Baron Discovery Fund (BDFIX)

Portfolio Management

RandolphGwirtzman
Randolph Gwirtzman

Fund Manager since 2013

View All Commentary by Randolph LairdBieger
Laird Bieger

Fund Manager since 2013

View All Commentary by Laird

Fund Description

Baron Discovery Fund invests primarily in small growth companies.
 

Fund Resources

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Portfolio Commentary

Institutional Performance

Review and Outlook (for quarter ended 3/31/2015)

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

Contributors (for quarter ended 3/31/2015)
  • Foundation Medicine, Inc. is a diagnostic lab company that specializes in the most complex cancers. Shares doubled in January when Roche Holdings announced a strategic relationship and initiated a tender for over 50% of Foundation Medicine’s shares at $50 per share. Foundation Medicine uses DNA sequencing to find over 300 cancer genes. Its IT platform links pharmaceutical firms with oncologists and scientific research. We believe it is the best positioned company in the emerging multi-billion dollar complex cancer diagnostics market.

  • Shares of Esperion Therapeutics, Inc., a biotech company developing LDL cholesterol lowering therapies as a follow on or addition to statins, increased sharply in Q1 due to two factors. First, a hold was removed that had prevented Esperion from moving its most advanced therapy, known as ETC-1002, into Phase III clinical trials. Esperion also gave incrementally positive data updates from two separate Phase II clinical trials of the therapy. Given the sheer size of the potential market, we believe Esperion has high potential revenue expectations.

  • Shares of regional gaming company Pinnacle Entertainment, Inc. increased sharply in Q1 on strong industry fundamentals and improved spending at its properties, leading to higher revenue and margins across its portfolio. An offer by Gaming and Leisure Properties Inc. to purchase Pinnacle’s real estate assets also boosted shares. We believe the deal will eventually go through, albeit at a higher price than the current offer.

Detractors (for quarter ended 3/31/2015)
  • Shares of BioScrip, Inc., a provider of specialty drug infusion services, were down in Q1. We believe BioScrip is on the cusp of breaking out of some operating difficulties caused by its (in retrospect) overly aggressive acquisition strategy. We saw some early signs of this in the Q3 earnings report. Shares sold off in March after reported Q4 results showed a large charge for bad debt and a capital raise to shore up its balance sheet. We still believe the management is solid and the valuation is reasonable.

  • Coupons.com Incorporated is the leading digital couponing platform. Shares fell in Q1 due to lower-than-expected Q4 revenue and Q1 outlook as a result of the failure of large advertiser campaigns held a year ago to repeat. Management expects transaction volumes to be weighted more toward the second half of 2015, aided by the roll out of its new Retail IQ product with several grocery chains. With online couponing less than 5% of the $315 billion in annual coupon transactions, we see a long runway of growth ahead.

  • Varonis Systems, Inc. provides software solutions for human-generated unstructured enterprise data, including spreadsheets, documents, presentations, emails, and other employee-generated data. During Q1, the stock price fell as investor expectations for a Q4 “beat” versus prior management guidance were not met. We take a longer term view and see a large market opportunity that Varonis can capture. We have high conviction in management’s ability to execute its growth plan.

Quarterly Attribution Analysis (for quarter ended 3/31/2015)

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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The prospective performance of the companies discussed herein is based on our internal analysis and reflect our opinions only. We cannot promise future returns and our opinions are a reflection of our best judgement at the time of publication. Our views are not intended as recommendations or investment advise to any person and are subject to chage at any time based on market and other conditions and Baron has no obligation to update them. Investing in the stock market is always risky. Current and future portfolio holdings in the Fund are subject to risk.

Source: FactSet PA.