Review and Outlook

as of 12/31/18

We are living at a time in human history where innovation is accelerating at an exponential pace. Within the space of about three decades, communications have morphed from rotary-style phones to voice activated hand-held computers that can practically read your mind. Medical imaging has gone from fuzzy images to high resolution, real-time maps that can electronically guide surgery. And in this time, innovators in medicine appear to have reached the threshold of unlocking the human genome to understand the genetic codes that cause disease, so we may find them and treat them.

The pace of innovation is relentless and will not be deterred by a volatile stock market. The pioneers who take innovation and commercialize it for consumption tend to be rewarded in time (and we, as investors, strive to share in those rewards by investing in the best of these entrepreneurs). Of course, the timing of reward capture is highly uncertain. That is why we believe in long-term investing, where we seek to achieve excess market returns by investing strategically rather than by trading tactically.

Baron Discovery Fund declined in concert with the overall market in an exceptionally volatile quarter. No sector contributed. Health care services was the only contributing sub-industry, driven by positive performance of Guardant Health, Inc., a provider of biopsy tests for cancer patients that went public in early October. Holdings in the Health Care, Information Technology (IT), and Industrials sectors detracted the most from performance. Health Care had a challenging quarter, with the six largest detractors all within the sector. Application software led the decline within the IT sector, with seven out of eight holdings in that sub-industry experiencing double-digit drops in share price as stocks with high multiples sold off. Industrials sank on overall sector weakness driven largely by concerns around slowing growth in China.

We are mindful of the pain that can be caused in down markets. That is why we continue to rely on our time-tested, repeatable investment process. It seems to us that there is a higher probability of a positive return through investing in a company with favorable prospects at a reasonable price than through attempting to time the mercurial moods of the market. We will continue our carefully reasoned process in both good and bad markets, as we strive to earn our targeted returns on capital.

Top Contributors/Detractors to Performance

as of 12/31/18

Contributors

  • Corium International, Inc. is a specialty pharmaceutical company that is developing extended release patches to treat patients with Alzheimer's disease. Shares increased when it was acquired by a private equity firm during the quarter.
  • Shares of Macau casino operator Studio City International Holdings Limited increased despite concerns around a Macau slowdown, as the casino's target of a mass market customer has served it well. While the VIP segment of Macau has seen a deceleration of spend, the mass segment continues to grow at a healthy double-digit rate. The latter is the casino's main target audience, as only 10% of its earnings come from the VIP segment of the market. We think Studio City's $1.4 billion expansion will be a positive and the company will generate strong double-digit returns on capital.
  • Anaplan, Inc. provides a cloud software solution that allows customers to connect data, people, and plans across the enterprise, replacing manual planning processes done on worksheets and point solutions. Shares of Anaplan increased following the company's IPO and strong quarterly results delivering revenue and free cash flow exceeding Street expectations. We believe Anaplan has a significant runway for growth as the speed of disruption accelerates, driving the need for a real-time, collaborative, and data-driven planning process, which is enabled by the Anaplan software.

Detractors

  • IntriCon Corporation is a medical device company that sells components for Medtronic's diabetes business and value-based hearing aids. Shares fell after the company reported quarterly results that missed expectations. We believe IntriCon's base business is well positioned for growth in the near term and its hearing aid business has potential to accelerate growth in the next few years, driven by regulations permitting direct-to-consumer sales of hearing aids.
  • Shares of Teladoc Health, Inc., the U.S.’s largest telehealth company, fell with the broader market retreat, which was particularly brutal for high-growth stocks. The sell-off also reflected news of the resignation of the CFO/COO for violation of the company's workplace relationship policy. We believe the incident will not stall Teledoc's substantial momentum in the rapidly expanding telehealth space, where it is the dominant player. Guidance was reiterated and the CFO/COO's acting replacement is well known and respected by investors. We remain bullish on prospects for Teladoc.
  • Sientra, Inc. is a medical device company that is one of only three manufacturers of breast implants in the U.S. Shares were down in the quarter after management said that production from its new outsourced plant would be delayed from one to two quarters due to its methodical ramp of volume. We are not concerned, as it is critical that the products be perfect before sold and the delay appears to be minor. In addition, Sientra's new Miradry product for underarm sweat/odor seems to be performing above industry expectations.

Quarterly Attribution Analysis (Institutional Shares)

as of 12/31/18

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 12/31/18

Baron Discovery Fund declined 23.36% in the fourth quarter, trailing the Russell 2000 Growth Index by 171 basis points as negative stock selection overshadowed the positive effects of relative sector weights and cash exposure in a down market.

