Review and Outlook
During a period marked by increased volatility, the U.S. stock market ended the fourth quarter higher. The freefall in oil prices dominated business headlines. Domestic (WTI) oil prices fell over 40% in the quarter, driven down by slower global demand growth and rising oversupply. The price of crude oil dropped to $53 per barrel as of year-end, down almost 50% from its June high and the lowest level since May 2009.
Domestically, generally positive economic reports supported the view that the U.S. economy is accelerating, outpacing much of the rest of the developed world. Unemployment was down, average hourly earnings increased, and consumer confidence rose. Higher-than-expected automobile sales and construction spending bolstered the recovery narrative.
Baron Partners Fund increased in the fourth quarter. Information Technology (IT), Consumer Discretionary, and Health Care contributed the most to performance. Only Energy detracted. IT performance was driven by share gains in the second biggest contributor to Fund performance, CoStar Group, Inc., as well as FactSet Research Systems Inc., and Gartner, Inc., in the context of a rebound in high-growth technology stocks. Consumer Discretionary performance was boosted by investments in hotels, resorts & cruise lines, as travel-related businesses benefited from a strengthening U.S. economy. The sector also included the top contributor in the fourth quarter, CarMax, Inc. Health Care benefited from increases in the stock prices of life science tools & services company Illumina, Inc., the leader in next generation DNA sequencing platforms; and health care equipment company IDEXX Laboratories, Inc., a leading provider of veterinary diagnostics. The steep drop in oil prices weighed heavily on the Energy sector, and the Fund’s two Energy holdings, Concho Resources, Inc. and Helmerich & Payne, Inc. were the top two detractors to Fund performance.
We think oil prices may remain relatively low in the near term and possibly longer. In our view, this is a positive for the U.S. economy and non-energy U.S. stocks. Energy-intensive businesses will have lower energy costs, resulting in higher cash flow, and consumers will have more disposable income.
We view the current low price of oil as an opportunity to explore new and additional investments in companies affected by the price of oil. We are studying companies in energy-intensive industries, such as airlines, cruise lines, and automotive companies, as well as businesses that benefit from increased activity in those industries, such as travel-related businesses. Given the anticipated increase in disposable income, we are also researching additional businesses in the Consumer Discretionary sector, which has historically been a major focus for us. We see these and many more opportunities for 2015, especially in what we believe to be a favorable investment environment.
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 Partners Fund (Retail Shares) gained 5.33% in the fourth quarter, yet modestly underperformed the Russell Midcap Growth Index by 51 basis points, primarily 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, 2014, Baron Partners Fund had 117.0% of its net assets invested in securities, and this use of leverage in favorable market conditions meaningfully contributed to relative performance for the quarter and year.
The Fund’s investments within the Information Technology (IT) and Utilities sectors were the largest contributors to relative performance. Strength in IT was largely attributable to the outperformance of CoStar Group, Inc., one of the Fund’s largest contributors on an absolute basis in the quarter, and FactSet Research Systems, Inc., a provider of financial information to the global investment community. FactSet’s shares rose after the company’s organic growth rate accelerated and its customer and seat count additions exceeded expectations. Another contributor to relative performance in the sector was Gartner, Inc., the leading independent provider of research and analysis on the IT industry. Shares of Gartner benefited from strong financial results, accelerating contract value in its core Research business, and continued share repurchases. Within Utilities, a combination of the Fund’s larger exposure to this outperforming sector and the outperformance of its only holding in the sector, ITC Holdings Corp., aided relative results. ITC was also one of the Fund’s largest contributors to absolute performance in the quarter.
The Fund’s investments within the Financials, Energy, and Consumer Discretionary sectors were the primary detractors from relative results. In the Financials sector, The Carlyle Group, an alternative asset manager, and Gaming and Leisure Properties, Inc., an owner and operator of regional casino assets, detracted the most from relative results. Shares of Carlyle declined after lower investment realizations resulted in a lower dividend payout, and lower performance fees caused a sharp drop in distributable earnings. Shares of Gaming and Leisure fell modestly as investors were disappointed with the company’s pace of acquisitions. Stock-specific weakness in Financials was partly offset by its larger exposure to this outperforming sector. Within Energy, the Fund’s larger exposure to the sector through its investments in Helmerich & Payne, Inc. and Concho Resources, Inc. detracted the most from relative results. These businesses were hit hard by the sharp drop in oil prices during the quarter. Weakness in Consumer Discretionary was mainly attributable to the underperformance of the Fund’s largest holding in the sector, Tesla Motors, Inc., but this negative effect was somewhat offset by its larger exposure to this outperforming sector. Tesla was also one of the largest detractors on an absolute basis. Other sources of underperformance in the sector were Hyatt Hotels Corp., a global lodging company, and Manchester United plc, an English Premier League professional sports team. Hyatt’s shares declined due to lower margins at two Asian properties, while shares of Manchester United were down due to a secondary offering.
Yearly Attribution Analysis
The Baron Partners Fund (Retail Shares) increased 10.26% for the year, yet trailed the Russell Midcap Growth Index by 164 basis points. During the year, stock selection and, to a lesser extent, sector weightings hurt relative performance.
Aside from leverage, the Fund’s larger exposure to the outperforming Utilities sector, through its investment in ITC Holdings Corp., and the outperformance of its investments within the Health Care sector contributed the most to relative performance. Strength in Health Care was largely due to the outperformance of Illumina, Inc., which was also the Fund’s largest contributor to absolute performance during the year. Health care equipment companies IDEXX Laboratories, Inc. and Edwards Lifesciences Corp. also contributed to relative performance. Shares of IDEXX, a leader in veterinary diagnostics, appreciated on better-than-expected earnings and progress on moving to a direct distribution model in the U.S. Shares of heart valve manufacturer Edwards rose over 50% after transcatheter heart valve sales growth accelerated during the year. Sales were up due to numerous developments including: favorable clinical data, a broader range of valve sizes, regulatory approval of Edwards’ next generation valves, and improved hospital economics with respect to the transcatheter procedure.
Underperformance of the Fund’s investments within Financials and Industrials detracted the most from relative results. Within Financials, a combination of stock selection and the Fund’s meaningfully larger exposure to the underperforming asset management & custody banks sub-industry hurt relative results. Weakness in the sector was mostly attributable to the underperformance of The Carlyle Group, Gaming and Leisure Properties, Inc., and Arch Capital Group Ltd. Carlyle was one of the Fund’s largest detractors from absolute performance, while shares of insurance company Arch fell due to negative pricing trends in the reinsurance market. Within the Industrials sector, Verisk Analytics, Inc. and SolarCity Corp. were the most significant detractors from relative results. Shares of Verisk, which provides information about risk to companies in the insurance, health care, and mortgage industries, declined after earnings fell slightly short of expectations. The Fund exited its position in SolarCity after the company’s shares sold off late in the year due to what we believe was an unwarranted investor perception that renewable energy is correlated to oil prices. The Fund’s lack of exposure to outperforming airline stocks also detracted from relative results.
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