Review and Outlook
We were pleased with the increase in our performance this quarter. Of course this is only a short sliver of time, and we strive to earn our returns over the long term in the context of a multi-year investment horizon. In our opinion, it is only through a strategic longer-term view that we can have the key variant opinions that give us a potential investment edge.
Health Care, Industrials, and Consumer Discretionary were the top contributing sectors. Consumer Staples detracted. Health Care performance was led by the health care services, health care technology, and health care equipment sub-industries. The sector included top contributor, Press Ganey Holdings, Inc. Top five contributor ExamWorks Group, Inc. was another notable performer. Industrials benefited from positive performance of the Fund’s aerospace & defense investments, including The KEYW Holding Corporation and Mercury Systems, Inc., two of the top three contributors in the period. Investments in the restaurants and casino & gaming sub-industries boosted results of the Consumer Discretionary sector, including fast food restaurant chain Wingstop, Inc., a top five contributor to performance. Consumer Staples was the only sector to detract in the quarter, due to the weak performance of the third biggest detractor Barfresh Food Group, Inc.
Any number of factors can affect shorter-term performance, including style (growth, value, momentum), industry type (defensive, cyclical, etc.), market capitalization size, technical factors and even reflexivity (where a feedback loop is effectively created that creates virtuous or destructive cycles that perpetuate themselves). Of course, macroeconomic shocks, like the recent Brexit vote, can also cause massive market dislocations. The relative weighting of any of these given factors and/or exogenous shocks or stimulants versus our portfolio can vary radically in a short period of time. We are not market timers because we do not believe that we can accurately predict and modify the portfolio to respond constantly to the vagaries of such changes in these multiple variables. Most of the time, the overall market in the short term is affected by the story of the day. But often times, that story turns out to be not very meaningful on an ex-post basis (remember Y2K?). Generally it is uncertainty, rather than an actual known bad event, that causes the biggest market dislocations. Uncertainty dramatically affects the style factor of the day, and can cause wide variations in actual versus expected performance given a set of fundamentals for a particular company or portfolio.
We are excited about the prospects of the companies in which we invest. Our perspective is that the innovation being driven by these companies will lead to strong revenue and cash flow growth for years into the future. We believe our investors will be rewarded as these plans are realized. While we cannot guarantee results, we strive to earn compounded annual returns of at least 15% by targeting companies that can grow cash flows at these rates with a high probability of conviction. This has been particularly difficult in the current markets. However, we continue to believe this is possible.
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 Discovery Fund increased 10.16% in the second quarter and outperformed the Russell 2000 Growth Index by 692 basis points due to stock selection.
Outperformance of the Fund’s Health Care, Consumer Discretionary, and Industrials investments contributed the most to relative results. Within Health Care, outperformance of health care services holdings ExamWorks Group, Inc. and American Renal Associates Holdings, Inc. and larger exposure to this strong performing sub-industry aided relative results. Shares of ExamWorks, which enables insurers to obtain and schedule independent medical examiners, were sold after increasing sharply on the announcement that the company was being acquired by a private equity firm. Shares of dialysis clinic operator American Renal Associates rose following the company’s successful IPO in mid-April. Strength in the sector was also attributable to the outperformance of Press Ganey Holdings, Inc. and of most of the Fund’s health care equipment investments, led by Glaukos Corporation. Press Ganey was the largest contributor to absolute performance, while shares of Glaukos rose as improved sales of its lead product, iStent, drove strong revenue growth in the quarter. Within Consumer Discretionary, outperformance of casino & gaming investments Pinnacle Entertainment, Inc. and Isle of Capri Casinos, Inc. added the most value. Shares of Pinnacle increased as the company closed on the sale of its real estate assets to Gaming and Leisure Properties and established a platform for growth with the announced acquisition of the Meadows racetrack in Pennsylvania. Isle of Capri’s stock price rose after the company reported solid earnings and indicated it would look at unlocking shareholder value by possibly selling its real estate to a REIT or the entire company to a potential buyer. Lack of exposure to poor performing apparel retail stocks, which fell 9.8% within the index, and outperformance of restaurant holdings Wingstop, Inc. and Krispy Kreme Doughnuts, Inc. also lifted relative results. Wingstop’s shares appreciated after the company reported Q1 financial results that beat Street expectations across virtually all metrics. We sold Krispy Kreme after its share price rose sharply on the news that it had agreed to be acquired by a unit of JAB Holding Company. Industrials holdings outperformed their index counterparts after increasing 21.2%, driven by aerospace & defense investments The KEYW Holding Corporation, Mercury Systems, Inc., and DigitalGlobe, Inc. KEYW and Mercury were two of the largest contributors on an absolute basis, while shares of satellite operator DigitalGlobe rose after the company reported strong Q1 financial results and reiterated annual guidance.
Underperformance of the Fund’s only holding in the Consumer Staples sector, Barfresh Food Group, Inc., and its average cash exposure of 6.2% in an up market detracted the most from relative results.
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