Review and Outlook
Oil markets faced continued headwinds as the oversupply situation triggered by OPEC’s decision not to rein in production last November materialized. U.S. oil prices fell by 11% in the quarter. While U.S. inventories built to record levels, inventories in Europe and Asia did not build as expected. This divergence suggested that the oversupply problem was 1) constrained to the U.S. market, and 2) not as bad as initially feared. Global demand was stronger than expected, driven by higher demand in the U.S., India, and more recently in China. As the quarter progressed, a number of forces began to exert themselves that we believe have led to a bottom for the oil market and perhaps the U.S. natural gas market, which in turn led to a strong recovery in share prices and a solid start to the year for Baron Energy and Resources Fund.
We believe the Fund did well in part because we did not panic last quarter and materially alter the portfolio or our overall strategy. We felt secure in the belief that we owned good companies with good assets/businesses that were excessively penalized by the downturn and still offered excellent value. We opportunistically added shares in some of our more battered and undervalued names and added some new names at attractive prices. Performance in the quarter was entirely a function of our stock selection within Energy, certain renewable energy stocks classified within Utilities and Information Technology, as well as a Materials holding that supplies the global oil industry. Poor contributions from various Materials and Industrials holdings partially offset the combined contribution of these investments.
We believe demand could increase as quantitative easing improves the economic outlook in key developed economies. When combined with slowing supply growth (if not outright declines), we believe this stronger demand will lead to a more balanced oil market in the quarters ahead and a recovery toward “normalized” prices that, in our view, should range between $70-90 over time. As long-term investors, we believe our patience and our strategy of investing in companies that can grow in a “normalized” or price-neutral environment is likely to be even more rewarded when we have opportunities to invest during a period in which commodity prices are so far below our view of “normalized” prices. This is what we did during the first quarter.
While the Energy sector has always experienced significant short-term volatility, we believe the long-term returns and potential for future gains make investment in energy a worthwhile proposition. We think the current downturn will prove relatively short-lived as the problems are relatively small compared to the massive demand shock faced in 2009, or the massive supply capacity overhang that plagued the industry in the mid-late 1980s. The growth themes and opportunities for value creation that we have highlighted the last several years, such as the development of unconventional resources, the need for increased infrastructure investment, and the role of technology in unlocking the resources needed to meet growing market demand for oil and gas remain intact and are the core of our investment strategy.
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 Energy and Resources Fund (Institutional Shares) increased 1.73% in the first quarter and outperformed the S&P North American Natural Resources Sector Index by 324 basis points.
The Fund’s small and small to mid–cap energy holdings, which were meaningful detractors in the fourth quarter of 2014, generated modest positive returns this quarter, and contributed positively to relative results. The Fund’s lack of exposure to lagging large-cap energy stocks, such as integrated oil & gas companies, also aided relative performance.
The Fund’s oil & gas exploration & production (E&P), oil & gas storage & transportation, and renewable energy-related investments were the largest contributors to relative results. The Fund’s E&P holdings contributed the most to relative performance after rising 7.0% as a group, with SM Energy Co., Concho Resources, Inc., Newfield Exploration Co., and Laredo Petroleum, Inc. each up double digits. The Fund’s storage & transportation investments, which consist mostly of master limited partnerships (MLPs) and general partnerships (GPs), rose 3.9% as a group and outperformed their counterparts in the index by 279 basis points, led by double-digit gains from Tallgrass Energy Partners, LP and SemGroup Corp. Despite declining oil prices, shares of MLP Tallgrass outperformed after management accelerated its growth plans and outlined an annualized growth rate target of 20% over the next three years. Shares of C-Corp SemGroup outperformed as management moved forward with its MLP strategy of selling assets at an accelerated pace and announced a $500 million greenfield Gulf Coast pipeline project. The Fund’s significantly larger exposure to the outperforming storage & transportation sub-industry also added value. Strength in renewable energy-related holdings was due to the outperformance of SunEdison, Inc., an Information Technology company and one of the Fund’s largest contributors to absolute performance, as well as renewable electricity companies Abengoa Yield plc and TerraForm Power, Inc. Shares of Abengoa Yield benefited as investors reacted positively to the company’s securing financing for its development portfolio, while TerraForm’s shares rose sharply after the company’s deal for First Wind Energy closed.
The Fund’s lower exposure to oil & gas refining & marketing stocks, which rose 17.5% as a group within the index, and underperformance of its oil & gas equipment & services investments detracted the most from relative results. Weakness in equipment & services was mostly attributable to the underperformance of RigNet, Inc., a provider of remote communication systems and services principally to the global oil and gas and maritime industries, and Canyon Services Group, Inc., a Canadian-based oilfield service company that specializes in hydraulic fracturing. RigNet’s shares suffered amid concerns that weakness in demand and utilization from offshore drilling rigs, its biggest customer segment, is causing a slowdown in the company’s business. Canyon Services Group was the Fund’s third largest detractor on an absolute basis and was sold early in the quarter.
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