Review and Outlook
Baron Discovery Fund increased 13.36% in the fourth quarter, outpacing the benchmark Russell 2000 Growth Index, which increased 10.06%. In 2014, the Strategy increased 13.45% vs. a 5.60% return on the Index.
The fourth quarter was characterized by the dramatic drop in oil prices and the outperformance of the U.S. economy vs. its peers in Europe and Asia. As a result, the U.S. dollar has continued to strengthen. The yield on the 10-year treasury held in the low 2% range, as commodity price deflation appeared to offset improvements in GDP, at least for now. These factors set the stage for strong performance by U.S.-based small cap stocks. In fact, in the fourth quarter we saw significant outperformance of small caps versus large cap stocks, which was a reversal from the prior quarter.
Similar to the third quarter, the atmosphere was generally good for Health Care stocks. Spectranetics Corp., a medical device manufacturer and our largest position; AAC Holdings, Inc., an operator of drug rehabilitation centers; and Inogen, Inc., a provider of portable oxygen concentrators for patients were among our best performers. These results reflect Health Care’s acyclical nature, as well as positive fundamentals at these companies. Among our Information Technology holdings, cybersecurity companies Varonis Systems, Inc. and Barracuda Networks, Inc. both performed well. In addition, the increase in disposable income due to lower oil prices led to a significant improvement in consumer-oriented stocks.
Materials company Flotek Industries, Inc., which services the Energy industry, and Energy company PBF Logistics LP, a midstream MLP, detracted. The stock of global trade software company Amber Road, Inc. was hit with news of a meaningful customer loss. We made a couple of mistakes with Regional Management Corp., a lender, and Ascent Capital Group, Inc., a residential alarm company that showed surprisingly weak subscriber metrics, both of which we sold.
We bought DigitalGlobe, Inc., a satellite imaging company as a “fallen angel” and consumer names JUST EAT plc, a U.K.-based restaurant software company, and Pinnacle Entertainment, Inc., a regional gaming company. We also bought commercial real estate owner/operator Rexford Industrial Realty, and Atlas Energy, LP, an Energy MLP that we believe sold off too harshly. We sold Rose Rock Midstream L.P. and PBF Logistics LP to lighten our Energy exposure, as well as coffee distributor Farmer Bros. Co. and regional gaming company Churchill Downs Inc., both of which we think had become fully valued.
We adhere to our investment philosophy of finding small cap growth stocks with what we believe are excellent management teams, protected markets and solid long-term business plans. We make investments one at a time, with an eye toward earning 15% annualized returns. Entering 2015, the markets have been spooked by dropping oil prices, potentially indicating negative effects from deflation. Nevertheless, we think the U.S. economy is stable to growing, and the strength of the dollar indicates that investors agree. While the Federal Reserve might start to raise rates during 2015, it seems unlikely it will move much higher than the secular lows we are now seeing. We view the climate for investing in small cap U.S. growth stocks as favorable.
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 Discovery Fund (Retail Shares) increased 13.36% in the fourth quarter and outperformed the Russell 2000 Growth Index by 330 basis points due to stock selection.
The Fund’s investments within the Health Care, Energy, and Information Technology (IT) sectors were the primary contributors to relative performance. Within Health Care, a combination of stock selection and the Fund’s larger exposure to this top performing sector aided relative results. The Fund’s investments in the sector increased 27.8%, driven by gains in AAC Holdings, Inc. and The Spectranetics Corporation, which rose 106.1% and 30.1%, respectively. These companies were also the Fund’s two largest contributors to absolute performance in the quarter. Other sources of outperformance in the sector were the Fund’s health care equipment holdings, led by Inogen, Inc. Shares of Inogen, the leading global maker of portable oxygen concentrators, rose more than 50% as management delivered better-than-expected quarterly results and raised 2014 guidance. Within Energy, the outperformance of Atlas Energy, L.P., the general partner of MLP’s Atlas Pipeline Partners, L.P. and Atlas Resource Partners, L.P., and the Fund’s lower exposure to oil & gas exploration & production companies added the most value. Following a sharp decline in Atlas’ share price, which we believe was related to the drop in oil prices, we purchased its shares late in the quarter and subsequently the company’s stock price appreciated more than 10% through the end of the year. Our ongoing research and understanding of the fundamentals of this business provided us with the conviction to buy on what we believed was temporary weakness. Strength in IT was mainly due to the outperformance of the Fund’s three systems software investments, Varonis Systems, Inc., Qualys, Inc., and Barracuda Networks, Inc., which together rose 48.3% and outpaced their peers in the index by 23.6%. Varonis was one of the Fund’s largest contributors to absolute performance, and shares of Qualys and Barracuda, which are both providers of security-related software solutions, spiked as frequent headlines about cyber threats spurred demand. The Fund’s larger exposure to systems software, which was the top performing IT sub-industry in the index, also lifted relative performance.
