Review and Outlook
Stock markets around the world fell sharply at the beginning of the year based on a variety of factors, most important being the continued drop in the price of oil, fears that the Chinese economy would suffer a hard landing and further devalue its currency, and concern that U.S. interest rates would be rising in the face of economic uncertainty. Oil bottomed, the dollar declined, high yield bonds recovered, emerging markets turned and U.S. stocks acted strong in the back half of the quarter. The Federal Reserve also waved a cautious flag and set a more patient course on raising interest rates, which was positively received by investors.
When we spoke to our companies, we heard that business was solid and on course and the outlook for future growth was fine. This reinforced our confidence and confirmed our belief that, especially these days, the market is simply a barometer of investor sentiment and does not know more than fundamental investors who are close to their companies.
Baron Small Cap Growth Fund declined in the first quarter. Investments in Consumer Discretionary and Consumer Staples contributed to performance. Materials, Health Care, and Energy were the top detracting sectors from performance. While Consumer Discretionary holdings had mixed performance, contributors outweighed detractors. Positive performance was led by restaurants holding Cheesecake Factory Inc., whose stock rose on reported Q4 earnings that beat Street forecasts. Consumer Staples had a relatively solid quarter, as investors sought the perceived safe haven of this defensive sector in a volatile market. Materials lost ground mainly as a result of weak performance of specialty chemicals holdings, led by Flotek Industries, Inc., a supplier of chemical additives to the oil & gas industry whose shares fell due to the sharp decline in drilling and completion activity. Health Care was hurt by poor performance across a number of sector holdings, led by DexCom, Inc., the second largest detractor from performance in the quarter. Energy’s weak performance was a result primarily of stock price drops in oil & gas storage & transportation investments, including Scorpio Tankers Inc., a leading owner and operator of product tankers, which move refined products from refineries to consuming markets.
The market has recovered as the causes for despair have dissipated. Oil and commodity prices have firmed, the dollar has declined, China has not suffered a hard landing, and the Federal Reserve has delayed increasing rates. Though the U.S. GDP is expected to grow only about 1% in the first quarter, we expect growth to pick up, and we view the U.S. economy as relatively healthy. Global growth appears to be improving aided by the monetary easing that has been going on for the last year.
Stocks have rebounded from being inexpensive mid-quarter to being reasonably valued now. We are heartened by the market action, which was led by quality companies and oversold stocks at the expense of highly valued momentum stocks. As we enter earnings season, we believe that particular results of individual companies will be most important to future price action.
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 2.75% in the first quarter, yet outperformed the Russell 2000 Growth Index by 193 basis points, primarily due to relative sector weights.
Health Care and Information Technology (IT) investments were the largest contributors to relative performance. Within Health Care, lower exposure to lagging biotechnology and pharmaceutical stocks, which were down sharply in the index, and outperformance of its only pharmaceutical holding, Catalent, Inc., contributed 430 basis points to relative results. Shares of Catalent, a provider of advance delivery technologies and development solutions, performed well on double-digit revenue growth in its Discovery and Clinical Services and Oral Technologies segments. Sector strength was also attributable to outperformance of health care equipment holdings IDEXX Laboratories, Inc. and Cantel Medical Corp. Shares of veterinary diagnostics leader IDEXX rallied on strong financial results, while shares of Cantel, which sells infection prevention and control products, increased after the company noted it was increasing expenses in anticipation of large customer orders. Life sciences tools & services investment Mettler-Toledo International, Inc. also added value after shares rose modestly while index peers were down 11.8%. Within IT, outperformance of electronic equipment & instruments holdings Cognex Corp., a leading provider of industrial automation equipment, and FEI Company, a manufacturer of high end electron microscopes, contributed the most to relative results. Shares of Cognex rose on strong financial results, driven mostly by performance in its Endoscopy segment. FEI’s shares increased on investor expectations that investments by semiconductor foundries in next generation equipment will accelerate through 2016. Another contributor to relative results in the IT sector was FleetCor Technologies, Inc., which provides fuel cards and other payment services to vehicle fleets.
Underperformance of Industrials, Materials, and Consumer Discretionary investments detracted the most from relative results. Weakness in Industrials was mainly due to the underperformance of On Assignment, Inc., although the negative impact of On Assignment was partly offset by larger exposure to this strong performing sector, which increased 5.5% in the index. On Assignment was the largest detractor on an absolute basis. Materials investments trailed their counterparts in the index after falling 11.7%, with specialty chemical holdings Flotek Industries, Inc. and Platform Specialty Products Corp. leading the decline. Flotek’s shares declined due to the sharper-than-expected decline in drilling and completions activity. We sold Platform’s shares after excessive leverage and lowered EBITDA expectations left it unable to pursue its acquisition strategy. Within Consumer Discretionary, underperformance of The Container Store Group, Inc. and lack of exposure to outperforming apparel and general merchandising stocks weighed the most on relative results. Shares of Container Store, a leading specialty retailer of storage and organization products in the U.S., were sold in early January following disappointing Q3 earnings results.
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