Baron Small Cap Fund gained 1.53% in the June 2011 quarter, and year-to-date, the Fund is up 11.73%. Our performance is ahead of the Russell 2000 Growth Index (down 0.59% in 2Q and up 8.59% year-to-Date) and the S&P 500 Index (up 0.10% in 2Q and up 6.02% year-to-date) for both periods.
The stock market was volatile in the second quarter. The market continued its upswing early in the quarter, rising 3%, then swooned, dropping about 7% from peak to trough, only to recover and finish flat for the quarter.
The U.S. economy noticeably slowed from expectations of 4% growth towards 2%, and the future path of growth is uncertain, which raises concern about future corporate profit growth. Daunting government debt issues here and in Europe are front and center and unresolved. Inflation spiked in China and authorities raised rates to slow down the economy.With so much going wrong, the market surprisingly held firm because, in our view, corporate profits are thriving and earnings drive the stock market.
We made our returns in the quarter in our Consumer Discretionary and Industrial stocks, which is unusual since one would expect these sectors to languish with the slowing economy. However, our holdings, for the most part, are bucking the trend and still growing robustly. Our Energy holdings were weak as oil and commodity prices retraced. And our Telecom stocks (communications towers) were lower on the news of carrier mergers.
Fossil (FOSL), the fashion watch purveyor, rose 25.7% in the quarter and was our biggest contributor. The company reported 35% revenue growth and 62% profit growth and forecast continued rapid growth.Watch sales in Asia have been booming, and the company is just starting its major rollout of watch concessions. In our view, the potential to grow in international markets is enormous. When coupled with a reacceleration of store openings in the U.S.,we believe the company will be substantially larger and more profitable in time.
Liberty Media Corp. (LCAPA), John Malone's investment vehicle, continued to appreciate as Sirius XM stock rose. Liberty got its 40% stake in Sirius through a $250 million convertible loan in 2008 and that investment is now worth $5.5 billion! LCAPA continued to repurchase stock since it trades less than NAV, and it also agreed to acquire Barnes and Noble.
Telvent (TLVT), the infrastructure management systems provider, announced that it was being acquired by Schneider Electric at a nice premium.We are fine with the bid and believe our conviction in the company (even as it had to fight through issues in its Spanish local market) has been rewarded.
Crocs (CROX), the manufacturer and retailer of casual footwear, continued its turnaround under new management. The company has broadened and diversified its product line and has rebuilt wholesale relationships. The sell-through of its new and innovative offerings has been encouraging as have been the early results from new retail store openings.
Our weakest performers this quarter were our energy exploration and production holdings: Brigham Exploration (BEXP), Concho Resources (CX) and GeoResources (GEOI). Oil prices declined in the quarter and energy stocks fell after an extended period of outperformance. There were also some issues with current production (caused by bad weather), but this is temporary. Additionally, some of the cutting edge technologies and techniques used by these companies have been questioned in connection with environmental safety, which weighed on the stocks, but we remain assured of their soundness.
Our senior living holdings, Brookdale Senior Living and Emeritus, declined this quarter after being among our top performers in the prior quarter. The general housing markets remain weak, which has put a pall over all housing related equities. The companies have continued to post good, but not great, results, as rate and occupancy growth is tough in this macro environment.We still believe that the stocks are significantly undervalued both absolutely and relative to other real estate sectors and trade at big discounts to asset values.
Lamar Advertising (LAMR), a leading owner/operator of outdoor billboards, reported weak results as local advertising remains stubbornly slow, in contrast to national advertising, which is in a healthy rebound.We expect to see local advertising pick up, but we are monitoring the situation.
The Fund remains invested in the same sectors as usual. Compared to the Russell 2000 Growth Index, we are overweight in Consumer, Industrials and Energy and underweight in Technology and Health Care.
The median market cap of the Fund was $2.0 billion at the end of the quarter. During the quarter, new investments averaged $1.5 billion in market cap (the max we can purchase is $2.5 billion).We sold stocks with an average market cap of $3.1 billion. These stats are similar to our actions in the first quarter, and we expect the relative market cap of the Fund to continue to decline as we add small stocks and trim similar amounts of our larger ones.
