Review and Outlook
The first quarter of 2016 was marked by heightened volatility. From the start of the new year, the Russell 2000 Growth Index went in one direction – straight down. By the time the index bottomed on February 11, it had vaporized 18.92% of its value. The rebound that followed left the index down “only” 4.68%. Our portfolio of smaller, earlier stage companies, with a weighted average market capitalization of about $1.4 billion, modestly outperformed the benchmark, with a weighted average market capitalization of about $2.0 billion. We believe this result is a testament to the portfolio’s reconfiguration last year, including larger position sizes geared to more established companies with higher cash flow and less revenue volatility balanced against positions in exciting earlier stage growth companies. We think this is the right mix in the current environment.
Baron Discovery Fund declined in the first quarter. Information Technology (IT) and Financials contributed to performance. Health Care, Materials, and Consumer Discretionary were the top detracting sectors. Contribution of the IT sector was driven primarily by semiconductor companies Mellanox Technologies, Ltd. and M/A-COM Technology Solutions Holdings, Inc., as well as electronic manufacturing services company Mercury Systems, Inc. Mercury, Mellanox and M/A COM were the second, third, and fourth largest contributors, respectively. College housing REIT Education Realty Trust, Inc. was the primary driver of positive performance of the Financials sector. The Health Care sector detracted due to sharp declines among the Fund’s investments in the pharmaceuticals and biotechnology sub-industries, including Pacira Pharmaceuticals, Inc., the second largest detractor in the quarter. Materials lost ground due to a sharp decline in the Fund’s only sector holding, Flotek Industries, Inc., which supplies chemical additives to the oil & gas industry. The Consumer Discretionary sector had a mixed quarter, although detractors outweighed contributors. ClubCorp Holdings, Inc., the third largest detractor in the quarter, led the decline in the sector.
We believe that going forward, we will be able to continue to perform well against the index in most environments, though our smaller capitalization bias favors up markets versus severe down markets. We continue to target companies that we believe can provide at least a 15% annualized return over time. Of course, there are no guarantees.
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 fell 4.23% in the first quarter, yet outperformed the Russell 2000 Growth Index by 45 basis points due to stock selection.
Health Care, Information Technology (IT), and Financials investments were the largest contributors to relative performance. Within Health Care, outperformance of the Fund's biotechnology holdings, led by TESARO, Inc., and lower exposure to this lagging sub-industry contributed 269 basis points to relative results. Oncology company TESARO outperformed after being added early in the quarter. Investments in ExamWorks Group, Inc. and Inogen, Inc. also added value after their stock prices increased by double digits. Strength in IT was partly attributable to outperformance of semiconductor holdings M/A-COM Technology Solutions Holdings, Inc. and Mellanox Technologies, Ltd. and larger exposure to this better performing sub-industry. Mellanox was the third largest contributor on an absolute basis, while MA-COM’s shares rose as the company executed its strategy to gain share in key markets. Mercury Systems, Inc., the second largest contributor to absolute results, and laser manufacturer Coherent, Inc. also contributed to relative performance in the IT sector. Coherent’s shares performed well after announcing large orders for flat panel display equipment, and the acquisition of a competitor to help strengthen its position in the $1.25 billion fiber laser market. The Fund's Financials holdings consisted mostly of REITs; and several of these investments outperformed, led by Education Realty Trust, Inc., Rexford Industrial Realty, Inc., and American Assets Trust, Inc. All three were bolstered by solid earnings results. Larger exposure to REITs, which rose 10.9% in the index, also lifted relative results.
Investments within the Industrials, Materials, and Consumer Discretionary sectors were the primary detractors from relative performance. Weakness in Industrials was partly attributable to the underperformance of CaesarStone Sdot-Yam Ltd. and industrial machinery holdings, led by NN, Inc. We exited our position in quartz countertop manufacturer CaesarStone on concerns around delays in the production ramp of a new manufacturing facility. We sold out of NN due to the company’s elevated leverage, high debt costs, and uncertainty surrounding the integration of a large acquisition. Lack of exposure to transportation-related stocks, which were up double-digits in the index, also hampered relative performance. Underperformance of the Fund's sole Materials holding, Flotek Industries, Inc., and its lower exposure to this outperforming sector hurt relative results. Shares of Flotek, which supplies chemical additives to the global oil & gas industry, fell due to the sharp decline in drilling and completions activity. Within Consumer Discretionary, underperformance of Habit Restaurants, Inc. and ClubCorp Holdings, Inc. detracted the most from relative results, but this negative impact was somewhat offset by larger exposure to this outperforming sector. ClubCorp was the third largest detractor from absolute results. Shares of restaurant operator Habit fell due to heightened concerns around promotional activity.
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