Review and Outlook

as of 09/30/18

U.S. equity indexes rose meaningfully during the quarter. Corporate earnings continued to impress, and the domestic unemployment rate reached new lows. Interest rates moved higher, as did most gauges of price inflation. Growth stocks continued to outpace value stocks, and large-cap stocks generally outperformed.

Against this backdrop, Baron Asset Fund gained 8.13% in the quarter. Health Care, Information Technology (IT), and Industrials holdings contributed the most to performance. Health Care holdings had a strong quarter, with 10 out of 12 stocks advancing, led by IDEXX Laboratories, Inc. and Illumina, Inc., the second and third largest contributors respectively. Life sciences tools manufacturer Bio-Techne Corporation was another noteworthy contributor after shares rose on strong quarterly results highlighted by 9% organic revenue growth. IT also gained on overall sector strength. All 12 of the Fund’s holdings appreciated, led by top contributor Gartner, Inc. Leading data and analytics vendor Verisk Analytics, Inc. led contribution among Industrials holdings, after reporting earnings results that exceeded Street expectations.

Investments in Communication Services and Real Estate detracted. A drop in the share price of top detractor Zillow Group, Inc. weighed on performance of the new Communication Services sector. Real Estate holdings gave up ground on overall sector weakness due to rising interest rates.

We remain optimistic about the prospects for U.S. equities. The economy remains robust, and we believe that the outlook for continued strength in corporate earnings remains solid. U.S. unemployment is quite low, most leading economic indicators remain positive, and we believe that inflation fears may be overblown. Although the market has begun to focus on the implications of rising long-term interest rates, we believe that equities can continue to perform well in this environment.

We believe that our portfolio of well-managed, competitively advantaged, fast growing companies will continue to perform well, although we cannot guarantee that they will. We continue to believe that high quality, mid-sized growth stocks represent a compelling long-term investment opportunity. During the past 15-, 20- and 30-year periods, mid-cap growth stocks, as a category, have outperformed small-cap and large-cap growth stocks. However, mid-caps have underperformed both these asset classes during the past three-year period. We are optimistic that this trend will reverse, presenting an attractive opportunity for the mid-cap growth asset class in the future.

Top Contributors/Detractors to Performance

as of 09/30/18

Contributors

  • Shares of Gartner, Inc., a provider of syndicated research, contributed to performance. We believe forward-looking metrics in Gartner’s traditional IT research business are strong, with contract value growing at a mid-teens rate. Gartner recently introduced a seat-based product to heritage CEB clients, and is generating traction in closing new customers with this improved product. The company meaningfully expanded its sales force to pursue this large incremental opportunity, and we expect to see heritage CEB growth accelerate from 2% into the mid-to-high teens over time.
  • Shares of veterinary diagnostics leader IDEXX Laboratories, Inc. contributed to performance, buoyed by continued strong competitive trends, highlighted by instrument installed base growth of 20%, domestic lab growth more than twice that of competitor VCA, and improving sales productivity. We think new proprietary innovations and field salesforce expansion should be meaningful contributors to growth. Margins are moving significantly higher, and we believe they can approach 30% over the next several years. 
  • Illumina, Inc. is the leading provider of next generation DNA sequencing instruments and consumables. The stock rose after the company reported financial results that exceeded investor expectations, driven by strong growth of sequencing consumables. We believe Illumina will continue to benefit from increased adoption of DNA sequencing in clinical applications such as cancer diagnosis and treatment. 

Detractors

  • Zillow Group, Inc. operates the leading online real estate sites in the U.S. Shares detracted based on a lower revenue and profitability outlook. Revenue guidance was negatively impacted by reduced rental revenue and a slight delay in the roll-out of Zillow Instant Offers, the company's new home buying initiative. We retain conviction, as we believe Zillow will continue to grow its share of the $8 billion real estate advertising market.
  • The Stars Group Inc. is a leading company in online wagering and is currently in the process of acquiring Skybet, another UK-based online wagering platform. Shares detracted as investors reduced their exposure to gaming shares globally based on weak results in Macau and slow growth in Las Vegas. We believe shares are attractively priced at current levels, and over time, we expect investors to understand that the opening of online wagering in the U.S. represents a substantial opportunity for the company.
  • MarketAxess Holdings Inc. operates the leading electronic platform for trading corporate and sovereign bonds. Despite reporting strong second and third quarter results, with daily trading volume up double-digits in a market where total volume fell, the stock declined due to investor concerns about market competition. We remain invested because we expect MarketAxess will be the prime beneficiary of the secular shift to electronic trading in the corporate bond market.

Quarterly Attribution Analysis (Institutional Shares)

as of 09/30/18

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.

as of 09/30/18

Baron Asset Fund gained 8.13% in the third quarter and outperformed the Russell Midcap Growth Index by 56 basis points due to a combination of stock selection and relative sector weights.

Investments in Health Care and Information Technology (IT) and lack of exposure to the lagging Materials sector contributed the most to relative results. Stock selection in Health Care added over 90 basis points to relative results, driven by the outperformance of DNA sequencing platform Illumina, Inc., life sciences tools developer and manufacturer Bio-Techne Corporation, and veterinary diagnostics leader IDEXX Laboratories, Inc. IDEXX and Illumina were the second and third largest contributors to absolute results respectively, while Bio-Techne’s shares rose after reporting strong quarterly results, highlighted by 9% organic revenue growth. Bio-Techne recently acquired Exosome Diagnostics, which developed a non-invasive liquid biopsy test to help physicians determine whether a prostate biopsy is necessary in patients with ambiguous screening results. The transaction has potential to become a meaningful growth driver for the company, in our view. Aside from stock selection, meaningfully higher exposure to this sector, which was up more than 12% in the index, added value. Strength in IT was driven by the outperformance of syndicated research provider Gartner, Inc. and credit card processor Worldpay, Inc. Gartner was the largest contributor on an absolute basis, while Worldpay’s stock price was up after the company’s quarterly results exceeded Street expectations across all of its market segments.

Underperformance of investments in Consumer Discretionary and Industrials and higher exposure to the declining Financials and Real Estate sectors detracted the most from relative performance. Within Consumer Discretionary, underperformance of global ski resort operator Vail Resorts, Inc. and online gambling company The Stars Group Inc. hurt relative results. Vail’s shares fell late in the quarter after season pass sales growth came in modestly below Street expectations, while Stars Group was the second largest detractor from absolute performance before being sold late in the quarter. Weakness in Industrials was mainly due to the underperformance of water heating equipment manufacturer A. O. Smith Corporation and real estate information and marketing services company CoStar Group, Inc. Shares of A. O. Smith declined due to disappointing organic sales growth in China. The primary drivers were soft water heater sales due to a weak housing market and poor air purifier sales due to an improvement in air quality. CoStar’s stock price failed to keep pace with the broader Industrials sector after experiencing meaningful gains in the first half of the year.