Review and Outlook
Baron Opportunity Fund has had a solid start to the year. The market environment has been more favorable than last year for the higher growth, innovative businesses in which we invest. More importantly, our companies have continued to show solid operating progress and the innovative themes on which we focus have continued to cement themselves into the fabric of our business and consumer lives.
The lion’s share of our investments reported solid results during the recent earnings season. We view earnings reports as the latest check on whether the fundamental growth drivers we have identified for our investments are playing out as we had envisioned and whether there are any material changes in the growth opportunities - good or bad - for our businesses. For companies facing challenges - competitive, economic, internal, etc. - we try to assess whether these challenges are normal stumbles or thesis-changers and a reason to exit our investment. We found that the vast majority of our companies are on the path to achieving our long-term investment theses. While a few are dealing with stumbles, we did not identify a single thesis-changer.
The long-term secular themes on which we focus continue to gain strength and play a bigger role in society. This continues to bolster our belief that a portfolio of well-managed, higher-growth businesses capitalizing on innovative and longer-term secular growth themes should outperform the broader market and passive indexes across market cycles. As we attend conferences, visit companies, meet with management, and listen to a wide range of earnings calls, it becomes more and more clear to us that the world is changing fast, that legacy business models and technologies are being left behind, and that consumers and enterprises alike are quickly adopting new ways of doing things. By way of example, we believe:
- DNA sequencing has brought us to the dawn of a new age of using genetic information to diagnose, treat and prevent disease and to develop a new generation of targeted drugs and therapies.
- Modern computing infrastructure and applications are being built for the cloud.
- Solar is the fastest growing segment of electricity generation.
- On demand digital media (music and video) will further disrupt traditional TV and radio ecosystems.
- Advertising will not only continue to shift to mobile devices and the broader Internet, but will become more relevant, targeted and people-based.
- Mobile, including a new generation of connected devices, will continue to occupy the central place in all of our lives.
This quarter we changed the Fund's primary benchmark from the Russell Midcap Growth Index to the all-cap Russell 3000 Growth Index. This was done in conjunction with a firm-wide review of how we define market cap categories for our Funds and a resetting of the market cap definitions of our small-, mid- and large-cap portfolios. We decided the best approach would be to give Baron Opportunity Fund maximum flexibility by removing any market cap restrictions and adopt an all-cap index as our primary benchmark.
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 gained 4.06% in the first quarter and performed in line with the Russell 3000 Growth Index.
Outperformance of the Information Technology (IT), Industrials, and Energy sectors and the Fund’s lower exposure to the lagging Financials sector contributed the most to relative results. Within IT, the Fund’s systems software holdings outperformed their index counterparts, increasing 13.2% with Qualys, Inc. leading the way. Shares of this security software provider rose as headlines about cybersecurity breaches helped the company report a strong finish to 2014 and raise its outlook for 2015. The Fund exited its position in Qualys late in the quarter because valuations in the security software space appeared stretched. Outperformance of the Fund’s Internet software & services investments, led by Twitter, Inc., JUST EAT plc, and Benefitfocus, Inc., and its significantly larger exposure to this strong performing sub-industry aided relative results. Shares of Benefitfocus increased by double digits on robust financial results, a strong 2015 outlook, and a strategic investment from Mercer. Renewable energy company SunEdison, Inc. also added value after shares rose on increased investor confidence in its ability to develop cash-generating assets and drop them down to its yieldco TerraForm Power, Inc. Within Industrials, outperformance of analytics vendor Verisk Analytics, Inc. and lack of exposure to the declining railroads and air freight & logistics sub-industries contributed the most to relative results. Shares of Verisk increased on reports of stellar financial results for its fiscal fourth quarter, with organic revenue growth improving 2.5% sequentially to 11.4%. Strength in Energy was mostly attributable to the outperformance of Concho Resources, Inc., an independent E&P company operating in the Permian Basin in West Texas and New Mexico. Concho’s shares rebounded after the company cut its spending rate, raised additional capital, and positioned itself well, in our view, to survive the downturn and emerge stronger when oil prices recover.
Our investments in the Health Care and Consumer Discretionary sectors were the largest detractors from relative results. Within Health Care, underperformance of athenahealth, Inc. and lower exposure to biotechnology stocks, which rose 9.9% in the index, detracted the most from relative performance. Shares of athenahealth, a provider of cloud-based payment and other services to doctors, fell due to a shortfall in 2014 internal bookings targets. Weakness in Consumer Discretionary was mainly due to the underperformance of AO World plc and Tesla Motors Inc, two of the Fund's largest detractors on an absolute basis. Another detractor from relative performance in the sector was Discovery Communications, Inc., the world’s leading pay TV programmer. Discovery’s shares declined along with other cable programmers due to a weaker domestic TV ad environment and concerns around loss of market share to digital video. We exited our position as we grew more convinced that as video consumption gains momentum, the loss in ratings and audiences at content networks is accelerating.
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