In the quarter we continued to actively add new names to the portfolio and increase existing positions. Three of our significant new purchases were initial public offerings. In general, new purchases have a special situation value bent to them. Cognex (CGNX) sells machine vision systems used to inspect products during the manufacturing process to ensure automated equipment is functioning properly. The company was started 30 years ago by a fascinating entrepreneur, who has created a unique corporate culture, and a market leader bent on innovation. Cognex products originally focused on semiconductor inspection, which proved very cyclical. But now the growth driver is factory automation, which accounts for over two-thirds of sales.We believe that this sector will organically grow over 30% going forward as Cognex's "ID" products replace lasers in factories and its machine vision products crack the Chinese market and gain share in Japan.
Vanguard Health Systems (VHS) is an operator of urban hospital systems. The company was founded eight years ago by an experienced health care management team that we respect very much and have successfully invested with before.Vanguard acquires troubled health care systems and turns them around by managing the hospitals and their capital allocation better. The company recently acquired a major system in Detroit, which increased its revenues by over a third. It plans to reinvest the system's cash flow in capital expenditures, both to build new hospitals and to improve existing facilities. If successful this would double the cash flow of the systems, which would imply that the systems were acquired for under two times cash flow.
Golar LNG Partners LP is a new Master Limited Partnership that owns and operates a fleet of ships that transport and/or regasify LNG (liquefied natural gas).We think that LNG is a big growth industry, and the fleet to serve the industry will grow substantially. Shipping rates have moved up, and we expect them to stay elevated. Golar's parent can earn a double digit return building new vessels, and we believe the MLP, as its funding vehicle, will have strong visible growth over the next three to five years.We think the company's dividend can almost double, and we think the initial going-in yield is attractive.
In the quarter, we sold most of our Telvent holdings, which is being acquired and much of our GenProbe position, as it put itself up for sale and the share price ran up.
We sold out of Rubicon when it met our price objectives.We sold our position in Covanta, Campus Crest, WMS Industries and Urban Outfitters to redeploy the capital into what we considered better ideas.
Subsequent to the end of the second quarter, the market suffered a vicious contraction. The Russell 2000 Index fell over 25% from peak to trough. Volatility has been intense. In one four day stretch the market either gained or lost over 4% of its value each day, which is unprecedented. Baron Small Cap Fund suffered along with the market and is presently down on the year.
Three shocks precipitated the market declines — first, the debt ceiling debate, second, the downgrade of the credit rating of the U.S. government, and third, increased worries about the possibility of European sovereign debt default and the risk of contagion and a credit crunch that could develop. Politicians airing their dirty laundry and the S&P downgrading the government's credit rating for ostensibly political reasons are disheartening developments but not so important. Perversely interest rates fell. However, the issues in Europe are complex and ongoing, and the path of resolution is uncertain, so is the issue we are more focused on.
Coming into the quarter, many credible strategists were predicting a re-acceleration of the economy as certain temporary hurdles to growth were behind us. However, that is highly unlikely now. The market's decline is taking purchasing power out of the pocket of the consumer. Confidence is seriously shaken, so we expect less consumer spending and business investment until we are on firmer ground. It seems that most investors are scared or fed up so are selling and heading to the sidelines. The market is adrift.
We agree that the economic outlook is pretty grim, however do not concede that a recession is likely, even if the market seems to be indicating it is.We anticipate lower earnings in the near future and have adjusted our internal estimates down accordingly. But even doing so, we believe that our stocks have over-corrected if all we are in for is "earnings risk". It is "systemic risk" which is in the future, well then, who knows what lies ahead.
Our portfolio is strong coming into the turmoil, meaning the Fund has a good cash cushion and our investments have rock-solid balance sheets and leading market positions. As often happens with panic selling, the moves in stocks have been indiscriminant and we observe that many of our best performers coming into the sell-off have fared the worst at first.We are trying to take advantage of the volatility to add to our favorites at cheap prices. We most favor companies that can grow fast organically, irrespective of if the economy grows at 4% or 1% pace and are cheap absolutely against what we think will be future earnings.
So though it may sound Polyanna-ish, our approach is to grit our teeth and get through it. That values are too compelling. And to work to take advantage of declines while still being mindful of important risks, (global recession and the health of Europe's banking system) in the near term.