Baron Energy and Resources Fund (BENIX)

Portfolio Management

James H. Stone

Fund Manager since 2011

View All Commentary by James

Fund Description

Baron Energy and Resources Fund invests in securities of energy and resources companies and related companies of all sizes.


Portfolio Commentary

Institutional Performance

Review and Outlook (for quarter ended 9/30/2016)

Baron Energy and Resources Fund posted strong performance again during the third quarter. Following the greater than 17% gain in the second quarter, the Fund rose by another 9.9%  and outpaced its benchmark – the S&P North American Natural Resources Sector Index – by 566 basis points. Following the Fund’s gains for the quarter, we are now within less than 100 basis points of our benchmark on a year-to-date basis, a big change from the Fund’s greater than 1,000 basis point relative deficit that we had at the end of the first quarter of this year.

Through the second quarter, the recovery in the Fund’s performance had largely coincided with the recovery in oil prices. However, in the third quarter, oil prices were essentially flat and yet the Fund’s Energy holdings generated a total return of 11.24% and outperformed the Energy holdings in our benchmark by 644 basis points. It is our view that because of our focus on growth oriented small-cap and mid-cap energy and resource companies, our Fund is structured to perform better in flat or rising oil and gas price environments than falling price environments, and this has clearly been borne out over the past several years. This is what we saw in the third quarter as it became increasingly clear that Energy’s two-year long recession had come to an end. While sharply rising oil prices in the second quarter provided a tailwind for the Fund, prices were flat in the third quarter and our Energy investments still posted solid gains and outperformed the benchmark as noted above.

Based on a combination of industry indicators such as oil and gas inventories, oil and gas supply and demand trends, commodity prices, and drilling rig and well completion activity, we believe that the first half of 2016 will be seen as the bottom of the recession for this industry, and that conditions are in place for fundamental longer-term recovery. We believe that such a recovery will result in a return to more normalized oil and gas prices, which we view as the price level necessary for industry participants to earn returns that are close to the cost of capital and are higher than current futures prices. A return toward normalized price levels should allow many of the companies in our portfolio to realize both cyclical and secular growth in earnings and cash flows over the next several years.

Despite the clear signs that the Energy sector’s recession has come to an end, investor surveys continue to show that institutional investors remain underweight relative to historical norms. We think this means that there is still a significant amount of capital remaining on the sidelines that could be put to work in the areas in which the Fund invests.

We continue to be positive on the outlook for investing in the Energy sector, which is the dominant portion of the Fund’s holdings (80.5% at quarter end).

Top Contributors/Detractors to Performance

Contributors (for quarter ended 9/30/2016)
  • Parsley Energy, Inc. is an independent exploration and production company focused on the Permian Basin in West Texas. Shares rose in Q3 on strong operational performance, significantly raised production guidance, lowered cash costs, and a three-year growth outlook that exceeded even the most bullish estimates. Parsley also boosted its drilling inventory through an acquisition. We expect Parsley will continue to deliver peer-leading operational performance, capitalize on its strong balance sheet, and grow its footprint through acquisitions.

  • Encana Corp. is an exploration and production company with primary operations in Western Canada and Texas. Shares rose in Q3 on raised production guidance, lowered cash costs, and significantly increased drilling activity in its highest return area. Encana has strong positions in two of the more attractive oil resource plays in the Permian and Eagle Ford basins and two of the lowest cost natural gas resource basins in Western Canada. Given its long-term growth potential, we think Encana is one of the most attractively valued E&Ps in the industry.

  • Concho Resources, Inc. is an independent oil and gas exploration and production company focused on the Permian basin in West Texas and New Mexico. Shares rose in Q3 on increased production guidance, lowered cash costs, and a solid operations update, as well as strong M&A activity in the Delaware Basin, which highlighted the value of its holdings in the basin. As one of the best run mid-cap E&P companies, in our view, we believe Concho is well positioned to exploit the deep economic inventory of drilling locations where it operates.

Detractors (for quarter ended 9/30/2016)
  • Shares of SolarEdge Technologies, Inc., a leading maker of inverters for solar energy systems, detracted in Q3 as changes in the U.S. market appeared to dampen growth prospects of large installers. As the business model shifts from lease to own, the U.S. solar market is shifting from large installers to smaller, local vendors. Fears around pricing pressure due to increased competition also hurt the stock price. Although we believe this is a temporary structural adjustment, we decided to reduce our position as the market transitions.

  • Core Laboratories N.V. is a leading provider of core and fluid analysis to the oil and gas industry. Shares fell on moderated short-term growth and margin recovery estimates and reduced revenue guidance. Core Labs dominates its niche, has limited competition, provides value added, non-commoditized services, and generates the highest returns on equity and capital in the industry. We believe strong secular growth drivers in each of its three businesses will allow it to outgrow other oilfield service companies while generating premium returns.

  • Shares of gold mining company Barrick Gold Corporation fell during Q3 in concert with a decline in gold prices. Gold prices surged following the Brexit vote in late June. As equity markets recovered, concerns over Brexit eased, and concerns regarding less accommodative monetary policies rose, gold and gold equities weakened. We believe it is prudent to maintain a modest exposure to gold at this time. We think the shares are attractively valued based on our outlook for gold pricing, Barrick’s growing gold volumes, and falling cost structure.

Quarterly Attribution Analysis (for quarter ended 9/30/2016)

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 Energy and Resources Fund rose 9.89% in the third quarter and outperformed the S&P North American Natural Resources Sector Index by 566 basis points, due to a combination of stock selection and relative sector/sub-industry weights. Smaller cap energy stocks outperformed for a second consecutive quarter, and the Fund’s bias towards these companies also aided relative performance.

Energy and Materials investments added the most value, while no sectors materially detracted from relative performance. Within Energy, outperformance of oil & gas exploration & production (E&P) holdings, led by Parsley Energy, Inc., Encana Corp., Concho Resources, Inc., and Rice Energy Inc., and larger exposure to this strong performing sub-industry contributed 309 basis points to relative results. Parsley, Encana, and Concho were the three largest contributors to absolute results, while shares of Rice, an independent E&P company focused on the Marcellus and Utica shales in Pennsylvania and Ohio, rose after the company raised production guidance, significantly lowered cash costs, and increased drilling activity without changing its capital budget. Lack of exposure to poor performing large-cap stocks in the integrated oil & gas sub-industry and outperformance of U.S. Silica Holdings, Inc. in the oil & gas equipment & services sub-industry also added value in the Energy sector. Shares of U.S. Silica, one of the largest low-cost suppliers of sand used as a proppant for the hydraulic fracturing of oil and gas wells, outperformed following the announcement of two strategic acquisitions. The overall uptick in drilling activity during the quarter also bolstered U.S. Silica’s stock price. Within Materials, outperformance of specialty chemicals holdings Flotek Industries, Inc. and Kraton Corporation and lower exposure to lagging gold stocks, which fell 8.4% as a group within the index, lifted relative results. Flotek’s shares rallied sharply following strong sales of the company’s proprietary product, complex nano-fluid, while shares of Kraton rose after investors reacted favorably to management’s long-term plan to achieve cost reductions and synergies from the Arizona Chemical acquisition.

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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 change 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.