Underperformance of the Fund’s investments within the Materials sector and its average cash exposure of 7.6% in a favorable period for small cap stocks detracted the most from relative performance. Weakness in Materials was mostly attributable to the underperformance of Flotek Industries, Inc., the Fund’s largest detractor on an absolute basis, and Westlake Chemical Partners LP, an MLP recently formed by Westlake Chemical Corp. to engage in the operation, acquisition, and development of ethylene production facilities and related assets. While operational results were strong, shares of both companies were hurt by the decline in commodity prices during the quarter.
Yearly Attribution Analysis
The Baron Discovery Fund (Retail Shares) gained 13.45% for the year and significantly outperformed the Russell 2000 Growth Index by 785 basis points, primarily due to stock selection.
The Fund’s investments within the Health Care and Energy sectors contributed the most to relative performance. Within Health Care, outperformance of the Fund’s pharmaceutical holdings, led by Pacira Pharmaceuticals, Inc. and Intersect ENT, Inc., and its larger exposure to these stocks added the most value. Pacira was the Fund’s largest contributor to absolute and relative performance during the year. Shares of Intersect, which developed a novel device called Propel for patients with chronic sinusitis, increased on reports of solid quarterly results and positive clinical trial data related to its pipeline product Resolve. Other meaningful contributors to relative performance in the sector were The Spectranetics Corporation, the Fund’s second largest contributor on an absolute basis; Inogen, Inc., the leading global maker of portable oxygen concentrators; and AAC Holdings, Inc., an owner/operator of substance abuse rehabilitation facilities. AAC’s shares traded up following the company’s IPO in early October and the successful launch of a new facility. AAC also gained momentum after reporting better-than-expected quarterly results in early November. Within Energy, the Fund’s larger exposure to MLPs, which tend to be less sensitive to oil price fluctuations, aided relative performance in a difficult period for energy stocks. The Fund’s MLP investments also outperformed after increasing almost 54% as a group during the year, led by Rose Rock Midstream, L.P., Western Refining Logistics, LP, and Tallgrass Energy Partners LP. All three of these MLPs benefited from strong operating results and acquisitions. RoseRock and Western Refining were sold late in the year as part of the portfolio managers’ effort to lighten the Fund’s exposure to the Energy sector. The Fund’s slightly lower exposure to oil & gas exploration & production stocks, which fell sharply due to the decline in oil prices also lifted relative results. RSP Permian, Inc. and Parsley Energy, Inc., which own and operate oil & gas assets in the Permian Basin in West Texas, each managed positive gains following their 2014 IPO’s before being sold in October.
The Fund’s investments within the Information Technology (IT) sector were the largest detractors from relative performance for the year. The Fund’s Internet software & services holdings fell 18.6% as a group, with E2open, Inc., SciQuest, Inc., and Xoom Corporation. driving the decline. E2open was one of the Fund’s largest detractors from absolute performance. The Fund exited its position in SciQuest, a cloud-based procurement software provider, due to contract risk within its customer base. The Fund sold its shares of Xoom, a provider of electronic fund transfer services to consumers, following weak quarterly guidance and concerns about competition from Western Union. Underperformance of PDF Solutions, Inc., a provider of yield management services to the semiconductor equipment industry, and the Fund’s lower exposure to outperforming semiconductor stocks also hampered relative performance. Shares of PDF Solutions were sold following the announcement that a meaningful contract might not be signed.
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