Baron Focused Growth Fund 3rd Quarter Letter

The fund declined 13.77%, trailing the benchmark

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Nov 06, 2015
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Dear Baron Focused Growth Fund Shareholder:

Performance

Baron Focused Growth Fund trailed its benchmark in the third quarter of 2015. The Fund declined in value by 13.77% (Institutional Shares) during this period while the Russell 2500 Growth Index, the benchmark against which we compare the performance of the Fund, declined by 11.05%. The S&P 500 Index, which measures the performance of large cap companies, declined by 6.44%. The Morningstar US OE Mid-Cap Growth Category*, measuring the performance of all United States open end, mid cap growth funds fell by 9.49% for the three months ending September 30, 2015. For the first nine months of the year, the Fund declined 7.95% (Institutional Shares) while the Russell 2500 Growth Index fell 3.85%.

A difficult market in the third quarter more than eliminated the gains achieved in the first half of the year. Investors have been skittish as oil prices have come under severe pressure, the Chinese stock market has substantially declined, and turmoil increased in the Middle East with Russia’s direct entry into the Syrian conflict. The Federal Reserve indicated that it too was concerned about the pace of global economic growth and chose not to increase interest rates in the period. In addition to these macroeconomic (“macro”) concerns, company-specific problems have had a negative impact on the markets. Volkswagen’s “emission cheating” software will likely have an important adverse impact on the finances of the second largest global car manufacturer. This is while Glencore, the world’s largest commodity trader, may also be on unsound footing as commodity prices have substantially declined.

Smaller companies’ stocks significantly underperformed those of larger companies in the period. The eight small cap companies held in the Fund represent 25.4% of the portfolio. This portfolio segment fell in value 26.4%, substantially more than the larger companies’ price decline. We do not think the broad decline of smaller cap businesses was a result of business fundamentals. Accordingly, we think their share prices now represent unusually attractive value. We think this is probably because those companies are underfollowed by Wall Street analysts. Consumer Discretionary businesses represent the largest segment of the Fund at 43.6% of the portfolio and should benefit from the equivalent of the substantial “tax cut” American citizens are experiencing as a result of lower energy prices. We think travel businesses like Vail Resorts, Inc. and Hyatt Hotels Corp. should be assisted by lower cost of transportation, while retailer CarMax, Inc. should be aided by customers having more disposable income.

Arch Capital Group Ltd. (ACGL, Financial) is a Bermuda-based specialty insurance and reinsurance company. Shares rose on reports of good quarterly financial results with its 9% growth in book value per share. Despite soft industry pricing conditions, Arch continues to generate above-average returns due to profitable underwriting, benign catastrophe losses, and favorable reserve development. The recently acquired mortgage insurance business is scaling up. M&A activity in the property & casualty insurance industry has also helped boost share prices. (Josh Saltman)

ITC Holdings Corp. (ITC, Financial) is the nation’s largest independent transmission company. Shares rose due to the relatively strong performance of the electric utility sub-industry as investors rotated away from risk in the broader stock market. We believe ITC has robust prospects for growth and will continue to execute on its growth strategy. The primary drivers for transmission investment, reliability and connection of new generation (including renewables), remain intact, and we believe ITC is well positioned to benefit from these trends. (Rebecca Ellin)

Shares of consumer products company Church & Dwight Co., (CHD, Financial) Inc. rose in the period. Despite continued category headwinds and a weak consumer market, performance was solid. Organic sales grew by over 5%, and we think momentum will continue, as the company has successfully addressed supply constraints in its vitamin business. Investors appeared confident in Church & Dwight’s ability to make growth-enhancing acquisitions. There is also speculation of a takeover by a firm looking to enter the U.S. market. (Michael Baron)

CaesarStone Sdot-Yam Ltd. (CSTE, Financial) is a leading global manufacturer of quartz surfaces for kitchens and bathrooms. Shares fell sharply in August after the company reduced its full-year revenue guidance on the second quarter earnings call. A negative report by a short seller of the stock also weighed on the stock price. We believe investors overreacted to both events and remain positive on our investment in CaesarStone, as earnings growth accelerates from successful new product launches and quartz market share gains vs. other countertop materials. (David Kirshenbaum)

Shares of Benefitfocus, Inc., (BNFT, Financial) a leading provider of cloud-based benefits software, detracted from the third quarter performance after performing well earlier in the year. The company conducted a secondary offering during the third quarter, which we believe weighed on the stock. It continued to generate robust financial results, growing its employee customer count by 36% and demonstrating initial traction with its newly launched modules. We believe that Benefitfocus serves an addressable market that is more than 100 times larger than its current business. (Neal Rosenberg)

