Review and Outlook
Stocks rebounded in the fourth quarter of 2015 as confidence in the strength of large economies picked up. Stocks rallied about 9% during October and November as economic reports showed renewed strength, especially jobs growth, and leading indicators in Europe and Asia improved. The small cap market reverted to its form of earlier in the year, as biotech/pharma and high growth tech stocks led the bounce. The Federal Reserve raised the fed funds rate in mid-December, the first increase since 2006. The increase was expected and generally applauded by the investment community on the rationale that monetary policy was “normalizing” with the economy in good stead. The Fed indicated that gradual increases in the fed funds rate were to be expected if economic activity continued to expand and inflation started to perk up. Against this backdrop, we continued to do what we do – try to find special small cap growth companies, the fundamentals of which remain strong in the face of a volatile market.
Baron Small Cap Fund gained in the fourth quarter. Industrials, Information Technology (IT), and Health Care were the top contributing sectors to performance. The Fund’s Industrials holdings had a strong quarter. The sector included the top three contributors to performance, Acuity Brands, Inc.; Waste Connections, Inc.; and On Assignment, Inc. IT’s contribution was driven largely by gains in the application software and IT consulting & other services sub-industries. Health Care’s advance was led by the Fund’s life sciences tools & services investments. Consumer Staples and Consumer Discretionary detracted. A sharp decline in the stock price of top detractor United Natural Foods, Inc. weighed on performance of the Consumer Staples sector. The Fund’s Consumer Discretionary holdings had a mixed quarter, although detractors outweighed contributors. In particular, the two specialty stores holdings hurt performance, including The Container Store Group, Inc., which was the third biggest detractor from performance in the period.
As the new year starts, fear has gripped the markets and stocks have suffered heavy losses. The major concerns are declining growth in China and the continued fall in the price of oil, which just broke $30 per barrel. Both are feared to be harbingers of slower global growth, with the potential contagion effect on our domestic economic climate. However, the U.S. economy is performing well. Jobs reports continue to be robust. Softness in the Energy and Industrials sectors is being offset by expansion in the service sectors. Many stocks have sold off to levels where we deem them very attractive. After two years of relative underperformance, small-cap stocks now trade in line with their normal 5% premium to large caps, at 16 times 2016 estimates.
We are aware of the challenges, but we have faith in our process and believe over the long term that it will be rewarded. We continue to favor companies that we believe are able to continue to grow despite the headwinds. We think our portfolio of small to mid-sized quality growth companies is well positioned. A key will be if earnings come in as we expect.
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 increased 4.09% in the fourth quarter, yet trailed the Russell 2000 Growth Index by 23 basis points. During the quarter, stock selection added value, but this positive impact was mostly offset by the Fund’s differences in sector weights relative to the index.
Industrials, Consumer Discretionary, and Energy investments were the largest contributors to relative results. Within Industrials, outperformance of Acuity Brands, Inc., Waste Connections, Inc., and On Assignment, Inc., the three largest contributors on an absolute basis, added the most value. The largest sector holding, aircraft parts manufacturer TransDigm Group, Inc., also performed well as the company executed on its strategy of organic and acquisitive growth. Within Consumer Discretionary, outperformance of Del Frisco's Restaurant Group, Inc. and Liberty Media Corp. and lack of exposure to lagging apparel retail, footwear, and general merchandising stocks contributed the most to relative results. Shares of Del Frisco’s, an operator of steakhouse restaurants, rose after Fidelity National Financial Ventures acquired a large stake in the company. Shares of Liberty Media, which owns interests in media, communications and entertainment businesses, performed well as a result of better operating results at SiriusXM Holdings, Inc., the largest component of Liberty Media’s asset value. Strength in Energy was mainly due to outperformance of the Fund’s six master limited partnership (MLP) investments, including Valero Energy Partners LP and Columbia Pipeline Partners LP, which all rebounded sharply after MLPs sold off in the third quarter. Shares of Valero increased on the announcement of an equity offering that strengthens its balance sheet. In addition, earnings were strong, with cash flows more than doubling distributions. Shares of Columbia rose sharply after its parent company decided to issue more equity to finance projects in the Appalachian basin. Favorable stock selection in Energy was somewhat offset by larger exposure to this poor performing sector, which was hurt by the decline in oil prices.
Health Care and Consumer Staples holdings were the primary detractors from relative performance. Within Health Care, meaningfully lower exposure to biotechnology and pharmaceutical stocks, which rose 9.5% and 22.3%, respectively, within the index, and underperformance of investments in these sub-industries detracted 145 basis points from relative results. Investments in Brookdale Senior Living, Inc. and DexCom, Inc. also weighed on relative performance. Shares of senior living operator Brookdale declined nearly 20% as its acquisition of Emeritus continued to be highly disruptive, resulting in disappointing performance and lowered estimates. Shares of DexCom, which sells a continuous glucose monitoring device for insulin-dependent diabetes patients, were hurt by the general underperformance of high growth stocks with high valuations. DexCom’s business has been strong, with revenue growth over 50% year-over-year. Weakness in Consumer Staples was mostly attributable to the underperformance of United Natural Foods, Inc., the largest detractor on an absolute basis.
Yearly Attribution Analysis
Baron Small Cap Fund fell 5.01% for the year and underperformed the Russell 2000 Growth Index by 363 basis points. During the year, the Fund’s relative sector weights detracted from relative performance.
Outperformance of the Fund’s Industrials holdings and its average cash exposure of 1.8% in a down market contributed to relative results. Favorable stock selection in Industrials was largely due to the outperformance of lighting solutions company Acuity Brands, Inc., solid waste company Waste Connections, Inc., aircraft parts manufacturer TransDigm Group, Inc., and staffing firm On Assignment, Inc. This positive effect was somewhat offset by the Fund’s larger exposure to this lagging sector, which fell 12.1% in the index.
The Fund’s Health Care, Consumer Staples, and Consumer Discretionary investments and its larger exposure to the poor performing Energy sector, which tumbled 35.6% in the index owing to the sharp drop in oil prices, detracted the most from relative results. Within Health Care, the Fund’s significantly lower exposure to outperforming biotechnology and pharmaceutical stocks detracted 132 basis points from relative results. The sharp decline in the stock price of Brookdale Senior Living, Inc. also hampered relative results in the sector. Within Consumer Staples, underperformance of United Natural Foods, Inc. and The Chefs' Warehouse, Inc. detracted the most from relative results. Shares of Chefs’ Warehouse, a food service distributor of specialty products to upscale restaurants and culinary schools, declined due to investor concerns regarding increased leverage following a large acquisition earlier in the year. Weakness in Consumer Discretionary was somewhat attributable to the underperformance of the Fund’s apparel accessories & luxury goods investments, led by Iconix Brand Group, Inc. and Fossil Group, Inc. Shares of brand manager Iconix fell sharply after the company missed earnings estimates due to a difficult retail macro environment. The Fund exited its position in watch vendor Fossil due to signs of a global slowdown in the watch category and a lack of conviction in the company’s ability to transition to a “wearables” category. The Fund’s investments in hardwood flooring retailer Lumber Liquidators Holdings, Inc., specialty storage retailer The Container Store Group, Inc., and mattress retailer Mattress Firm Holding Corp. also hurt relative performance. Shares of Lumber Liquidators fell after a 60 Minutes segment aired allegations that one of its products was not compliant with California regulations. The Fund subsequently exited its position. Shares of Mattress Firm fell after the company lowered earnings expectations in the face of a challenging economic environment in many of its Texas markets.
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