Review and Outlook
The U.S. economy strengthened in the second quarter, after a weak first quarter when GDP was negatively affected by declining commodity prices and terrible weather. Labor reports improved, both in jobs created and an acceleration in hourly wages, which was new. Housing sales have picked up. Inflation remained muted. Stock deals were back to all-time high levels of activity, another strong support for the market. However, this positive merger and economic backdrop was counter-balanced by serious geopolitical issues (Greece, China, Iran, Puerto Rico) and concerns about the U.S. Federal Reserve raising interest rates. All in all, the market went sideways.
Baron Small Cap Fund decreased in the second quarter. Information Technology (IT) and Health Care were notable sector contributors to performance. Materials, Consumer Discretionary, and Industrials were the top detractors. Holdings in IT consulting & other services, systems software, and data processing & outsourced services helped boost performance of the IT sector. Application software holding ACI Worldwide, Inc. was also a notable contributor within the sector. Health Care benefited from the positive contribution of the Fund’s life sciences tools & services, managed health care, and health care equipment investments. Materials lost ground primarily due to the weak performance of Berry Plastics Group, Inc., which gave back some gains as packaged food volumes remained flat to down. With both the second biggest contributor, Bright Horizons Family Solutions, Inc., and the third biggest detractor, Iconix Brand Group, Inc., Consumer Discretionary had a mixed quarter, although detractors outweighed contributors. Industrials was negatively impacted by stock drops in short line railroad Genesee & Wyoming, Inc. and aerospace & defense company DigitalGlobe, Inc.
The market started the third quarter held hostage to events in Greece and China. After rejecting one austerity plan as too harsh, Greece reversed course and accepted an even harsher plan to remain in the European Union and reopen its banks. The Chinese stock market collapsed, declining by a third in a three-week period. The downdraft followed a 150% increase over the previous 12 months. The Chinese government is feverishly attempting to stop the sell-off, fearful that the $3 trillion lost as the bubble deflates could further depress the weakening economy.
The U.S. economy is improving since the weak first quarter, but still not showing robust growth. The winners in the small-cap growth arena were mostly high growth biotechnology and Information Technology companies. We are under-represented here since many of these businesses trade at very high valuations or are not making money at all, which is different than our historical valuation-conscious approach to investing.
We have favored investing in high quality businesses that we believe can significantly grow their profits and value over time. We are comfortable owning them even as those multiples have expanded as long as we see growth in the future, and we can stomach the current valuations. We continue our efforts to uncover our next long term growth companies and to monitor progress of our present holdings.
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 declined 1.31% in the second quarter and underperformed the Russell 2000 Growth Index by 329 basis points. The Fund’s stock selection and, to a lesser extent, relative sector weights hurt relative performance. During the quarter, mid cap stocks lagged relative to small cap stocks and the Fund's exposure to the former as a result of its long-term investment approach also hurt relative performance.
Outperformance of Energy investments contributed the most to relative results, but this positive effect was partly offset by larger exposure to this lagging sector. Sector strength was mostly attributable to the outperformance of Scorpio Tankers, Inc., an oil and gas shipping company, and Valero Energy Partners LP, a high growth MLP formed by Valero Energy Corp. to own and operate its midstream assets. Shares of Scorpio rose due to improving product tanker shipping rates. Shares of Valero Energy performed well in the quarter despite the weak energy market. The Fund increased its position with the view that the company’s growth was secured regardless of the commodity cycle, making it attractive to energy investors.
Health Care, Consumer Discretionary, and Materials investments were the primary detractors from relative results. Within Health Care, meaningfully lower exposure to biotechnology stocks, which rose 12.7% in the index, detracted 116 basis points from relative performance. Sector weakness was also attributable to the underperformance of IDEXX Laboratories, Inc., the second largest detractor on an absolute basis, and Brookdale Senior Living Inc., a senior housing provider. Brookdale’s shares lagged over concerns regarding its integration with Emeritus and business fundamentals. The Spectranetics Corporation, a medical device company that specializes in equipment that clears plaque from arteries, also detracted. Shares declined on missed revenues in Q1 and lowered full year guidance. Within Consumer Discretionary, underperformance of apparel accessories & luxury goods holdings, led by Iconix Brand Group, Inc. and Tumi Holdings, Inc., detracted the most from relative performance. Iconix was the third largest detractor from absolute performance, while Tumi’s shares fell on reports of a disappointing start to the year, driven by decreased demand in some international markets and the domestic wholesale channel. Within Materials, underperformance of Berry Plastics Group, Inc. and Globe Specialty Metals, Inc. and larger exposure to this declining sector weighed the most on relative results. Shares of Berry, a plastics packaging company, fell on flat-to-down packaged food volumes and lack of meaningful contribution to revenue of its Versalite cup, a replacement for Styrofoam. Shares of Globe Specialty declined due to direct exposure to the prices of silicon metal and silicon-based alloy, which both fell in North America.
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