Review and Outlook
The third quarter was a challenging one. Concerns arose that growth in China was significantly slowing. The Chinese devalued their currency by 2%, which fueled the fire. Emerging market equities and currencies declined, and their economies entered recession. Fears were stoked that developed economies would suffer in conjunction. The U.S. market experienced its first correction in four years.
The tenor of the small cap market changed. Psychology turned negative. The down draft in prices spread from companies with big foreign exposures to engulf many of the sectors that had been the leaders for the previous year. Biotechnology, pharmaceuticals and high multiple technology stocks rolled over. Health Care stocks got spooked by comments by politicians that drug cost inflation needed to be better controlled. Investors sold “winners” to protect gains. Concern about a possible interest rate hike contributed to the weak market.
In all this negativity, there are some positive observations. If rates stay low, that would be good for stocks. The U.S. dollar was rising in anticipation of higher domestic interest rates, which was hurting our economy and reducing reported earnings of companies with international operations. This, too, is on hold. Investment sentiment quickly became negative. . . this is good for stocks. Stock multiples have contracted to a point where they seemed reasonable, even cheap in many cases, against our expectations of future earnings.
We believe earnings will be the key to the market and it is what we are most focused on. It has been a market where struggling companies that miss earnings expectations have been blasted, no questions asked, and the stocks have gone down more and stayed down longer than in normal market environments. Many performing companies have become market darlings, trading up to hefty valuation levels we feel uncomfortable with. Many of these companies are not yet profitable and trade at revenue multiples or other concoctions, which do not hold up well in corrections.
We are hoping to invest somewhere in the middle. We seek to invest in businesses that are able to show significant organic revenue growth (usually 5-20%), which can increase margins so profits are growing faster than revenues, that can supplement this with accretive acquisitions, debt repayment or share repurchase, so that per share earnings grow even faster; and where trading multiples can (ideally) expand or stay around present levels.
Going forward, the bull case for stocks is that the economy will continue to expand at a modest, yet self-sustaining rate. Monetary policy will be friendly, meaning when rates do rise that it will be gradual and will not choke off growth. We think stock valuations will remain reasonable and inexpensive relative to low levels of interest rates and inflation. The bear case is that a recession is in the offing or the market will be gripped by contagion. The bull case seems more likely to us, and we are generally positive about the U.S. economy and underlying fundamentals. But we are hearing of weakening conditions from some of our portfolio companies so we are watching carefully.
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 Small Cap Fund declined 12.52% in the third quarter, yet outperformed the Russell 2000 Growth Index by 54 basis points, partly due to stock selection. The Fund’s average cash exposure of 2.3% and lower exposure to higher beta stocks also added value as the market experienced heightened volatility and turned lower during the quarter.
The Fund’s Health Care, Industrials, and Information Technology (IT) investments were the largest contributors to relative results. Strength in Health Care was partly due to the outperformance of health care equipment and life sciences tools & services holdings, led by IDEXX Laboratories, Inc. and ICON plc, respectively. IDEXX was the second largest contributor on an absolute basis, while shares of ICON, a leading Contract Research Organization, rose on raised guidance for fiscal year 2015 and a $400 million share repurchase plan. Another contributor to relative performance in the health care equipment sub-industry was DexCom, Inc., which sells a glucose monitoring device for diabetics. The company reported another strong Q2, with revenue increasing close to 60% year-over-year. Significantly lower exposure to lagging biotechnology and pharmaceutical stocks, which fell 23.5% and 25.0%, respectively, within the index, also contributed 166 basis points to relative performance. Within Industrials, outperformance of the Fund’s three largest sector holdings, Waste Connections, Inc., Acuity Brands, Inc., and TransDigm Group, Inc. added the most value. Shares of solid waste services company Waste Connections rose on favorable volumes and pricing. Shares of lighting company Acuity Brands outperformed on another quarter of stellar results, helped by a rebound in non-residential construction and the retrofit trend towards energy efficient LED lighting. Within IT, outperformance of the two largest sector holdings, The Ultimate Software Group, Inc. and Gartner, Inc., was somewhat offset by its lower exposure to this better performing sector. Ultimate Software was the third largest contributor to absolute performance, while shares of IT research firm Gartner outperformed on strong earnings results and share repurchases.
Underperformance of Consumer Staples, Financials, and Consumer Discretionary holdings and larger exposure to the lagging Energy sector detracted the most from relative results. Within Consumer Staples, underperformance of and larger exposure to food distributors The Chefs' Warehouse, Inc. and United Natural Foods, Inc. detracted from relative results. Lack of exposure to the packaged foods & meats sub-industry, which managed a gain of 4.0% in the index, also hurt relative results. Weakness in Financials was mostly due to underperformance of Financial Engines, Inc. within the asset management & custody banks sub-industry and larger exposure to this lagging sub-industry. Financial Engines was the third largest detractor from absolute performance. Regional banks outperformed within the benchmark’s Financials sector and lack of exposure to these stocks also hampered relative results. Within Consumer Discretionary, underperformance of Mattress Firm Holding Corp., the second largest detractor on an absolute basis, weighed the most on relative results. Brand manager Iconix Brand Group, Inc. and live event producer SFX Entertainment, Inc. also detracted from relative performance after their shares fell sharply in the quarter.
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