Review and Outlook
The first quarter of 2016 was among the most challenging periods in recent memory. In the first six weeks of the year, the S&P 500 Index fell 10.5%. In the second half of the quarter, the market stabilized and recovered all of its losses from the beginning of the year. We took advantage of the largely indiscriminate market sell-off in the first half of the quarter to continue to execute on strategic initiatives regarding portfolio positioning and structure of Baron Real Estate Fund:
- We purchased a number of “best in class” companies that have been “on sale.”
- We lowered overall leverage of the Fund’s holdings by trimming or exiting our positions in companies with more highly leveraged balance sheets.
- We decreased our exposure to smaller and less liquid companies.
- We continue to de-emphasize complex companies that may have a narrower investor audience and are less likely to receive full credit for the company’s intrinsic value.
- We trimmed exposure to geographic markets that may face headwinds due to low oil prices (e.g., Houston), elevated real estate construction activity (e.g., New York City hotels), or unfavorable international exposure (e.g., Brazil).
- We increased exposure to REITs to 34.2%. We did so because we believe the near-term prospects for REITs appear relatively attractive.
We recognize that the broad stock market, including many real estate stocks, has been on a steady upward climb since the global financial crisis. We therefore anticipate that there may be periods of market weakness in the years ahead. Nevertheless, we maintain a favorable outlook for real estate. The factors that have fueled the resurgence in real estate largely remain in place. Demand persists, and continues to outstrip supply in most markets. Balance sheets of real estate-related companies are generally in solid shape. Credit remains available at low interest rates. Finally, the overall performance of our real estate companies, and our discussions with various top management teams, does not, in our view, portend an imminent recession.
We believe that the Fund, with its differentiated approach to investing in real estate, is well suited for the twists and turns of the market that may lie ahead. The Fund’s expansive, balanced, and more diversified approach to investing in broader real estate categories – not a REIT-only approach – provides the flexibility and dimension to perform well in several different market environments. As such, we maintain that the overall prospects for real estate and the Fund remain promising.
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 Real Estate Fund fell 4.53% in the first quarter and trailed the MSCI USA IMI Extended Real Estate Index by 867 basis points. During the quarter, stock selection and, to a lesser extent, relative real estate category weights detracted from relative performance.
The data centers category contributed to relative performance as a result of the outperformance of the Fund’s only holding in the category, InterXion Holding N.V. The company, which provides network-dense, carrier-neutral colocation data center services across Europe, was the largest contributor on an absolute basis.
Real estate services, hotels & leisure, and building products/services were the largest detractors from relative performance. Within real estate services, larger exposure to this weak performing category, which declined 15.3% in the index, and underperformance of its three holdings in the category, Jones Lang LaSalle, Inc., CBRE Group, Inc., and Kennedy-Wilson Holdings, Inc., hurt relative results. Jones Lang and CBRE were the two largest detractors on an absolute basis. Shares of Kennedy-Wilson fell despite reporting strong Q4 results and management issuing an upbeat outlook for 2016. We suspect underperformance was due to concerns that 1) the commercial real estate cycle is in the late innings; 2) credit market volatility could hurt the profitability of asset management firms; and 3) complex, illiquid stocks like Kennedy-Wilson tend to suffer when macroeconomic conditions are uncertain. We believe any potential market dislocations could lead to attractive acquisition opportunities for Kennedy-Wilson, as the company has low leverage and a proven track record of making opportunistic acquisitions during times of distress. Within hotels & leisure, underperformance of cruise line holdings Royal Caribbean Cruises Ltd. and Norwegian Cruise Line Holdings Ltd. and larger exposure to this lagging category detracted the most from relative performance. Royal Caribbean and Norwegian were pressured by investor concerns over the possibility of a U.S. recession. However, we believe booked positions for 2016 indicate these companies are not losing pricing power as feared. These companies also continue to generate strong cash flow, which is being used to pay down debt and buy back shares. Leisure company ClubCorp Holdings, Inc. and timeshare operator Diamond Resorts International, Inc. also weighed on performance. ClubCorp’s shares declined on concerns around lower oil prices hurting business at its golf clubs in Texas, which comprise 35% of EBITDA. Shares of Diamond Resorts were hurt by a negative news article questioning its sales practices. We exited our positions in ClubCorp and Diamond Resorts. Weakness in building products/services was mainly due to the underperformance of building products holdings CaesarStone Sdot-Yam Ltd., a leading global manufacturer of quartz surfaces, and Builders FirstSource, Inc., one of the largest suppliers and manufacturers of structural and related building products for new home construction. Caesarstone’s shares fell over concerns that a recently constructed manufacturing facility was taking longer than expected to ramp up production, while Builders FirstSource was sold in favor of higher conviction ideas.
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