., which manufactures and markets the da Vinci Surgical System, and senior housing providers, Emeritus Corp. and Brookdale Senior Living, Inc. Within Consumer Discretionary, a combination of stock selection and the Fund’s larger exposure to the lagging sector detracted from relative results. Numerous holdings in the sector underperformed, led by BJ's Restaurants, Inc., an operator of casual dining restaurants, and HomeAway, Inc., the #1 player in the online vacation rentals space. We believe HomeAway’s performance was impacted by a sell-side downgrade of the stock, based on concerns around slowing listings growth. We believe the company is in the early innings of consolidating a highly fragmented market. Underperformance in Industrials was mainly attributable to the performance of TransDigm Group, Inc., which designs, produces, and supplies engineered aerospace components for commercial and military aircraft customers in the U.S. Another detractor in the sector was Ply Gem Holdings, Inc., a leading manufacturer of exterior building products in North America.
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