Review and Outlook
The U.S. stock market continued its strong run during the third quarter. Once again, the market took its cue from the Federal Reserve. The Fed surprised the market at its September meeting by deciding not to begin tapering its bond purchase program (QE). The market responded as one would expect: interest rates fell and equity markets took off. As Chairman Bernanke has emphasized, we believe the Fed will continue to closely monitor economic conditions – including the impact of gridlock in Washington, D.C. over the budget and the debt ceiling – before setting a timeline for its inevitable and gradual exit from QE.
In the meantime, the U.S. economy is slowly but steadily improving, interest rates remain at historically low levels, corporate balance sheets are flush with cash and the foundation for healthy equity markets remains solid.
The Baron Opportunity Fund had a strong quarter. For the first time in several quarters, the Fund’s Information Technology investments led the way. We believe that the sector is in the beginning stages of a generational shift from old to new technologies, headlined by cloud computing, big data and mobility, that in time, will favor the latter. Our IT investments are either focused on these newer enterprise technologies, or on Internet and (what we call) information services. This quarter saw solid gains from a number of our holdings in these themes. Consumer Discretionary was also strong. Top performers included Liberty Media Corp., whose value is driven largely by satellite radio leader Sirius XM Radio; online travel agency priceline.com, Inc.; and performance apparel company Under Armour, Inc.
Holdings that lagged included Angie’s List, Inc., whose stock fell based on concerns around pricing tests the company was carrying out toward the end of the quarter; and online vacation rental company HomeAway, Inc., due to concerns over slowing listing growth.
The Fund continues to find attractive new investment opportunities. In the third quarter, we added positions in DreamWorks Animation SKG, Inc., Mellanox Technologies Ltd., Concho Resources, Inc., and SodaSteam International Ltd. We also decided to re-invest in daily-deal pioneer Groupon, Inc., which has completely reinvented its business with mobile at the core.
Baron Opportunity Fund invests in businesses that are innovating and disrupting their industries. In its simplest form, innovation is about taking an idea and turning it into a business. The last 20 years have given rise to amazing innovations: the Internet, smart phone, and social networks, to name a few. Despite the doubters, innovation is not slowing down. To borrow from the immortal Steve Jobs: there is always “one more thing” around the bend. Innovation is synonymous with the human endeavor. It springs from our uniquely human capacity to dream, imagine, change, create, improve, win – and, yes, to profit.
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.
The Baron Opportunity Fund (Institutional Shares) gained 11.95% in the third quarter, outperforming the Russell Midcap Growth Index by 261 basis points. During the quarter, the Fund’s stock selection and, to a lesser extent, sector weights contributed to relative performance.
The Fund’s investments within the Information Technology (IT), Consumer Staples, and Consumer Discretionary sectors were the primary contributors to relative performance. Within IT, a combination of stock selection and the Fund’s larger exposure to the sector, and particularly to the top performing Internet software & services sub-industry, contributed to relative results. Shares of Xoom Corporation, which operates an online consumer-to-consumer international money transfer business, rose in the period after reporting strong quarterly results helped by several successful business initiatives. As a result, this Internet software & services stock added the most value within the sub-industry and the sector. The Fund’s application software investments also outperformed, led by salesforce.com, inc., the leading innovator in cloud computing, with a broad suite of cloud-based productivity applications, and RealPage, Inc., which provides property management software and analytical tools for the rental housing industry. Within Consumer Staples, outperformance of Sprouts Farmers Markets, Inc. combined with the Fund’s lower exposure to the worst performing sector in the index, aided relative results. Shares of Sprouts, one of the fastest growing healthy food retailers in the country, more than doubled following the company’s IPO in early August, making it one of the most successful IPOs in recent history. The majority of the Fund’s investments in the Consumer Discretionary sector outperformed, led by Under Armour, Inc., a manufacturer and distributor of performance apparel. Sales growth exceeded 20%, and the company’s quarterly earnings surpassed analyst expectations. Under Armour continued its investments in support of future growth as the company seeks to expand internationally, grow its footwear businesses, and develop its direct-to-consumer channel. Other contributors in the sector were priceline.com Inc., a leading global online travel agent, and Liberty Media Corp., which owns interests in a broad range of media, communications, and entertainment businesses.
The Fund’s investments within the Industrials sector were the largest detractors from relative performance. Weakness in the sector was mainly due to the underperformance of DigitalGlobe, Inc., an operator of satellites, which provide high-resolution earth imagery for government and commercial clients, and Ryanair Holdings plc, the lowest-cost short-haul airline in Europe. Shares of Ryanair came under pressure in early September after the company cautioned that near-term demand is expected to be weaker than previously expected.
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