Review and Outlook
During the three-month period ended June 30, 2015, Baron Asset Fund gained 0.76%, the Russell Midcap Growth Index declined 1.14%, and the S&P 500 Index gained 0.28%.
The Fund’s positive return was driven by strong performance among several health care-related companies, including Illumina, Inc., a leading technology provider to the DNA sequencing market, and Universal Health Services, Inc., an operator of acute care and behavioral health hospitals. In addition, Pall Corp., a filtration technology company with significant customers in the health care industry, agreed to sell itself at a large premium. Financial Services holdings also did well, as Arch Capital Group, Ltd rose on merger speculation in the insurance industry, and Charles Schwab Corp. benefited from rising interest rates during the period. Rising commodity prices during the quarter were a positive driver of the Fund’s Energy sector holdings, including Shell Midstream Partners LP. Laggards included several companies that missed earnings expectations for company-specific reasons, including veterinary diagnostic firm IDEXX Laboratories, Inc. and social network LinkedIn Corp. The hotel sub-industry also lagged, as Choice Hotels International, Inc. and Hyatt Hotels Corp. detracted from results. Despite continued strong financial results, Hyatt lost ground as a result of investor concerns over a potential slowdown in the lodging cycle, as well as muted travel to South Korea in reaction to the MERS virus outbreak.
During the quarter we initiated a position in the newly issued Tallgrass Energy GP, LP, the general partner of a fast-growing master limited partnership. Tallgrass has an interest in various assets that transport, store and process natural gas and crude oil, primarily in the Appalachian Basin. We have been following this company (and its management team) for a long time through our Firm’s investment in Tallgrass Energy Partners, LP, which is led by many of the same executives. We have high conviction in the ability of Tallgrass Energy GP to grow its cash distributions at a rapid pace for the foreseeable future through its economic interest in the cash flow streams of high-quality infrastructure assets with limited exposure to commodity price and volume risk.
Nothing has changed our longstanding view that high-quality, mid-sized growth stocks represent an attractive investment opportunity. The U.S. economy remains among the world’s healthiest, its equity market multiples remain within the range of their long-term historic averages, and we expect that interest rates will continue to remain quite low by historic standards. 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 continue 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 increased 0.76% in the second quarter and outperformed the Russell Midcap Growth Index by 190 basis points due to stock selection.
Outperformance of investments within the Industrials, Financials, and Energy sectors contributed the most to relative results. Within Industrials, outperformance of industrial machinery holdings, led by Pall Corp. and The Middleby Corp., and lack of exposure to airline stocks, which fell more than 20% within the index, added the most value. Pall was the third largest contributor on an absolute basis, while shares of food equipment manufacturer Middleby rose on the company’s announcement that it was in preliminary discussions to acquire AGA Rangemaster Group plc, a U.K.-based residential kitchen equipment manufacturer. Financials holdings outperformed their index counterparts by 457 basis points, driven by gains from Arch Capital Group Ltd. and The Charles Schwab Corp. Shares of Arch, a specialty insurance and reinsurance company, rose on solid quarterly financial results with 15% growth in book value per share. Arch’s underwriting profitability remained strong, catastrophe losses remained benign, and it continued to experience favorable reserve development. Shares of Schwab, a brokerage firm, increased in the quarter despite headwinds related to lower trading volume and stubbornly low interest rates. We believe Schwab’s efforts to reduce its dependence on trading by offerings such as Schwab Intelligent Portfolio will create a more sustainable and profitable firm. Strength in Energy was mainly due to the outperformance of oil & gas storage & transportation holdings, led by Shell Midstream Partners LP and recent IPO Tallgrass Energy GP, LP. Shares of Shell, a master limited partnership created by Royal Dutch Shell to own and operate midstream assets in Texas and Louisiana, performed well on the company’s announcement that it was increasing distribution by 7.7% and acquiring additional interest in its IPO assets to maintain its growth path.
Consumer Discretionary and Health Care investments were the only meaningful detractors from relative performance. Weakness in Consumer Discretionary was mostly attributable to the underperformance of its hotel holdings, including Choice Hotels International, Inc., the second largest detractor on an absolute basis, and Hyatt Hotels Corp., as well as the underperformance of the Fund's only Internet retailer holding, The Priceline Group, Inc. Shares of Priceline declined in the quarter and significantly lagged the index’s Internet retail stocks, which rose nearly 25% as a group. Within Health Care, the underperformance of IDEXX Laboratories, Inc. detracted the most from relative results, but this negative effect was somewhat offset by larger exposure to this top performing sector. IDEXX was largest detractor from absolute performance in the quarter after the company’s stock price declined 17%. Despite the overall positive effect of the Fund’s larger exposure to Health Care, its lower exposure to outperforming biotechnology stocks continued to weigh on relative results.
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