Review and Outlook

as of 12/31/18

It was a rough fourth quarter for U.S. equity investors. The decline was broad-based, causing indexes to turn negative for the year and in the process, wiping out most of our gains. The market was slowly but persistently grinding lower until December 6, when the S&P 500 Index’s 50-day moving average crossed its 200-day moving average on the way down (apparently known as “the death cross”) sending the universal sell signal to every technical algorithm-trading machine, and the market went into a significant sell-off phase.

In the meantime, the federal government shut down is in its second month and domestic political uncertainty remains high. Trade tensions, Brexit, and rising interest rates continue to pose risks to investors. We continue to believe it is the latter that will have the largest impact on the short-to-intermediate direction of stocks. There is way too much uncertainty right now about economic growth for the Federal Reserve to remain on "auto-pilot." We think Chairman Powell’s remarks walking back that comment and stressing that the Fed is not on a pre-determined path and will be vigilant and patient if needed is the primary reason the markets are off to a good start in early 2019.

Baron Durable Advantage Fund declined in the quarter in concert with overall market weakness. No sector contributed. Investments in Information Technology (IT), Communication Services, and Financials detracted the most from performance. Top detractor Apple, Inc. led declines in IT. Second largest detractor Activision Blizzard, Inc. and third largest detractor Electronic Arts Inc. led weak performance within Communication Services. Financials lost ground on stock price drops in three out of four of the portfolio’s holdings within the sector.

Our goal is to invest in large-cap companies with, in our view, strong and durable competitive advantages, proven track records of successful capital allocation, high returns on invested capital, and high free cash flow generation, a significant portion of which is regularly returned to shareholders in the form of dividends or share repurchases. We hope to maximize long-term returns without taking significant risks of permanent loss of capital. We are optimistic about the prospects of the companies in which we have invested and have a full pipeline of new ideas we are actively working on to add to the portfolio during the coming quarters.

Top Contributors/Detractors to Performance

as of 12/31/18

Contributors

  • CME Group, Inc. is the world’s largest and most diversified derivatives marketplace. The stock performed well as elevated market volatility drove 31% growth in daily trading volume during the fourth quarter. The company also reported third quarter earnings that exceeded market expectations. We continue to own the stock because CME should benefit from higher volatility, interest rate normalization, and greater adoption of exchange-traded futures, in our view.

Detractors

  • Apple, Inc. is a technology company known for its iconic iPhone. The company was a detractor in the quarter because it surprised investors with an announcement that it would no longer report unit sales for its hardware products, coupled with concern over the company's Chinese manufacturing base and Chinese revenues as a result of escalating trade war tensions. We have significantly reduced our position given decelerating smartphone market growth but maintain some exposure given the hefty cash generation of the business and significant capital return profile.
  • Shares of Activision Blizzard, Inc., a leading video game publisher, detracted from performance in Q4. Destiny 2 is under-performing, there are questions around the launch slate for 2019, and more broadly, sentiment in the entire video game sector is negative at the moment. While this near-term environment is challenging, we retain long-term conviction in Activision due to a long track record of success and industry tailwinds that should benefit the company going forward, including the shift to digital, in-game monetization, mobile gaming, advertising, and eSports.
  • Shares of Electronic Arts Inc., a leading video game publisher, detracted from performance in Q4. The company reported underwhelming earnings driven by a deceleration in Live Services growth. More broadly, sentiment in the entire video game sector is negative at the moment. While this near-term environment is unfortunate, we retain long-term conviction due to industry tailwinds that should benefit the company going forward, including the shift to digital, in-game monetization, mobile gaming, advertising, and eSports.

Quarterly Attribution Analysis

as of 12/31/18

Yearly Attribution Analysis (for year ended 12/31/2018)