Review and Outlook
This quarter was very similar to the one ended in March, where a good earnings season combined with solid economic data (steadily improving unemployment, low inflation, rising business and consumer confidence) led the market higher until mid-September. Then signs emerged that Europe was deteriorating, the growth in emerging markets continued to slow (growth recession they called it), crude oil WTI broke $90, and the outbreak of the Ebola virus was no longer contained to West Africa. In a two week swoop, the market erased earlier gains with mid cap and small cap stocks getting hit particularly hard. The decline persisted into early October, with the S&P 500 Index giving up all of its gains year-to-date and the Russell 2000 Growth Index sporting double-digit declines. “Is this just a correction or is the bull market finally over? Is this the time to buy or is this the time to sell?” the talking heads were asking. Separating the noise from valuable perspectives and looking for and developing unique insights is what we try to do at Baron Funds.
Conceptually, we find it more stressful when the market is running straight up than when the stock prices are coming down. As capital allocators we are always looking for mispriced opportunities, which are easier to find when stocks are on sale. Our conviction is always highest when we can buy at sizable discounts to the business’ intrinsic values and we worry less about figuring out exactly when that dynamic might change.
The Information Technology sector included the four top individual contributors to the Fund, which helped boost sector performance in the quarter. Financials and Consumer Staples contributed modestly to performance as well. Financials gained ground primarily on the strength of CME Group Inc., the world's largest and most diversified derivatives marketplace. A solid quarter for the Fund’s sole Consumer Staples position, big box retail chain Costco Wholesale Corp., boosted performance of that sector. Consumer Discretionary, Materials, and Energy were the top sector detractors. While Consumer Discretionary holdings had a mixed quarter, the sector was weighed down by the weak performance of three of the top five individual detractors. Materials fell on weakness by the Fund’s sole sector holding, Monsanto Company. The Energy sector was hurt by falling commodity prices in the quarter.
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. 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 (although, not equally distributed), 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.
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) rose 0.59% in the third quarter, yet modestly underperformed the S&P 500 Index by 54 basis points. During the quarter, the Fund’s relative sector weights added value, but this positive effect was offset by stock selection.
The Fund’s investments within the Information Technology (IT) sector and its lower exposure to the lagging Energy and Utilities sectors contributed the most to relative results. Within IT, outperformance of the Fund’s Internet software & services holdings and its meaningfully larger exposure to this sub-industry, which rose 6.5% as a group in the index, aided relative performance. Strength in Internet software & services was largely attributable to the outperformance of Facebook Inc. and Twitter, Inc., which were also the Fund’s two largest contributors on an absolute basis. Another contributor in the sub-industry was LinkedIn Corp., the leading online professional networking platform. Shares of LinkedIn increased in the quarter due to strong second quarter results, with revenue growth of 47% year-over-year and its Marketing Solutions business showing revenue acceleration.
The Fund’s investments within the Consumer Discretionary, Health Care, and Materials sectors were the primary detractors from relative results. Within Consumer Discretionary, underperformance of the Fund’s casinos & gaming and restaurant holdings and its larger exposure to these lagging sub-industries hurt relative results. Shares of Las Vegas Sands Corp. and Wynn Resorts Ltd. declined in the quarter after China's corruption crackdown and more stringent visa restrictions slowed growth in Macau. YUM! Brands, Inc., the parent company of fast food chains Taco Bell, KFC, and Pizza Hut, also weighed on relative performance in the sector. The Fund decreased its position in YUM! after the company’s shares fell on negative publicity surrounding accounts of improper food handling practices by a former local supplier in China, where the company generates about half its revenues. We consider this setback to be temporary and believe YUM! will continue to grow units and profits at a rapid pace in China and other emerging markets. Within Health Care, the underperformance of the Fund’s largest holding in the sector, Illumina, Inc., overshadowed the positive effect of its larger exposure to biotechnology stocks, which rose 17.5% as a group in the index. Illumina was also one of the Fund’s largest detractors from absolute performance. Weakness in the Materials sector was due to the underperformance of Monsanto Co., which was also one of the Fund’s largest detractors on an absolute basis.
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