Review and Outlook
The market for small stocks was volatile in the third quarter. Shares were weak in July, rallied back almost to their highs in August, and declined again in September.
A number of factors appeared to be behind the sell-off. First, the U.S. Federal Reserve is nearing the end of its QE3 bond-buying program. Many observers attribute earlier market gains to this easy money policy that is now at an inflection point. The market stumbled at the end of QE1 and QE2. Second, geopolitical tensions were intense in the quarter, with unsettling conflicts between Russia and Ukraine, Israel and Gaza, and ISIS and Syria/Iraq. Third, foreign economies – Europe, China and South America – have slowed noticeably. Coupled with the rise in the U.S. dollar, this means earnings from abroad will likely be less than previously expected. And fourth, and maybe most importantly, the market’s erratic behavior has caused investors to take notice of the previously mentioned points and sell stocks, fearing the end of the five-year bull market.
We believe small cap stocks performed poorly because they performed well for so long, the gap in valuations between small and big companies had widened, and the sell-off caused a “flight to safety,” which favors stocks of bigger, more secure companies.
Telecommunication Services was the only sector contributor in the quarter, rising on the strength of the Fund’s two sector holdings. Consumer Discretionary detracted the most, driven down in part by declines in airline/travel equities because of the Ebola scare. Energy also detracted as falling commodity prices weighed on stocks. Overall, our larger market cap holdings were among our best performers. Having some of these more seasoned holdings was a good thing as small stocks were under pressure.
The positives in the intermediate-term outlook are that the U.S. economy does not seem headed for recession. Inflation is tame, and even less of a concern with global growth slowing and the dollar’s rise. The Fed is acknowledging growth concerns and proclaiming to keep rates low for the foreseeable future. Valuations are higher than have been for a while, but still not extended beyond what is reasonable in historical context.
The negatives are that the bull market has been long (66 months) and pronounced (up 200%) –(however, we agree that bull markets don’t die from old age). QE3 is ending and rates will rise over time. Although stocks seem the best alternative. . . that does not mean they can’t go down, since there is no such thing as a “safe stock."
Although we monitor short-term market events closely, as long-term investors, our primary focus remains on our investments. Can they grow earnings and economic value over the long term, as we project? How are their businesses affected by the current economic environment? Are their managements making right decisions and continuing to impress us? Do we believe they will be long-term winning businesses and stocks? Since we believe that our research and our long-term fundamental approach have provided shelter from the storm in the past, we turn again to them now and believe they will lead us to earn good returns for our investors over the long term.
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 Small Cap Fund (Retail Shares) declined 4.91% in the third quarter, yet outperformed the Russell 2000 Growth Index by 122 basis points. During the quarter, the Fund’s stock selection added value and more than offset the negative effect of sector weightings.
The Fund’s investments within the Information Technology (IT), Telecommunication Services, and Industrials sectors were the largest contributors to relative results. More than half of the Fund’s holdings in the IT sector outperformed, led by FleetCor Technologies, Inc., which provides payment processing services to vehicle fleets around the world, and Gartner, Inc., the leading independent provider of research and analysis on the IT industry. Shares of FleetCor rose on news of the company’s acquisition of competitor Comdata, Inc. The company also reported solid second quarter results and raised full-year guidance. Shares of Gartner increased on better-than-expected financial results and continued share repurchases. Strength in the Telecommunication Services sector was largely attributable to the outperformance of long-term holding SBA Communications Corp. The company was also one of the Fund’s largest contributors on an absolute basis. Within Industrials, outperformance of the Fund’s largest holding in the sector, TransDigm Group, Inc., added the most value. The company, which has been held in the Fund since 2006, was also one of the largest contributors to absolute performance in the quarter. Waste Connections, Inc. and DigitalGlobe, Inc. also aided relative performance in the sector. Shares of Waste Connections, an integrated solid-waste services company, outperformed after the company raised guidance and implied that free cash flow will be used to make acquisitions or repurchase stock. Shares of DigitalGlobe, an operator of a constellation of satellites, rose after the company reported better-than-expected quarterly results, announced a $75 million share repurchase program, and accelerated the launch date for the WorldView-4 satellite to meet demand.
The Fund’s investments within the Consumer Staples and Financials sectors and its meaningfully lower exposure to outperforming biotechnology stocks in the Health Care sector detracted the most from relative performance. The Portfolio’s investments in Consumer Staples fell 9.8% as a group, with The Chefs’ Warehouse, Inc. and Fairway Group Holdings Corp. leading the decline. Shares of Chefs’ Warehouse, a food-service distributor of specialty products to upscale restaurants and hotels throughout the U.S., lagged after the company faced challenges in managing the margins of a newly acquired business. Shares of Fairway, a specialty food retailer in New York, have come under pressure over concerns around new store productivity, the health of the chain’s real estate pipeline, and unanticipated management changes. Over the long term, we believe this highly differentiated grocery store represents a multi-year, double-digit growth business with significant opportunity to take share throughout the Northeast. Weakness in Financials was mainly due to the underperformance of Financial Engines, Inc., which was also the Fund’s largest detractor on an absolute basis.
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