Review and Outlook
During a period marked by increased volatility, the U.S. stock market ended the fourth quarter higher. The freefall in oil prices dominated business headlines. Domestic (WTI) oil prices fell over 40% in the quarter, driven down by slower global demand growth and rising oversupply. The price of crude oil dropped to $53 per barrel as of year-end, down almost 50% from its June high and the lowest level since May 2009.
Domestically, generally positive economic reports supported the view that the U.S. economy is accelerating, outpacing much of the rest of the developed world. Unemployment was down, average hourly earnings increased, and consumer confidence rose. Higher-than-expected automobile sales and construction spending bolstered the recovery narrative.
Baron Fifth Avenue Growth Fund increased in the fourth quarter. Information Technology (IT), Health Care, and Financials contributed the most to performance. Consumer Discretionary and Telecommunication Services detracted. While IT had a somewhat mixed quarter, double digit increases in the Fund’s data processing & outsourced services investments boosted sector contribution. Health Care contributed with solid gains across the Fund’s life sciences tools & services and biotechnology holdings. Double digit gains in the Fund’s two Financial holdings lifted sector performance. Consumer Discretionary lost ground primarily due to weak performance of the Fund’s casinos & gaming and Internet retail investments. The stock price of the Fund’s sole Telecommunication Services holding, SoftBank Corp., fell. SoftBank is a major stakeowner in Alibaba Group Holding Ltd., which had its IPO in the quarter. SoftBank took a hit as investors who used to buy SoftBank as a proxy for owning Alibaba shares shifted assets directly into Alibaba.
As this bull market run enters its seventh year, it seems that the consensus is again calling for a pause. We do not have any insight on the direction of the market. However, we do observe that unemployment continues to drop, the economy continues to exhibit signs of strength, and the sharp decline in oil prices should provide meaningful savings to consumers. While we expect the markets to remain volatile, we remain positive on the overall environment. Over the last 50 years, despite the doubling of the population, average global income per capita has tripled, life expectancy has risen by a third, and child mortality is down 70%. Literacy rates are up meaningfully, and average IQs are considerably higher even after adjusting for inflation and better nutrition. People are healthier, smarter, and more prosperous than they have ever been. All predictions of doom have repeatedly proved wrong. Despite disasters and reverses, quality of life and material wealth and prosperity have continued to increase everywhere in the world, and we think that’s unlikely to change. Our goal remains to maximize long-term returns without taking significant risks of permanent loss of capital. Our focus continues to be on identifying and investing in what we believe are unique companies with sustainable competitive advantages that have the ability to reinvest 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 (Institutional Shares) increased 3.37% in the fourth quarter, yet trailed the Russell 1000 Growth Index by 141 basis points, mainly due to stock selection.
The Fund’s investments within the Energy, Health Care, and Materials sectors were the largest contributors to relative results. Within Energy, the outperformance of Shell Midstream Partners, L.P. and the Fund’s lower exposure to this lagging sector aided relative results. Shares of Shell Midstream, a midstream energy MLP spun off by Royal Dutch Shell during the quarter, increased sharply post-IPO as investors sought energy companies with stable cash flows and visible growth. Strength in Health Care was largely attributable to the outperformance of Illumina, Inc., which was also the Fund’s largest contributor on an absolute basis. Regeneron Pharmaceuticals, Inc., a producer of medicines for the treatment of serious medical conditions, and Alexion Pharmaceuticals, Inc., which develops therapeutics for patients with severe and ultra-rare disorders, also outperformed in the quarter. Regeneron’s shares rose in anticipation of the company’s Eylea launch in Diabetic Macular Edema and a positive interim look into a Phase III trial for one of its pipeline assets called Dupilumab. Shares of Alexion increased on better-than-expected quarterly results for the company’s one marketed product, Soliris. Within Materials, the Fund’s lack of exposure to commodity chemicals and outperformance of Monsanto Co., an agrochemical and agricultural biotechnology company and the Fund’s only holding in the sector, added value. Shares of Monsanto increased 6.7% after management reaffirmed its double-digit earnings growth target for 2015.
Stock selection within the Consumer Discretionary sector was by far the largest detractor from relative results. Underperformance of the Fund’s two casinos & gaming holdings, Wynn Resorts Ltd. and Las Vegas Sands Corp., and two Internet retail holdings, Amazon .com, Inc. and The Priceline Group, Inc., as well as its larger exposure to these underperforming sub-industries detracted approximately 154 basis points from relative performance. Wynn, a casino operator with locations in Macau and Las Vegas, was the largest individual detractor in the sector due to investor concerns over the Chinese government’s anti-corruption campaign and increased visa restrictions impacting the company’s operation in Macau. The Fund’s lower exposure to Industrials, which was one of the better performing sectors in the index, and the underperformance of the Fund’s only holding in Telecommunication Services, SoftBank Corp., also detracted from relative results. Shares of SoftBank, a Japanese conglomerate with a 37% stake in Alibaba Group Holding Ltd., declined just over 15% as investors who gained exposure to Alibaba through SoftBank, could now gain this exposure directly since Alibaba’s IPO.
Yearly Attribution Analysis
The Baron Fifth Avenue Growth Fund (Institutional Shares) gained 8.34% for the year, yet lagged the Russell 1000 Growth Index by 471 basis points. During the year, stock selection and, to a lesser extent, relative sector weights detracted from relative performance.
The Fund’s investments within the Health Care and Energy sectors contributed the most to relative results. Within Health Care, the outperformance of Illumina, Inc., which was also the Fund’s largest contributor to absolute performance during the year, contributed the most to relative results in the sector. Two of the Fund’s biotechnology investments, Regeneron Pharmaceuticals, Inc. and Alexion Pharmaceuticals, Inc., achieved 52-week highs in December and outperformed. Within Energy, a combination of stock selection and the Fund’s lower exposure to this underperforming sector aided relative results. The Fund’s investments in the oil & gas storage & transportation and exploration & production sub-industries outperformed, led by Shell Midstream Partners, L.P. and Concho Resources, Inc., respectively. Shell Midstream’s shares were up 78% following the company’s IPO in late October, while Concho’s shares held up well as the company continued to execute on its drilling program and saw improving well results.
As in the fourth quarter, the Fund’s investments within the Consumer Discretionary detracted the most from relative performance. For the year, the underperformance of the Fund’s two casinos & gaming holdings, Wynn Resorts Ltd. and Las Vegas Sands Corp., and two Internet retail holdings, Amazon.com, Inc. and The Priceline Group, Inc., as well as its larger exposure to these underperforming sub-industries detracted approximately 383 basis points from relative performance. Each of these four detractors declined for the year after meaningfully outperforming in 2013. Amazon.com, Inc., which was also the largest detractor for year on an absolute basis, and The Priceline Group, Inc. remain top 10 holdings. The negative fourth quarter impact that Alibaba Group Holding Ltd.’s September IPO had on SoftBank was the primary cause of its underperformance for the full year as well. SoftBank has a 37% stake in Alibaba, and the stock sold off when investors, who gained exposure to Alibaba through SoftBank, could invest in Alibaba directly.
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