Review and Outlook
U.S. stock markets made little progress during the three months ended June 30, 2015. Most indexes achieved modest gains. The Russell Mid Cap Growth Index lost 1.14% and the S&P 500 Index gained 0.28%.
Numerous cross currents impacted the economy and markets during the second quarter of 2015. The U.S. economy continued to steadily improve. Consumer and business confidence rose, unemployment fell, wages increased at an accelerating pace, housing prices continued to rise, automobile sales remained strong, and central banks worldwide implemented “easy” monetary policies to stimulate their economies. With our economy growing and reported inflation increasing in the U.S., interest rates, while still quite low, began to increase. This impacted interest-sensitive stocks, including REITs, MLPs and utilities. Continued strength in the dollar negatively impacted U.S. industrial and export-dependent businesses, whose stocks lagged in the period. Stocks in transport companies, whose results are closely correlated to industrial businesses, also lagged. Energy prices stayed low, to the benefit of consumers and energy-dependent businesses. A cutback in capital expenditures by energy companies partially offset the favorable impact of lower energy prices.
Baron Partners Fund increased in the second quarter. Consumer Discretionary, Financials and Information Technology (IT) contributed. Utilities, Health Care, and Industrials detracted. A strong performance by top contributor Tesla Motors, Inc., whose stock rose more than 40% in the quarter, drove contribution of the Consumer Discretionary sector. Professional sports team Manchester United plc and ski resort owner Vail Resorts, Inc. also showed strength. These positive results more than outweighed declines elsewhere in Consumer Discretionary, including the specialty stores, hotels, resorts & cruise lines, and automotive retail sub-industries. Four of the Fund’s five Financials holdings increased in the quarter, led by the third largest contributor, Arch Capital Group Ltd. IT advanced primarily on the strength of application software company Mobileye N.V., a maker of automated driver assistance technology. Rising interest rates weighed on the Utilities sector, including the Fund’s only sector holding, top detractor ITC Holdings Corp. Health Care had mixed results in the quarter. The sector included the second biggest detractor, IDEXX Laboratories, Inc., and the second biggest contributor, Illumina, Inc. Industrials detracted on weakness in Air Lease Corp., a global aircraft leasing company.
While it is not possible to predict stock markets over the short term, over the long term, stock prices and our economy are inextricably linked. For the past 55 years, GDP has grown 6.6% a year and stock prices have grown 6.6% a year. Taking dividends into account, stocks have doubled every 10 years. We have every reason to believe that our economy and stock markets will continue to achieve these historic results over the long term. We see many opportunities.
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 3.29% in the second quarter, outperforming the Russell Midcap Growth Index by 443 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 June 30, 2015, Baron Partners Fund had 119.0% of its net assets invested in securities, and this use of leverage in a down market detracted approximately 20 basis points from relative performance.
Outperformance of investments within the Consumer Discretionary, Financials and Information Technology (IT) sectors contributed the most to relative performance. Strength in Consumer Discretionary was mainly due to the outperformance of Tesla Motors, Inc., the largest contributor on an absolute basis. Outperformance of Manchester United plc and Vail Resorts, Inc. and lower exposure to the lagging apparel accessories & luxury goods sub-industry, which fell 8.9% in the index, also lifted relative results. Shares of English Premier League soccer team Manchester United increased after its fourth place finish made qualification to the Champions League a possibility. Shares of ski resort operator Vail rose due to stronger-than-expected season pass sales for the upcoming season. Financials investments outperformed their index counterparts, gaining 6.1%, led by Arch Capital Group Ltd. and The Charles Schwab Corp. Arch was the third largest contributor to absolute performance, while shares of brokerage firm Schwab increased despite headwinds related to lower trading volume and relatively low interest rates. Most IT holdings outperformed, led by application software companies Mobileye N.V. and FactSet Research Systems, Inc. Shares of Mobileye, a designer of advanced driver assistance systems software, rose on a strong start to 2015 and an upbeat earnings call. Another contributor to relative performance was CoStar Group, Inc., an information and marketing services provider to the commercial real estate industry. CoStar’s shares rose on robust revenue and earnings results, strong sales momentum in Apartments.com, and the acquisition of ApartmentFinder.
Larger exposure to the lagging Utilities sector through ITC Holdings Corp. and underperformance of Health Care holdings detracted the most from relative results. Within Health Care, underperformance of IDEXX Laboratories, Inc. and Inovalon Holdings, Inc. and lack of exposure to biotechnology stocks, which rose 6.4% in the index, hurt relative results. IDEXX was the second largest detractor on an absolute basis, while shares of health care data and analytics company Inovalon were negatively impacted by M&A activity in the managed care space, which creates the risk of customer consolidation. We view Inovalon as a unique business built on a proprietary data set. It addresses a $14 billion annual opportunity, and we believe logical adjacencies can increase the total addressable market by three to four times.
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