Review and Outlook
After a solid end to the fourth quarter of 2015, Baron Opportunity Fund had a rough start to the year. It was certainly poor from a quarterly performance perspective, but critically, in our view, not in the least from an investing perspective. Our underlying innovation themes continue to accelerate, and the vast majority of our individual investments have seen no change to their solid fundamentals. What happened in the quarter was straightforward: In January and February, the Fund’s performance was driven back by the gale force winds of a fear-driven market dominated by a “sell now, ask questions later” mentality. The Fund performed better in March. There is a lot of year left, and we continue to work at our research and portfolio management to perform as well as we can.
To paraphrase Benjamin Graham, in the short term the market acts as a voting machine. The votes of its participants are the multiples investors and traders are willing to pay at that very moment. Daily voting is based much more on sentiment or emotions than fundamental analysis. In optimistic environments, multiples rise; in fearful, risk-off settings, they fall. In aggressive risk-off markets, the multiples assigned to higher growth, higher multiple stocks – often the recent winners – fall the most. That is precisely what happened to us in January and February. Many of our winners from last year sold off due to short-term multiple contraction, in our opinion, without a whiff of a change in their fundamentals or long- term growth opportunities.
Our Baron investment philosophy is grounded in the view that in the long term, the market is a weighing machine (the second part of Graham’s observation). We do not try to predict the daily or monthly voting by the market. Instead, we hold fast to the belief that the market’s long-term weighing machine correctly values companies based on the fundamental growth drivers of their business.
That is why we focus on whether companies possess durable and powerful competitive advantages, their financial models and balance sheets, and the quality of their management teams. Valuation, of course, is a key piece of the puzzle. But while we monitor and consider current and near-term multiples, short-term valuation does not dominate our thinking. We have learned through years of experience that many of the truly special companies and some of the strongest long-term returners, like Amazon, Alphabet (Google), and Netflix, always appear somewhat expensive on near-term numbers. So we prioritize long-term valuation: investing when applying conservative and appropriate multiples to our internal forecasts of free cash flow and earnings can make at least a double over a 4-to-5-year period.
Our approach is a differentiated, long-term strategy. We provide our investors with something distinct from a passive ETF or generalized growth fund: a focused portfolio of higher growth and innovative businesses capitalizing on powerful secular growth trends. While we can offer no guarantees, we are committed to tipping the scales of the weighing machine in our investors’ favor.
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 decreased 7.76% in the first quarter and underperformed the Russell 3000 Growth Index by 810 basis points. During the quarter, stock selection and the Fund’s significantly larger exposure to poor performing Internet and software stocks hurt relative performance.
Outperformance of the Fund’s sole holding in the Energy sector, Concho Resources, Inc., and its lower exposure to lagging biotechnology stocks within Health Care contributed the most to relative results. Shares of Concho, an independent exploration and production (E&P) company focused on the Permian basin in West Texas and New Mexico, rose after the company enhanced its position in the Delaware basin, and provided a 2017 outlook that beat expectations. We think Concho is one of the best run mid-cap E&P companies and is well-positioned to exploit the inventory of drilling locations in the Delaware Basin in New Mexico/West Texas. We believe its strong balance sheet will enable it to navigate these turbulent times in the energy business and emerge as a stronger company.
Underperformance of Information Technology (IT) and Consumer Discretionary investments, lower exposure to the outperforming Industrials sector, and lack of exposure to the Consumer Staples sectors detracted the most from relative performance. Weakness in IT was partly due to the underperformance of Internet software & services holdings, led by LinkedIn Corp. and CoStar Group, Inc., and meaningfully larger exposure to this lagging sub-industry, which declined 1.9% in the index. LinkedIn was the largest detractor from absolute results before being sold in early February, while shares of CoStar, a real estate data and marketing services company, fell as high-growth, high-multiple technology stocks sold off. Systems software and application software investments also hurt relative results, driven by the underperformance of ServiceNow, Inc. and Guidewire Software, Inc., respectively. Shares of ServiceNow, a cloud-based workload management platform, declined due to a billings shortfall and tepid guidance despite solid Q4 results. Guidewire was the third largest detractor on an absolute basis. Significantly larger exposure to poor performing application software stocks, which fell 1.9% within the index, also hampered relative results. Within Consumer Discretionary, underperformance of Restoration Hardware Holdings, Inc. and Manchester United plc detracted the most from relative results. Restoration Hardware was the second largest detractor from absolute performance before being sold in early March, while shares of English Premier League professional sports team Manchester United declined over concerns that the team will not qualify for the Champions League next season. We believe the team still has a chance to qualify, and even if it does not, the financial impact will be modest. We expect the company to benefit from future sponsorship deals, the roll-out of new merchandise agreements, and a digital offering under development. Larger exposure to the underperforming Internet retail sub-industry through investments in Amazon.com, Inc., Netflix, Inc., and The Priceline Group, Inc. also weighed on relative results.
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