Review and Outlook
Last year’s volatility continued into 2016, with the U.S. equity markets plunging dramatically during the first six weeks of 2016 before executing an about-face to recover much of their losses, although small cap stocks fared worse than their larger cap counterparts. Concerns around the implications of a tightening credit market in the face of a possible U.S. recession, signs of slowing global growth, China and the RMB, and continued low oil prices drove the U.S. equity markets into correction territory by early February. During the quarter, oil prices declined at one point to near 15-year lows of $26/barrel, before rebounding to near $40/barrel by quarter end. In addition, slowed global growth and deflationary pressure early in the quarter prompted the central banks in Europe and Japan to ease monetary policy, including several that pushed interest rates into negative territory. As global concerns subsided, oil prices ticked up, and domestic job numbers improved, stock markets rallied strongly. In March, the U.S. Federal Reserve boosted equity markets even further with its suggestion that it would defer interest rate hikes that it earlier had been contemplating for 2016.
Baron Focused Growth Fund declined in the first quarter. Investments in the Consumer Discretionary, Health Care, and Consumer Staples sectors contributed to performance. Information Technology (IT) and Financials were sector detractors. Consumer Discretionary had a solid quarter, with the top three contributors all within the sector. Top five contributor Choice Hotels International, Inc. also added to sector performance. Shares of this hotel franchisor rose as its recurring revenue and earnings from franchise fees attracted investors seeking safe havens in a volatile quarter. Health Care advanced on an increase in the share price of Inovalon Holdings, Inc., the portfolio’s only sector holding. The stock price of this health care data and analytics vendor advanced as investors purchased shares at a discounted valuation. The Fund’s sole Consumer Staples investment, consumer products company Church & Dwight Co., Inc., benefited from an investor shift to this defensive sector in the first half of the quarter. The IT sector experienced losses in all four Fund holdings, as high-growth, high-multiple stocks sold off in the volatile market. FactSet Research Systems, Inc., a leading provider of investment management tools led the retreat in the Financials sector, as investors contemplated headcount reductions in its sell side business.
Overall, we think the U.S. economy is doing well. Wages have increased somewhat. Income growth and low prices at the gas pump are providing consumers with more money for discretionary spending. Until now, much of the savings from low energy prices was being used to pay down debt, as consumers and businesses were not convinced that prices would stay low. With the extended low oil price environment, we believe assets previously allocated to energy costs will soon start to be redeployed to other parts of the economy.
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.
Baron Focused Growth Fund declined 0.83% in the first quarter, yet outperformed the Russell 2500 Growth Index by 183 basis points due to differences in sector weights relative to the index.
The Fund’s Health Care and Utilities investments and its meaningfully larger exposure to the outperforming Consumer Discretionary sector contributed the most to relative results. Within Health Care, the Fund’s lack of exposure to lagging biotechnology and pharmaceutical stocks, which fell 31.2% and 24.4%, respectively, within the index, contributed 284 basis points to relative performance. Outperformance of the Fund’s only Health Care holding, health care data and analytics vendor Inovalon Holdings, Inc., also aided relative performance. Inovalon’s stock price rose in the quarter as investors purchased shares at a discounted valuation. We were encouraged by the +19% organic revenue growth Inovalon generated in its most recent quarter and remain optimistic about the company’s ability to compound revenue at mid-to-high-teens rates and drive sustained margin expansion. Within Utilities, outperformance of, and larger exposure to, ITC Holdings Corp. during the period held added the most value. We exited our position in ITC after Fortis, Inc. announced it would acquire the company.
The Fund’s Industrials and Information Technology (IT) holdings and its lack of exposure to the outperforming Materials sector were the primary detractors from relative performance. Within Industrials, underperformance of quartz countertop manufacturer CaesarStone Sdot-Yam Ltd. and the Fund’s lack of exposure to strong performing industrial machinery and airline stocks detracted the most from relative results. CaesarStone was the third largest detractor from absolute results after the company’s stock price declined more than 20% in the quarter. Within IT, underperformance of Guidewire Software, Inc. and the Fund’s significantly larger exposure to the poor performing Internet software & services sub-industry through its investments in CoStar Group, Inc. and Benefitfocus, Inc. hurt relative results. Despite reporting outstanding financial results, shares of Guidewire, CoStar, and Benfitfocus sold off aggressively alongside other high growth, high multiple technology stocks early in the quarter.
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