Review and Outlook
2014 was a challenging year for Baron Opportunity Fund, although performance improved in the fourth quarter and the Fund regained a significant percentage of its losses from the prior three quarters.
The market environment in 2014 presented a significant headwind to our strategy of investing in high growth, innovative businesses. Volatility that started with the mid-March risk-off pullback in growth stocks continued through much of the rest of the year. In this risk-adverse environment in which investors opted for short-term earnings over long-term value creation, many of the growth stocks we invest in trailed the market. The companies we tend to favor are investing today to capitalize on large opportunities for future growth and erect competitive moats. Investors who favor short-term results more than longer-term outcomes may overlook or discount the value of these businesses. As long-term investors, we have found that these investments in growth, which may penalize short-term profits, often generate larger profits, cash flow, and returns for investors later.
The Fund focuses on businesses and industry segments whose growth is being driven by disruptive innovation and where significant changes - i.e., generational shifts - are occurring. History teaches us that new winners emerge during periods of generational or paradigm shifts - think ABC, NBC and CBS during the TV age or Microsoft and Intel during the PC era. We believe innovation provides the foundation for businesses to generate long-term secular growth in revenues and profits. Moreover, we view innovation as critical to creating significant and durable competitive advantages, a factor we consider to be a key component of long-term value creation.
The Information Technology (IT), Health Care, and Industrials sectors contributed the most to Fund performance in the fourth quarter. Seven of the Fund’s top 10 holdings were in IT, including top three performers Gartner, Inc. and Red Hat, Inc. Other strong IT contributors included Guidewire Software, Inc., which makes core back-end software for insurance carriers, and Benefitfocus, Inc., a provider of cloud-based benefits software. Health Care had a strong quarter, with gains in six out of eight holdings, including Illumina, Inc. Shares of this next generation DNA sequencing company rose on reported revenue growth of 35% in Q3 and increased guidance for 2015. Industrials contributed on increases in three out of four sector holdings. Energy was the only material sector detractor in the quarter, as plummeting oil prices dragged down the stock of the Fund’s three Energy holdings.
In our view, the issues impacting the market in 2014 are unrelated to the long-term impact on the innovation themes on which we focus or the long-term drivers for the businesses in which we have invested. With a year of strong growth and lagging stock prices, we believe many of our high-growth businesses are now attractively valued on a growth-adjusted basis and, more importantly, against our long-term projections of earnings and cash flow. Our independent research underlies our conviction that the fundamentals of our companies are solid, and that the secular themes in which we are investing are not just intact but more powerful than ever.
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 Opportunity Fund rose 3.67% in the fourth quarter, yet trailed the Russell Midcap Growth Index by 217 basis points, primarily due to stock selection.
The Fund's investments in the Information Technology (IT) and Health Care sectors were the largest contributors to relative results. Within IT, the Fund's larger exposure to the systems software and IT consulting & other services sub-industries, coupled with outperformance of these holdings, meaningfully contributed to relative results. Red Hat, Inc. and Qualys, Inc. performed well in systems software, while Gartner, Inc. was the main contributor in IT consulting & other services. Red Hat and Gartner were also two of the largest contributors to absolute performance. Shares of security software provider Qualys rose as headlines about cyber security breaches helped management increase penetration in the high-end enterprise market. Another contributor to relative performance was Benefitfocus, Inc., the leading provider of cloud-based benefits software. Shares of Benefitfocus jumped on strong financial results, confidence around the company’s cash requirements, and a recognition by investors that the stock was undervalued. Favorable stock selection in IT was partly offset by significantly larger exposure to Internet software & services stocks, which declined 5.4% within the index. Strength in Health Care was mostly attributable to the outperformance of Illumina, Inc., the leader in next generation DNA sequencing instruments and consumables, and The Spectranetics Corporation, which develops laser-based devices for interventional cardiovascular therapy. Shares of Illumina were up after the company reported better-than-expected quarterly results and raised guidance for the year. Shares of Spectranetics increased in the quarter, driven in part by the July approval of a major product initiation.
Underperformance of Consumer Discretionary, Energy, and Materials, and the Fund’s lack of exposure to the outperforming Consumer Staples sector detracted the most from relative results. Within Consumer Discretionary, meaningfully larger exposure to the lagging Internet retail, automobile manufacturer, and broadcasting sub-industries, all of which declined in the index, detracted the most from relative performance. The underperformance of Manchester United plc, an English Premier League professional sports team, also hurt relative results. Manchester United’s shares fell due to a secondary offering. Energy holdings Oasis Petroleum, Inc. and Golar LNG Ltd. underperformed amid the drop in oil prices during the quarter, yet this negative effect was partly offset by the Fund's lower exposure to this lagging sector. These two stocks were the largest detractors from absolute performance. Weakness in Materials was mainly due to the underperformance of Flotek Industries, Inc., a leading supplier of specialized chemicals to the oil & gas industry. Flotek generated record revenues and strong profits in the quarter, but investor concerns about falling oil prices appeared to overshadow the positive fundamentals.
Yearly Attribution Analysis
Baron Opportunity Fund declined 1.40% for the year, underperforming the Russell Midcap Growth Index by 13.30%, mainly due to stock selection.
The Fund’s larger exposure to the outperforming Telecommunication Services sector, which rose 27.6% in the index, and its lower exposure to Energy, which was the worst performing sector in the index as a result of the sharp drop in oil prices, contributed the most to relative performance. These positive effects were overshadowed by underperformance of investments within the Information Technology (IT), Consumer Discretionary, Industrials, and Financials sectors.
Within IT, the Fund’s meaningfully larger exposure to Internet software & services, which declined 4.6% in the index, and underperformance of its holdings in this sub-industry, detracted the most from relative results. Among the largest detractors were Benefitfocus, Inc., the leading provider of cloud-based benefits software, and Xoom Corp., an online consumer-to-consumer international money transfer company. Shares of Benefitfocus were hurt by higher-than-planned investment spending, a secondary offering, and the sell-off in high-growth technology stocks. Xoom’s shares suffered as competitive pressures and poor execution around the World Cup led to slower growth rates. The company also experienced unexpected management changes. The Fund exited its position in Xoom late in the year. The majority of the Fund’s application software investments also underperformed, led by Splunk, Inc. and RealPage, Inc. Both companies were sold during the year due to deteriorating fundamental performance.
Within Consumer Discretionary, underperformance of movie & entertainment holdings DreamWorks Animation SKG, Inc. and Manchester United plc, and the Fund’s larger exposure to poor performing Internet retail and broadcasting stocks, hurt relative results. Shares of DreamWorks, which makes animated films and TV shows, fell on disappointing feature film results. Shares of Manchester United fell due to disappointing on-field results to start the season and a secondary offering.
The Fund’s Industrials holdings fell 4.1%, and trailed their index counterparts by more than 14%, led by DigitalGlobe, Inc. and Verisk Analytics, Inc. Shares of DigitalGlobe, a satellite imagery provider, moved sharply lower early in the year after the company missed earnings and lowered fiscal 2014 guidance. Shares of Verisk, which provides risk information to the insurance, health care, and mortgage industries, declined after earnings fell slightly short of expectations due to variability in the company’s health care and insurance verticals. The Fund’s lack of exposure to airlines, which benefited from the drop in oil prices, also hampered relative performance.
Weakness in Financials was mainly due to the underperformance of Financial Engines, Inc., which provides independent technology-enabled portfolio management services to defined contribution plan participants. The Fund exited its position after the company experienced slowing enrollment rate growth and diminishing margins.
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