Review and Outlook
The market continued its uptrend in the third quarter, recovering from the post-Brexit dip. The U.S. economy proved to be quite resilient. Job growth is solid and the unemployment rate has held at 5%. The figures are not too strong, though, so the Federal Reserve can delay raising interest rates until late this year. There is little to suggest that significantly higher inflation is in the offing. This environment of continued growth, even if muted, low interest rates, and modest inflation is a good backdrop for stocks.
Scant growth and cheap borrowing costs has led to an increase in mergers and acquisitions which have been positive for Baron Small Cap Fund. Year-to-date, six Fund holdings have been acquired (Press Ganey Holdings, Inc., FEI Company, Mattress Firm Holding Corp., ExamWorks Group, Inc., Bats Global Markets, Inc. and ITC Holdings Corp.), four by other public companies and two by private equity funds. Another holding, WasteConnections, Inc., was actually purchased in a reverse acquisition, though it is the surviving business.
The Fund increased in the quarter. Health Care, Industrials, and Consumer Discretionary were the top contributing sectors. Health Care benefited from increases in the share price of 17 out of 18 investments, including second largest contributor IDEXX Laboratories, Inc. TransDigm Group Inc., which was the Fund’s third biggest contributor, led contribution of the Industrials sector. Consumer Staples and Energy holdings detracted. Positive performance of Consumer Discretionary investments included top contributor Mattress Firm Holding Corp., which was acquired in the period. A decline in the share price of the Fund’s sole Consumer Staples investment, Chefs’ Warehouse, Inc., hurt that sector’s performance. Chefs’ was the second largest detractor in the quarter. Energy was a modest detractor as three of four sector holdings declined in the third quarter.
The negative tone of the presidential election is causing anxiety that we believe is temporarily weighing on consumer spending. Once it is over, we suspect we will revert to same fine environment for stocks, as has been the case year to date. We foresee continued moderate growth and do not fear a recession in the near future. We expect bond yields will rise, but moderately, and we believe that is already built into stock prices. Wages are increasing, which will pressure some businesses, but we still see margin expansion opportunities for companies with above average revenue growth. We are concerned that the dollar is back on the rise, since that would dampen growth somewhat and hurt earnings because of negative translation. We view the market as fairly valued, but believe multiples will stay in their present range. We think we will make our returns based on the growth of our companies’ earnings and their additive use of the cash flow their businesses generate.
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 rose 6.50% in the third quarter, yet underperformed the Russell 2000 Growth Index by 272 basis points due to a combination of stock selection, relative sector weights, and average cash exposure of 2.8% in an up market.
Consumer Discretionary and Financials investments contributed the most to relative performance. Strength in Consumer Discretionary was mostly attributable to the outperformance of Mattress Firm Holding Corp., whose stock price more than doubled after being acquired by South African firm Steinhoff International Holdings N.V. Investments in Liberty Media Group, a media holding company, and Party City Holdco Inc., which manufactures and distributes specialty party goods, also added value. Liberty Media’s shares performed well in reaction to the company’s plan to purchase a stake in Formula One Group, while Party City’s stock price rose after reporting strong same-store sales, revenues and earnings despite an otherwise lackluster environment for traditional specialty retailers. Within Financials, outperformance of investment bank Moelis & Company and financial exchange operator Bats Global Markets, Inc. lifted relative results. Shares of Moelis increased on solid revenue growth as the company’s advisory business topped Street expectations, while shares of Bats rose sharply after CBOE Holdings Inc. agreed to acquire the company.
Information Technology (IT) and Energy investments were the primary detractors from relative performance. Within IT, underperformance of application software holdings, led by The Ultimate Software Group, Inc. and Guidewire Software, Inc., weighed on relative results. Ultimate’s shares fell after Oracle, which owns a rival HR software solution, acquired NetSuite, giving rise to concerns that the acquisition would cause Ultimate to lose its existing partnership with NetSuite. Guidewire’s shares declined after earnings guidance was slightly below Street expectations due to an accounting-related deferral that we expect will reverse next year. Underperformance of Gartner, Inc., the largest detractor on an absolute basis, and lack of exposure to the strong performing semiconductors, systems software, and communications equipment sub-industries also hurt relative results. Weakness in Energy was due to the underperformance of oil & gas storage & transportation holdings, led by master limited partnerships (MLPs) Valero Energy Partners LP, PBF Logistics LP, and Dominion Midstream Partners, L.P. These "drop-down" MLPs underperformed as signs of OPEC stabilizing production caused investors in MLPs to shift from safety and commodity risk aversion to risk-on and commodity upside. Despite recent underperformance, we continue to view the above-market yield, stable fee-based cash flows, and visible growth that these MLPs offer as an attractive combination for long-term investors.
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