Review and Outlook
The U.S. equity market is now three for three after continuing its advance in the September quarter. In the “rising tides lifting all boats” environment, growth has finally outperformed value, with small cap continuing to dominate mid cap, which continued to outperform large cap. Paying homage to last year’s Baron Conference’s baseball leitmotiv, we hit a bunch of singles and a few doubles, and connected for our first home run. We also took a few walks along the way. Our performance this quarter allowed us to jump back in front of the benchmarks (albeit modestly) for the year-to-date and one-year periods.
Over the seven full quarters since we restructured the Fund (12/31/2011), Baron Fifth Avenue Growth Fund has cumulatively returned 47.4% (Institutional Shares) and 46.7% (Retail Shares), while the S&P 500 Index and Russell 1000 Growth Index have returned 39.0% and 39.3%, respectively.
In our last quarterly report, we described how Eddie Lampert’s idea of anticipation led us to investments in Illumina, Inc. and CME Group, Inc., which have worked out well for us in 2013. Last quarter, we also finished building our position in Facebook Inc., the world’s largest social networking company. This quarter, Facebook was the top contributor to Fund performance. For three straight quarters, we stuck by Apple, Inc. while its stock sagged. Our thesis is that Apple, as a unique creator and owner of a platform with connected devices, peripherals, software and services, will benefit from the network effect, combined with the higher switching costs associated with a platform and the strength of its brand. This quarter, Apple’s stock finally reversed course, and it was the #2 contributor to Fund performance. Not surprisingly, given the performance of Facebook and Apple (and others), Information Technology was the top sector contributor to the Fund.
Among sectors, Financials detracted slightly, dampened by the performance of ICICI Bank Limited, the Fund’s largest detractor in the quarter. Ralph Lauren Corp. gave up its gains after reporting a soft quarter, and CME took a breather after appreciating 52% over the prior two quarters.
The portfolio is constructed on a bottom-up basis, with the quality of ideas and conviction level being the most important determinants of the size of each investment. We expect top 10 holdings to be in the range of 35% to 45% of the Fund. The Fund’s sector weightings are incidental to portfolio construction.
We initiated a position in Frank’s International N.V., a leading provider of high end tubular services to exploration and production companies in the oil & gas industry, with a focus on complex and technically demanding wells.
Our objective is to maximize long-term returns without significant risk of permanent loss of capital. We aim to create a portfolio of unique companies with different end markets, sustainable competitive advantages and the ability to redeploy capital at high rates of return.
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 Fifth Avenue Growth Fund (Retail Shares) gained 13.45% in the third quarter, significantly outperforming the S&P 500 Index by 821 basis points primarily as a result of stock selection.
Outperformance of the Fund’s investments within the Information Technology (IT), Consumer Discretionary, and Energy sectors contributed the most to relative results. Outperformance of Internet software & services investments, Facebook, Inc., which operates the world’s largest social network, and LinkedIn Corp., the #1 professional networking platform, added the most value. Both companies reported outstanding quarterly results, with Facebook benefiting from improving mobile monetization and increasingly positive feedback from advertisers, while LinkedIn showed acceleration in its engagement metrics. Another contributor in IT was ASML Holding N.V., which designs and manufactures semiconductor production equipment. Shares of ASML increased from $79 to $99 in the quarter driven by closing its strategic acquisition of Cymer, beating quarterly earnings estimates, and reiterating its full year revenue guidance. The Fund’s meaningfully larger exposure to IT, which was one of the better performing sectors in the index, also aided relative results. Within Consumer Discretionary, a combination of stock selection and the Fund’s significantly larger exposure to the sector contributed to relative performance. Two key contributors in the sector were casinos & gaming investments Wynn Resorts Ltd. and Las Vegas Sands Corp. Both companies operate casinos in Macau and this market experienced robust growth in the quarter, with more visitors and infrastructure improvements. Priceline.com, Inc., a leading online travel agency, outperformed after the company reported strong quarterly results and an improving outlook for 2013. Strength in the Energy sector was attributable to outperformance of the Fund’s two holdings in the sector, Frank's International N.V., a 75-year old global provider of mission critical products and services to the oil & gas industry, and Golar LNG Ltd., which is engaged in transportation and regassification of liquefied natural gas. Shares of Frank's rose sharply following the company’s IPO in early August.
The Fund’s investments within the Financials and Materials sectors were the largest detractors from relative performance. Within Financials, the Fund’s holdings in the sector fell 1.31% with ICICI Bank Limited, one of the largest banks in India, leading the decline. The Fund sold its position in ICICI Bank due to concerns about the current economic environment in India. Another detractor in the sector was CME Group, Inc., which operates exchanges for financial derivatives. After appreciating 52% in the first half of the year, shares of CME declined in the quarter due to what we believe was profit taking and lower-than-expected pricing on swap clearing. Weakness in Materials was mainly attributable to the underperformance of BASF SE, one of the largest manufacturers and suppliers of chemicals, plastics and performance products. Shares of BASF fell 3.5% before the Fund exited the position in early August.
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