Shares of The Carlyle Group, (CG, Financial) an alternative asset manager, declined in the period. The company continues to perform well in its corporate private equity division. However, its newer divisions in Real Assets and Investment Solutions and Global Market Strategies have faced issues. While poor performance in these areas will likely result in lower near-term distributions, we think Carlyle still holds long-term promise as it launches new products and performance of existing funds may improve. (Michael Baron)

Mobileye N.V. (MBLY) is an Israeli-based, software and systems design leader for camera based ADAS (advanced driver assistance systems). MBLY’s algorithms help avoid accidents by implementing an advanced set of applications ranging from warnings (collision warning, lane departure warning) to active safety (Autonomous Emergency Breaking and Auto Pilot features). We believe MBLY has a dominant and defensible market position in ADAS due to its technology, as evidenced by its design wins with 75% of the most significant worldwide original equipment manufacturers (OEMs). Our proprietary research and public announcements from existing supply chain companies lead us to believe that MBLY has a great opportunity to significantly grow units and prices for the foreseeable future. We think that over the next decade almost every car on the road will have camera based algorithms deployed in it as a basic feature (a part of a larger sensors’ system). We believe these features will help save thousands of lives and billions of dollars. With its technology and low selling price, we believe MBLY is well positioned to capitalize on its existing relationships with the majority of worldwide OEMs and grow its revenues and cash flows at a very fast rate. We believe MBLY could be the parallel of “Intel inside” in the auto world. (Gilad Shany)

Portfolio structure

The objective of Baron Focused Growth Fund is to double its value per share within five years. Of course, we may not achieve our objective. Our strategy to accomplish this goal is to invest for the long term in a focused portfolio of what we believe are appropriately capitalized, well-managed, small and mid-cap businesses at attractive prices. We attempt to create a portfolio of less than 30 securities diversified by GICS sectors that will be approximately 90% as volatile as the market. These businesses are identified by our Firm’s proprietary research.

We think all the businesses in which Baron Focused Growth Fund has invested have the potential to double in size within approximately five years and double again over the subsequent five years. We think these well-managed businesses have sustainable competitive advantages and strong, long-term growth opportunities. Considering current stock price valuations, we believe we have the opportunity to meet our performance goals during the next decade, although there is no guarantee that we will do so.

As of September 30, 2015, Baron Focused Growth Fund held 24 investments. The median market capitalization of those small and mid-sized growth companies was $5.41 billion. Compared to its benchmark, the Fund’s investments have higher profitability (as exhibited through greater operating margin, net margin and free cash flow margin). They also exhibit better internal returns (higher return on invested capital and return on equity). And they are more conservatively financed (lower debt to market capitalization ratio) and have more consistent earnings (lower standard deviation of earnings growth and lower beta). We find these metrics important in helping limit risk for a concentrated portfolio.

The Fund has had less exposure to the Health Care sector than its index. Currently, the Fund does not hold any Health Care investments, while the average weighting in its benchmark index is 22.0%. Additionally, the Fund currently does not hold any Energy positions, although this sector constitutes a small portion of the index. The Health Care sector, and particularly the biotechnology category, has been an extremely strong performer the past few years as investors speculate on increased drug approvals and their profitability. However, this strength reversed in the third quarter as the Health Care sector was the second worst performing category (behind Energy) in the Russell 2500 Growth Index, declining 16.50%. We have felt that the industry did not offer the attractive risk/reward characteristics. We have historically avoided biotechnology stocks in this focused portfolio since the outcomes for many such companies are binary.

Instead, the Fund has invested in businesses with, in our view, multiple growth opportunities. Examples included businesses like financial technology platform FactSet Research Systems, Inc., which is growing its small customer base in a sizeable category, while also introducing new products and services allowing it to increase price per account; and Manchester United plc, a sports franchise that we believe can increase sponsorships, improve global merchandising, more effectively monetize television broadcasting and launch subscription-based digital content. We believe these multifaceted businesses will provide steadier and more impressive returns over the long term than companies solely reliant on a single product’s success.

Thank you for investing in Baron Focused Growth Fund. We are continuing to work hard to justify your confidence and trust in our stewardship of your family’s hard-earned savings. We are also continuing to try to provide you with information I would like to have if our roles were reversed. This is so you can make an informed judgment about whether Baron Focused Growth Fund remains an appropriate investment for your family.