Aside from cash, lack of exposure to the Energy and Materials sectors, which were down sharply in the index, and investments in Real Estate contributed to relative performance. Within Real Estate, higher exposure to REITs, which performed relatively well in a down market, and outperformance of cold storage REIT Americold Realty Trust added value. Americold’s shares were up slightly in the quarter as cold storage fundamentals remain healthy, with a shortage of available high-quality space leading to steady rent growth. Americold's differentiated customer-centric business model is leading to high growth via market share gains, margin expansion, and development opportunities.

Underperformance of investments in Health Care, Information Technology (IT), and Consumer Staples weighed the most on relative results. Stock selection in Health Care detracted 234 basis points from relative performance, driven by IntriCon Corporation, Teladoc Health, Inc., and Sientra, Inc., which were the three largest detractors on an absolute basis. Weakness in the sector also came from the underperformance of hormone replacement drug maker TherapeuticsMD, Inc. and recent addition Ra Medical Systems, Inc., which designs, manufactures, and sells the Dabra laser system and disposable catheters used by physicians for the treatment of vascular blockages in the legs. TherapeuticsMD’s second drug for hot flashes received approval during the quarter, while Ra Medical’s first quarterly results as a public company topped investor expectations due to strong vascular sales. Despite these positive developments, shares of both companies were down as part of a larger overall drop in the sector that was particularly brutal for high-growth stocks. Negative stock selection in IT, owing largely to the underperformance of Yext, Inc. and Coherent, Inc., was somewhat offset by higher exposure to this better performing sector. Shares of digital knowledge management leader Yext declined due to a pullback in sales to small- to mid-sized businesses as the company increases focus on enterprise businesses. Shares of industrial laser company Coherent fell after the company lowered its fourth quarter sales outlook due to several factors, including execution challenges in one of the company's German manufacturing sites and a softening demand environment in China. Within Consumer Staples, underperformance of Limoneira Company, a 125 year-old company specializing in the growing and packing of lemons and avocados, hurt relative results. The company’s fourth quarter business update and preliminary fiscal year 2019 guidance underwhelmed investors, as rain-driven delays to the lemon harvests in Arizona pushed some volumes into next year.

as of 12/31/18

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

Baron Discovery Fund was up 0.64% for the year, outperforming the Russell 2000 Growth Index by 995 basis points due to a combination of stock selection, relative sector weights, overexposure to strong-performing stocks with higher P/E multiples, and cash exposure late in the year when the market declined sharply.

Apart from cash, investments in Industrials, Health Care, and Information Technology (IT) and lack of exposure to the lagging Materials sector contributed the most to relative results. Stock selection in Industrials added 287 basis points to relative results, led by the outperformance of wind turbine blade manufacturer TPI Composites, Inc. Shares of TPI rose after the company confirmed it has a clear path to doubling revenues by 2021. Lack of exposure to poor performing building products, construction & engineering, and trucking stocks and outperformance of aerospace & defense companies Mercury Systems, Inc. and The KEYW Holding Corporation also added value. Strength in Health Care was attributable to the outperformance of health care technology, life sciences tools & services, and health care supplies holdings, led by Teladoc Health, Inc., CareDx, Inc., and Cerus Corporation, respectively. Teladoc was the second largest contributor to absolute results, while shares of transplant diagnostics leader CareDx rose on robust sales of AlloSure, its kidney transplant test. Shares of Cerus, which produces devices to inactivate pathogens in donated blood, increased. In Europe, Cerus grew sales and prepared to file its CE Marking application for its red blood cell product. In the U.S., the company made progress on its penetration of the blood bank market for platelets. Within IT, higher exposure to application and systems software stocks and outperformance of The Trade Desk lifted relative results. Trade Desk was the largest contributor on an absolute basis after the company’s shares climbed more than 150% during the year. Investments in Qualys, Inc., Yext, Inc., Novanta Inc., LiveRamp Holdings, Inc., and Varonis Systems, Inc. also added value.

Consumer Discretionary and Communication Services investments hurt relative results. Consumer Discretionary holdings underperformed due to share price declines from casino operator Red Rock Resorts, Inc. and party goods retailer Party City Holdco, Inc. Shares of Red Rock fell on news that the company increased its investment in Palms Casino Resort. Weak data out of Las Vegas this summer also weighed on the stocks of all casino operators, including Red Rock. Party City’s stock declined as its largest private equity sponsor continued to sell down its ownership. Weakness in Communication Services was driven by the underperformance of GCI Liberty, Inc., a holding company with substantial stakes in General Communications and Charter Communications. Shares declined in the period after Charter reported underwhelming video and broadband subscriber growth.