Review and Outlook
Through much of the second quarter, the market continued to recover nicely from the sharp risk-off mindset that prevailed the first six weeks of the year. In January and February, investors appeared to put significant weight on macro downside risks: a sharp economic slowdown in China, the end of the U.S. economic recovery, persistent low and even negative sovereign interest rates, collapsing oil prices, etc. It appears that concerns over these fears have turned more optimistic as the data (including expanding U.S. leading indicators, rising oil prices, and declining high yield credit spreads) has improved. In the last week of the quarter, the surprising Brexit vote drove a temporary sell-off in the market.
While we, of course, stay well-versed on such things as the domestic and global economy, the Fed, terrorism and military actions, politics, and anomalous events like Brexit, these have little impact on Baron’s investing philosophy and approach. Yes, Brexit has created uncertainty regarding whether Great Britain will abide by the referendum vote and leave the European Union; what the terms of an exit, if it occurs, will ultimately be; and what impact an exit or merely the risk of one will have on the global economy and the tone of the world’s stock markets. While we intend to stay informed, it is almost impossible to predict what will happen. Who would have thought that all British politicians involved in both sides of the Brexit vote would have lost power? Or that the market would have shot up after just a two-day sell-off? We have not made any changes to the portfolio due to Brexit alone and have no present intention of doing so.
With Baron Opportunity Fund, we aim to offer our investors a portfolio focused on high growth, innovative businesses capitalizing on powerful secular trends – a Fund highly differentiated from a passive index or ETF, as well as a generalized growth fund. We aim to differentiate not by trying to figure out cyclical growth drivers but by focusing, almost exclusively, on secular growth. We seek to identify powerful long-term trends – which we refer to as generational, paradigm, or tectonic shifts – that will drive robust growth regardless of the strength or weakness of the underlying economy.
Some of the secular themes in which we invest include cloud computing and software-as-a-service (SaaS), mobile, big data, digital media, targeted digital advertising, e-commerce, genetics, electronic medical records, immune-oncology, cybersecurity, electric vehicles and autonomous driving, and electronic payments. These themes span industries and represent the world’s future, not its past. They are visible, impactful, and persistent. They will play out over a long period of time, literally 10 years or more. They will disrupt existing industry dynamics. We believe the winners will capture large profit pools from the legacy way of doing things. By investing in these themes, our goal is to deliver dependable high-growth rates that are greater than the general economy, as reflected in broad market indexes, although we cannot guarantee it.
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 increased 3.44% in the second quarter and outperformed the Russell 3000 Growth Index by 264 basis points, primarily due to stock selection. Smaller cap stocks outperformed large cap stocks during the quarter, and greater exposure to smaller cap stocks also aided relative performance.
Outperformance of Information Technology (IT), Consumer Discretionary, and Financials investments contributed the most to relative results. IT holdings added 375 basis points, driven by Internet software & services holdings CoStar Group, Inc., Zillow Group, Inc., and Benefitfocus, Inc. CoStar was the second largest contributor to absolute performance, while shares of real estate website operator Zillow rose on improving fundamentals and the favorable settlement of a lawsuit with Move, Inc. Shares of benefits software vendor Benefitfocus rose on outstanding financial results driven by traction in new logo acquisition and cross-sales of new modules. Favorable stock selection in Internet software & services was partly offset by meaningfully larger exposure to this poor performing sub-industry, which declined 2.0% in the index. Outperformance of application software holdings, led by Guidewire Software, Inc. and Mobileye N.V., and larger exposure to this strong performing sub-industry also added value. Guidewire was the third largest contributor to absolute performance, while driver assistance software company Mobileye recouped first quarter losses on news of two autonomous program wins. Lack of exposure to Apple, Inc., a sizeable position in the index whose shares fell nearly 12%, and outperformance of Gartner, Inc. also lifted relative performance in IT. Strength in Consumer Discretionary was mostly attributable to Amazon.com, Inc., the largest contributor on an absolute basis, and Manchester United plc, an English Premier League professional sports team. Manchester United’s shares recovered in anticipation of potentially better field results under new coach Jose Mourinho. Within Financials, outperformance of global colocation REIT Equinix, Inc. contributed the most to relative results.
Underperformance of Health Care investments and lack of exposure to Consumer Staples, which rose 3.9% in the index, detracted the most from relative performance. Weakness in Health Care was partly due to the underperformance of pharmaceutical holdings, led by Pacira Pharmaceuticals, Inc. and Allergan plc. Pacira was the third largest detractor from absolute results, while shares of Botox manufacturer Allergan fell after the U.S. Treasury disallowed the Pfizer-Allergan inversion. Investments in Illumina, Inc., the largest detractor on an absolute basis, and Alexion Pharmaceuticals, Inc., a biotechnology company serving orphan disease markets, also hurt relative performance. Alexion’s shares fell due to slowing growth of lead product Soliris and a light launch for new drug Kanuma.
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