Review and Outlook
U.S. stock markets continued to exhibit volatility during the three months ended December 31, 2015, as investors reacted to events overseas and at home. After a significant decline in the third quarter, the fourth quarter began with a strong rally in U.S. equities. Markets were boosted by soft economic data suggesting the Federal Reserve would continue to delay a rate hike. Talk of additional stimulus from the European Central Bank and a rate cut by China augmented the global trend of easy monetary policy. An easing of concerns around the negative impact of a slowdown in China and a modest recovery in oil prices also helped drive gains.
As the quarter progressed, signs of an improving U.S. economy and a seemingly more stable global economy inspired the Fed to signal it would start a rate increase cycle. In December, the Fed raised interest rates modestly for the first time since 2006. After an initial rally, the markets sold off some fourth quarter gains over concerns about the implications of Fed tightening in the face of questions around employment trends, commodity prices, overseas growth, and corporate earnings.
Baron Partners Fund increased in the quarter. Information Technology (IT), Utilities, and Industrials contributed. Consumer Discretionary, Financials, and Health Care detracted. IT gains were driven primarily by CoStar Group, Inc., the quarter’s top contributor to performance. Utilities moved higher on the strong performance of ITC Holdings Corp., the second largest contributor in the quarter. Industrials benefited from share price increases in all four of the Fund’s investments in the sector. Consumer Discretionary had a mixed quarter, although detractors outweighed contributors. The sector included both the third largest contributor, Vail Resorts, Inc., and two of the top three detractors, Dick’s Sporting Goods, Inc. and CarMax, Inc. Financials had a mixed quarter, although detractors outweighed contributors. Weakness in Inovalon Holdings, Inc., the Fund’s second biggest detractor, weighed on the Fund’s Health Care investments.
A significant percentage of the market weakness was attributable to Energy and companies that service the energy industry as a result of the decline in oil prices. We think the constrained economic environment caused by low oil prices will eventually be offset by faster growth in the rest of the economy, as assets previously allocated by consumers and businesses to energy-related costs are redeployed.
Investing for growth is investing in the future, and when the future seems especially uncertain, investors tend to exit growth stocks. This behavior has caused the recent contraction in many growth stocks, despite the strong fundamentals and continued growth of these companies. Furthermore, the economy is in good shape and has been getting stronger. We believe this creates investment opportunities for growth investors like us.
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 Partners Fund increased 2.84% in the fourth quarter, yet trailed the Russell Midcap Growth Index by 128 basis points due to stock selection.
The Fund may use leverage and is especially likely to do so when we believe prospects for businesses are favorable and stock prices of those businesses do not reflect those prospects. As of December 31, 2015, Baron Partners Fund had 129.8% of its net assets invested in securities, and this use of leverage in an up market contributed 103 basis points to relative performance.
Aside from leverage, Utilities, Information Technology (IT), and Industrials investments and lack of exposure to the lagging Energy sector contributed to relative results. Within Utilities, outperformance of ITC Holdings Corp., the second largest contributor on an absolute basis, and larger exposure to this top performing sector added value. Strength in IT was mainly due to the outperformance of CoStar Group, Inc. and Gartner, Inc. and larger exposure to this strong performing sector. CoStar was the largest contributor to absolute performance, while shares of IT research provider Gartner rose as key forward-looking metrics continued to look strong. Within Industrials, outperformance of Fastenal Co., a leading distributor of industrial supplies, and Air Lease Corp., which leases commercial aircraft to airlines around the world, contributed to relative results. Both companies delivered earnings reports that beat Street expectations.
Financials, Consumer Discretionary, and Health Care holdings and lack of exposure to the outperforming Consumer Staples sector detracted the most from relative results. Weakness in Financials, mostly owing to the underperformance of Arch Capital Group Ltd. and Gaming and Leisure Properties, Inc., was somewhat offset by meaningfully larger exposure to this outperforming sector. Shares of Arch, a specialty insurance and reinsurance company, declined following a period of significant share price outperformance. Shares of specialized REIT Gaming and Leisure declined as a result of uncertainty surrounding its plans to finance the purchase of Pinnacle Entertainment’s real estate assets. Within Consumer Discretionary, meaningfully larger exposure to this lagging sector and underperformance of Dick's Sporting Goods, Inc., CarMax, Inc., and Tesla Motors, Inc. weighed the most on relative results. Dick's and CarMax were two of the largest detractors from absolute performance, while shares of Tesla fell due to increasing investors skepticism regarding the sustainability of demand and Tesla’s ability to meet annual goals. Tesla has successfully executed on two top-of-the-line cars in an impressively short time frame. As it moves down market in its price point, we think operations will be a bigger challenge than demand. We look forward to the expected introduction of Model 3 in the spring of 2016. Health Care investments lagged their counterparts in the index, with Inovalon Holdings, Inc. and IDEXX Laboratories, Inc. driving the decline. Inovalon was the second largest detractor on an absolute basis, while shares of IDEXX, a leading provider of diagnostics to the veterinary industry, declined as slower macro conditions and forex headwinds hurt 2016 guidance.
Yearly Attribution Analysis
Baron Partners Fund declined 2.43% for the year and underperformed the Russell Midcap Growth Index by 223 basis points. Stock selection added value, but was overshadowed by the negative effect of differences in sector weights relative to the index.
Outperformance of the Fund’s Industrials and Information Technology (IT) investments and its lower exposure to the poor performing Energy and Materials sectors, which were pressured by falling commodity prices, contributed the most to relative results. Strength in Industrials was mostly attributable to the outperformance of Verisk Analytics, Inc., a leading provider of data and analytics to insurance, financial services, and energy markets. Verisk reported outstanding financial results during the year. It also announced its intent to divest its health care analytics business, which has proven to have less consistent growth and lower margins than the broader business. Within IT, outperformance of CoStar Group, Inc. and FactSet Research Systems, Inc. added the most value. CoStar was the second largest contributor to absolute performance, while shares of market data vendor FactSet rose before being reclassified from IT to Financials by GICS at the end of October. FactSet’s financial results demonstrated accelerating market share gains as the company grew its annual subscription value by +9.4% organically and user base by +13.9%, well ahead of market growth in the low single digits.
The Fund’s Health Care investments, its lack of exposure to the top performing Consumer Staples sector, and its larger exposure to the lagging Utilities and Consumer Discretionary sectors were the primary detractors from relative performance. Within Health Care, underperformance of Inovalon Holdings, Inc. and the Fund’s lack of exposure to strong performing biotechnology stocks, which rose 14.4% as a group within the index, detracted the most from relative results. Inovalon was the second largest detractor from absolute performance after the company’s stock price fell more than 40% for the period held.
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