Review and Outlook
During the three-month period ended September 30, 2015, most market indexes dropped sharply. Stocks began their decline in late August, before partly recovering, and then falling sharply again in late-September. Baron Asset Fund fell 8.25%; the Russell Midcap Growth Index declined 7.99%, and the S&P 500 Index declined 6.44%. The reasons for the market decline included increased uncertainty about the health of the Chinese economy, and the potential ramifications this might have on global growth; the continued decline in energy and commodity prices; and the shockwaves from a rapid decline in biotechnology shares, driven by concerns about that industry’s pricing trends. Although we believe the Fund had limited direct exposure to these developments, many of our investments suffered over these concerns, nonetheless.
The investments that performed best against this challenging backdrop included Health Care companies that lacked even tangential exposure to the drug pricing concerns that affected many important participants in the sector, including IDEXX Laboratories, Inc., a veterinary diagnostic firm. Several Information Technology businesses reported good results, indicating that they were insulated against these issues, including VeriSign, Inc., SS&C Technologies, Inc. and Equinix Inc. (a data center and co-locator provider that is classified by GICs as a REIT). Finally, companies with proprietary data and analytics, characterized by highly-recurring, largely subscription-based revenues, also performed relatively well, including Verisk Analytics, Inc., Nielsen Holdings Plc and Gartner, Inc.
The worst performers included DNA sequencer manufacturer Illumina, Inc., which suffered from company-specific issues and fall-out from the sell-off in biotechnology shares. China-related concerns affected Mettler-Toledo, Inc., a weighing device manufacturer with an important presence in that market. The continued drop in energy prices hurt midstream energy master limited partnerships Shell Midstream Partners LP and Tallgrass Energy GP LP, as well as FleetCor Technologies, Inc., which provides credit card processing services for large oil companies.
Nothing has changed our longstanding view that high-quality, mid-sized growth stocks represent an attractive long-term investment opportunity. The U.S. economy is among the world’s healthiest, and, particularly after this quarter’s stock market correction, its equity market multiples are within the range of their long-term historic averages. Interest rates remain at historic lows, and although past performance is not indicative of future performance, we believe history demonstrates that equity markets often perform well even after rates increase. Employment and housing trends continue to improve, and energy prices remain meaningfully below their recent levels. We believe that our portfolio of well-managed, competitively advantaged, fast growing companies will have the potential to perform well in this environment.
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 Asset Fund fell 8.25% in the third quarter and underperformed the Russell Midcap Growth Index by 26 basis points. During the quarter, the Fund’s stock selection added value, but this was more than offset by the negative effect of relative sector weights.
Outperformance of Information Technology (IT) and Financials investments, lower exposure to the lagging Materials sector, and average cash exposure of 1.9% in a down market contributed the most to relative results. Strength in IT was mainly due to the outperformance of the majority of application software holdings, led by SS&C Technologies, Inc. and FactSet Research Systems, Inc., both of which provide products and services for the financial industry. SS&C’s shares rose after it closed the acquisition of Advent Software and announced the acquisition of Citi Alternative Investor Services. FactSet’s shares benefited from accelerating organic revenue growth and enhanced seat count additions. Verisign, Inc., the third largest contributor on an absolute basis, and Gartner, Inc., an IT research firm, also lifted relative performance. Gartner’s shares outperformed due to strong earnings results and sustained share repurchases. Within Financials, outperformance of Arch Capital Group Ltd., the second largest contributor to absolute performance, and Equinix, Inc., a network neutral global operator of data centers, added the most value. Equinix’s shares increased after it completed its REIT transformation, reduced its cost of capital, and bid for a large European competitor.
Energy, Utilities, and Consumer Staples investments were the primary detractors from relative performance. Within Energy, underperformance of oil & gas storage & transportation holdings and larger exposure to this lagging sub-industry detracted the most from relative results. Holdings in this sub-industry, led by Shell Midstream Partners, L.P. and Tallgrass Energy GP, LP, experienced sharp declines as a result of selling pressure due to lower growth expectations and tax-loss selling. Weakness in Utilities resulted from underperformance of TerraForm Power, Inc., the second largest detractor on an absolute basis, and TerraForm Global, Inc., a SunEdison yieldco focused on emerging markets. TerraForm Global went public in the quarter at a much lower-than-anticipated valuation. Concurrent with the equity IPO, TerraForm Global was dependent on raising debt, which came in much more expensive than anticipated given difficult conditions in high yield and emerging markets. The high cost of capital caused the equity price to plunge even further, calling into question the company’s growth prospects. Within Consumer Staples, lower exposure to this defensive sector and underperformance of United Natural Foods, Inc. weighed on relative results. Shares of United Natural, a healthy foods distributor to North American supermarkets, declined due to a contract loss representing 5% of sales after a customer underwent a change in ownership.
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