Review and Outlook

as of 09/30/18

After staging a recovery in the second quarter of 2018, U.S. equities continued their advance in the third quarter. Large-cap stocks outperformed small-caps, and growth outpaced value across most size segments. Volatility was subdued as the markets shrugged off trade tensions and ongoing turmoil in Washington and focused on strong corporate earnings and solid economic conditions to push to record highs.

Against this backdrop, Baron Fifth Avenue Growth Fund appreciated 6.0% in the quarter. While we are typically happy with a 6% gain, this was a relatively challenging quarter for the portfolio. We had plenty of winners with seven holdings each contributing over 50 basis points to returns. We had an additional eight investments that contributed over 20 basis points each, with 14 of our holdings rising over 10% during the quarter. Unfortunately, we had an unusually high number of losers with seven double-digit decliners. Several of our China-based holdings were hit hard late in the quarter as trade tensions escalated, and the negative impact on the growth of Chinese economy became more likely. We were clearly early in returning Facebook, Inc. to a full position and committed an investment error in getting involved with The Stars Group Inc. Though a relatively small position it did result in some permanent loss of capital.

Toward the end of the quarter and into October, the market pulled back sharply and experienced a substantial increase in volatility. We have no idea how long this period of increased volatility could persist. The Federal Reserve is raising interest rates, trade tensions are starting to have an impact on global growth, China’s economy is slowing down, energy prices are rising, politics and regulations continue to be unpredictable – these are all serious challenges with clearly uncertain outcomes. History would suggest that most will prove passing or manageable. More important to us is the continued secular acceleration of digital ad spending and e-commerce growth, with spending on cloud computing growing more than 60%. The digitization phenomenon, while still early, is starting to reach inflection points in many new areas (not only media and retail, but medicine, transportation, and consumer banking are in the midst of full blown disruptions now). We believe this should favor many of the companies in which we are invested.

The business of capital allocation (or investing) is the business of taking risk, managing the uncertainty, and taking advantage of the long-term opportunities that those risks and uncertainties create. We are confident that our process is the right one, and we believe that it will enable us to make good investment decisions over time.

Top Contributors/Detractors to Performance

as of 09/30/18

Contributors

  • Amazon.com, Inc., the world’s largest online retailer, contributed to performance as it continued to increase its total addressable market at an unprecedented pace. We believe Amazon can keep gaining share in the $1 trillion global advertising market, which would not only present a large revenue opportunity, but also substantially improve the company’s core margins. Amazon remains one of our highest conviction investment ideas, and we believe it may one day become the most valuable company in the world.
  • 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. 
  • Veeva Systems Inc. is the leading provider of cloud-based data management solutions for the life sciences industry. Shares increased sharply on reports of another strong quarter, including traction with newer solutions and early positive results from its recently announced Nitro product. Veeva continues to report healthy margins growth driven by a combination of sustainable growth in both top and bottom lines. While its core product, Vault, serves as Veeva’s current growth engine, we expect its expanding product line will create additional, multi-year growth opportunities.

Detractors

  • Alibaba Group Holding Limited is China’s largest e-commerce company, owning the country’s two largest online shopping platforms in addition to 33% of Ant Financial. Shares detracted from performance due to fears over a trade war and the company's plan to continue investing in grocery and online food delivery, contributing to lower overall margins. We retain conviction, as we expect continued growth in all areas and a high reinvestment rate in newer market segments. We remain optimistic about Alibaba’s long-term prospects.
  • Shares of Facebook, Inc., the world’s largest social network, detracted from performance. The company provided a relatively muted outlook on revenue growth while raising estimates of expenses as it ramped up efforts to eliminate malicious content from the network and investments in longer-term growth initiatives. Based on vast network of users, the ongoing monetization of Instagram, and the future monetization of WhatsApp and Messenger, we remain optimistic regarding Facebook’s prospects.
  • Naspers Limited is a South African company that operates a pay television business, a small print media business, and an internet division. The majority of its value is attributed to its large ownership stake in Tencent Holdings. Shares declined due to a widening discount between its investment in Tencent and the total net asset value of the combined Naspers investment. Naspers is considering ways to narrow this discount, which include potentially listing on other foreign exchanges and accelerating growth of the late stage venture business. We retain conviction.