Review and Outlook
After the initial shock of the Brexit vote in late June, the U.S. stock markets settled down in the third quarter, experiencing significantly less volatility than in the first half of 2016. Stable economic data, monetary policy rates that remained relatively unchanged, and the lack of a major disruptive event allayed investor concerns and drove a broad-based rebound during the three-month period ended September 30, 2016.
Investor appetite for risk increased, and stocks (particularly small-cap stocks) rose more or less steadily throughout the quarter. Lower quality stocks outperformed their higher quality counterparts. After mostly underperforming in the first half of the year, risk-on categories such as biotechnology and semiconductors outperformed. On the other hand, defensive sectors retreated after strong performance in the first half of 2016.
Baron Growth Fund increased in the quarter. Holdings in Consumer Discretionary, Financials, and Industrials were the top contributors. Consumer Discretionary had a somewhat mixed quarter, with both top contributor Vail Resorts, Inc. and third largest detractor Under Armour, Inc. within the sector. Financials advanced primarily on the strength of third largest contributor Arch Capital Group Ltd. Performance of the Industrials sector was led by composite decking manufacturer Trex Company, Inc. The company’s share price advanced on the strength of Q2 results and Q3 guidance that beat Street estimates.
Consumer Staples and Telecommunication Services investments detracted as investors shifted out of defensive sectors. All four Consumer Staples holdings fell, led by private-label food company TreeHouse Foods, Inc., which gave up some gains as a result of concerns regarding the integration of the Conagra private label food business. We believe TreeHouse, as a pure private-label company, is well-positioned to take advantage of secular growth in this market. Telecommunication Services detracted somewhat due to weak performance of the Fund’s only sector holding, Iridium Communications Inc. Despite strong Q2 financial results, delays in payments from a customer raised concerns. In addition, the SpaceX explosion of a Falcon 9 missile increased the risk of a delayed launch schedule. We see potentially significant cash flow yields for the NEXT constellation launch in 2018 and beyond and look forward to launches later this year.
The U.S. economy showed signs of acceleration in the third quarter. Historically, the U.S. stock market has been closely aligned with GDP. In 1960, GDP was $520 billion and the Dow Jones Industrial Average was 600. In 2007, GDP was $14 trillion and the Dow was 14,000. In 2015, GDP was $17.9 trillion and the Dow was 17,000. We think the U.S. economy and the stock market are closely intertwined. Over the past half century or so, our economy and stock market have grown at a compound annual rate between 6-7% in nominal terms. Factoring in annual dividends of about 2-3%, stock prices have approximately doubled every 10 years during the same period. We think our nation’s economy and stock markets will continue to achieve similarly strong results over the long term.
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 Growth Fund increased 2.59% in the third quarter, yet underperformed the Russell 2000 Growth Index by 663 basis points due to a combination of stock selection and relative sector weights. The notable outperformance of lower quality stocks in the quarter also weighed on relative performance.
Lower exposure to the lagging Industrials sector, lack of exposure to the poor performing Utilities sector, and outperformance of Consumer Discretionary investments contributed the most to relative results. Strength in Consumer Discretionary was mostly attributable to the outperformance of ski resort operators Vail Resorts, Inc. and Whistler Blackcomb Holdings, Inc., whose stock prices were up sharply in early August after Vail agreed to acquire Whistler Blackcomb. Outperformance of sporting goods retailer Dick’s Sporting Goods, Inc. and lower exposure to poor performing restaurant stocks, which fell 4.7% within the index, also added value. Favorable stock selection in the Consumer Discretionary sector was offset by larger exposure to the underperforming apparel, accessories & luxury goods, hotels, resorts & cruise lines, and education services sub-industries.
Information Technology (IT), Health Care, and Financials holdings were the largest detractors from relative results. Within IT, underperformance of the Fund’s two largest sector holdings, Gartner, Inc. and CoStar Group, Inc., and lack of exposure to outperforming semiconductor stocks detracted the most from relative results. Gartner was the largest detractor from absolute performance, while shares of CoStar, a real estate information and marketing services company, fell slightly on modest multiple compression after outperforming in Q2. Underperformance of application software holdings, led by ANSYS, Inc. and Guidewire Software, Inc., and lack of exposure to the strong performing systems software and communications equipment sub-industries also weighed on relative results. Within Health Care, meaningfully lower exposure to strong performing biotechnology stocks, which rose nearly 23% within the index, detracted 101 basis points from relative results. The underperformance of Inovalon Holdings, Inc., the second largest detractor from absolute results, and Bio-Techne Corporation, which sells specialized proteins, antibodies and assay kits used to investigate possible therapies for diseases, also hurt sector performance. Although Bio-Techne reported strong organic revenue growth during the quarter, the stock price declined due to dilution from a recent acquisition and foreign currency headwinds. Within Financials, underperformance of FactSet Research Systems, Inc. and Primerica, Inc. and significantly larger exposure to this lagging sector hurt relative results. Shares of FactSet, a financial information provider to investment firms, underperformed as growth moderated slightly due to choppy end markets, while Primerica gave back some gains after significantly outperforming in the prior quarter.
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