Review and Outlook
In general, we thought the first quarter represented a strong start to 2015 for Baron Discovery Fund. Both the Fund and the Russell 2000 Growth Index outperformed the S&P 500 Index, as many large caps were pressured by the negative impact of the strengthening U.S. dollar on profits of companies with overseas operations. The Fund’s companies continue to grow despite macro headwinds that included potential U.S. Federal Reserve interest rate hikes and a stronger dollar.
Health Care was the largest contributor to performance. Within Health Care, we saw strong stock performance across the board (diagnostic testing, biotech, specialty pharma, medical devices and healthcare services). We did trim some positions in the quarter when valuations started getting close to our price targets. That being said, we continue to find new Health Care companies with both strong growth prospects and reasonable valuations.
Consumer Discretionary was also a top contributor during the quarter. Consumers started to benefit from lower gas prices which, combined with a stronger employment backdrop, helped sales at some of our regional casinos, specialty retailers and restaurant holdings. While we think difficult winter weather conditions will impact earnings in the first quarter, we think the longer term prospects for our retailers, restaurants and hotels & casinos are as bright as they have been since the financial crisis.
The Materials and Financials sectors were the top detractors from performance in the quarter. Materials detracted due to stock drops in our two Energy-related holdings in the sector, as a result of headwinds created by sinking oil prices. Moderate declines in several of our REIT holdings, possibly as a result of uncertainty over interest rates, weighed on performance of the Financials sector.
Because we typically buy businesses which, in our opinion, have high barriers to entry, we expect to see a handful of our companies acquired each year. With businesses that have high barriers to entry, when another company wants to get into the same market, it is generally faster and significantly cheaper to buy the business than to try and develop the same business from the ground up. Last year was somewhat anomalous as only one of our companies was acquired (Open Table). Acquisition activity picked up notably in the first quarter of this year. Two of our holdings accepted takeover offers (Polypore International and E2Open), one company was the recipient of a large investment at a stock price that was up almost 100% from where it had been trading prior to the announcement (Foundation Medicine) and one company received an offer for its real estate holdings that valued the entire company at a 50% premium to where it had been trading (Pinnacle Entertainment). We believe these offers validate our thesis, and while we do not expect to see this level of activity every quarter, we do believe that we will continue to see more takeover offers going forward.
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 (Institutional Shares) gained 6.78% in the first quarter and performed in line with the Russell 2000 Growth Index.
The Fund’s investments within Health Care and Consumer Discretionary and its lower exposure to the lagging Consumer Staples and Industrials sectors were the largest contributors to relative performance. Strength in Health Care was mostly attributable to the outperformance of the Fund’s biotechnology holdings, led by Foundation Medicine, Inc. and Esperion Therapeutics, Inc. These companies were also the Fund’s largest contributors on an absolute basis after their shares more than doubled in the period. The Fund’s larger exposure to pharmaceutical stocks, which rose 14.9% as a group within the index, and outperformance of its investments in this sub-industry also added value. Among the largest contributors to relative performance in pharmaceuticals were Intersect ENT, Inc., which sells a device that is implanted in patients who have had surgery for chronic sinusitis, and TherapeuticsMD, Inc., which is focused on the hormone replacement therapy market. Shares of Intersect ENT increased after the company beat earnings expectations and noted that product development is advancing on schedule, while TherapeuticsMD’s shares rose in anticipation of the company reporting drug trial results in third quarter of 2015. Within Consumer Discretionary, the Fund’s larger exposure to casinos & gaming through its investment in top performing Pinnacle Entertainment, Inc. and the outperformance of apparel retailer Boot Barn Holdings, Inc. contributed the most to relative results. Pinnacle was the Fund’s third largest contributor to absolute performance, while shares of Boot Barn were up after the company reported better than expected quarterly results and raised guidance for its first fiscal year as a public company.
Underperformance of the Fund’s investments within the Information Technology (IT), Financials, and Materials sectors and its average cash exposure of 5.7% in a favorable period for small-cap stocks detracted the most from relative performance. Weakness in IT was mainly due to the underperformance of Varonis Systems, Inc. and Coupons.com, Incorporated, two of the Fund’s largest detractors on an absolute basis. The Fund’s limited exposure to semiconductors and its lack of exposure to application software, which were two of the best performing IT sub-industries in the index, also hampered relative results. Within Financials, underperformance of hotel & resort REITs Strategic Hotels & Resorts, Inc. and Chesapeake Lodging Trust detracted the most from relative results. The Fund’s larger exposure to the lagging industrial REITs sub-industry through its investment in Rexford Industrial Realty, Inc. also weighed on relative performance. The Fund’s Materials investments trailed their counterparts in the index after falling 7.5% as a group, with Flotek Industries, Inc. and Westlake Chemical Partners LP driving the decline. Shares of Flotek, a leading supplier of specialized chemicals to the oil & gas industry, fell as the sharper-than-expected decline in U.S. drilling and completion activity has taken a toll on its earnings outlook.
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