Dear Baron Growth Fund Shareholder:
U.S. stock markets experienced unusual volatility during the three months ended Dec. 31, 2015. Baron Growth Fund (the “Fund”) increased 1.40% (Institutional Shares). The Russell 2000 Growth Index, the small-cap benchmark against which we compare the performance of this Fund, rose 4.32%. During 2015, the Fund declined 4.06% per share. This compared to a decline of 1.38% for the Russell 2000 Growth Index.
Although leading market indexes for both small and large companies were helped by the unusually strong performance of a small number of technology and health care stocks, the indexes changed little last year. This was because 59% of the stocks in the Russell 2000 Growth Index, which measures the performance of smaller companies, fell in price. The median decline of those stocks was 24.93%. Further, 50% of the stocks in the Standard & Poor's 500 Index, which measures the performance of larger companies, also fell in price last year. Their median decline was 15.93%. These results underscore that larger companies outperformed smaller companies, how challenging a year 2015 was for most investors and that the market’s advance was quite narrow, with declines in a majority of stocks offsetting strong gains in a few stocks.
Over the long term, the Fund has outperformed its benchmark on average by 5.5% per year since its inception on Dec. 31, 1994. Please see Table I. It has accomplished this with less “risk” than the market. We define “risk” as beta, which is a measure of the Fund’s volatility in comparison to the market as a whole. The Fund’s beta has been 0.68 for the 21 years since its inception. This means the Fund has been 68% as volatile as its benchmark. Please see Table III.
During the seven years from Dec. 31, 2008, in the midst of a financial crisis, through Dec. 31, 2015, Baron Growth Fund’s absolute performance net of fees was in the 51st percentile*. Only average. Stock prices during this period, regardless of fundamentals, were more correlated. However, since the Fund’s absolute performance over the period was cumulatively 171.17%, which means it nearly tripled in value per share since the financial crisis of 2008-09, we think being average during that period was acceptable.
For many reasons, stocks are likely to be less correlated in the near future than they were in the recent past. In such environments, based on Baron Growth Fund’s present portfolio, as well as due to our consistent investments in Baron research analysts and portfolio managers, we think Baron Growth Fund will again soon achieve strong relative performance, although there is no guarantee that this will be the case. Please see Table II to study Baron Growth Fund’s relative and absolute performance in the three distinct periods during Baron Growth Fund’s 21-year history.
We hope to be able to achieve our objective of doubling the per share value of Baron Growth Fund every five or six years. Of course, we cannot assure you that we will achieve this goal. Although my family and I are the largest investors in Baron Funds, we have continued to purchase significant additional Baron Growth Fund shares.
We provide the information in Performance Table I to comply with FINRA and SEC performance advertising rules. However, we believe the 21 years since Baron Growth Fund’s inception on Dec. 31, 1994 divided into the three periods described below more accurately depicts how the Fund performed during periods of euphoria or stress. Such periods have generally resulted from events that could not be foreseen and that significantly affected economies and markets. Please see Performance Table II. We try to describe these three periods in the paragraphs following Table II.
We refer to the period from Baron Growth Fund’s inception on Dec. 31, 1994 through Dec. 31, 1999 as “Yesterday.” This period included the “Internet bubble.” Baron Growth Fund outperformed the Russell 2000 Growth Index by 10.91% per year annualized, despite owning virtually no Internet or technology stocks.
We call the period from Dec. 31, 1999 through Dec. 31, 2008 “The Long and Winding Road.” These years included the bursting of the Internet bubble, 9/11, wars in Iraq and Afghanistan, the housing bubble and a financial panic. If you were unlucky enough to purchase Baron Growth Fund at the worst possible time, before the Internet bubble burst, and sell at the bottom of the market nine years later, the worst possible time to sell, you would have earned 24.48%, 2.46% per year annualized. If instead you had invested in a passive index fund or an ETF that performed similarly to the Fund’s benchmark index, you would have lost 35.24% during the period or 4.71% per year annualized. This represents a 7.17% per year excess return for Baron Growth Fund compared to a passive index investment.
From the depths of the 2007-08 financial crisis to the present are what we call the “Here Comes the Sun” years. Baron Growth Fund trailed its benchmark by 1.01% per year annualized after all fees and expenses. Since the Fund was less volatile than its benchmark, it achieved 2.41% alpha per year. The most important development during this period was an economic recovery driven by Federal Reserve “quantitative easing.” The Fund outperformed the large-cap S&P 500 index by 0.51% per year annualized. The Fund earned annualized returns of 15.32% for these seven years, a period marked by more correlated stock prices regardless of business fundamentals.
The Fund’s consistent long-term approach of investing in what we believe are high quality, competitively advantaged, small-cap growth businesses run by exceptional entrepreneurs has generated substantial alpha and excess returns since its inception, “Any Time at All.” Please again see Table II.
Coupled with higher absolute long-term returns than the benchmarks, we think we can continue to achieve substantial alpha and excess returns per year on average. There can obviously be no guarantee we can achieve our goals.
Shares of Vail Resorts Inc. (MTN, Financial), an operator of ski resorts across the U.S. and Australia, increased in the fourth quarter as the company generated strong results from its first season at Perisher in Australia, as well as robust pass sales for the current ski season in the U.S. In addition, snow storms across Tahoe, Colorado and Utah resulted in positive sentiment on the stock. The company continued to generate significant cash flow, and it has started to use it to repurchase stock. (David Baron)
ITC Holdings Corp. (ITC, Financial) is the nation’s largest independent transmission company. ITC’s shares rose in the fourth quarter in response to a company announcement that it is reviewing strategic alternatives to maximize value for shareholders, including a potential sale of the company. ITC will be sold at a premium to the current share price. ITC’s stable regulatory structure, ability to earn returns on equity at the mid- to high teens level, and above-average growth rate will appeal to buyers. (Rebecca Ellin)
Shares of CoStar Group Inc. (CSGP, Financial), a real estate information and marketing services company, contributed to fourth-quarter performance. The company’s financial results beat Street expectations, particularly on margin expansion. Bookings growth was strong, with net annualized subscription bookings more than doubling versus the prior year. CoStar is poised to generate accelerating organic revenue growth and significant margin expansion as it leverages the multifamily marketing investments made over the last 18 months. (Neal Rosenberg)
Shares of athletic apparel company Under Armour Inc. (UA, Financial) fell in the fourth quarter. While the company reported another strong quarter of top-line sales growth, some macro headwinds, investments, higher costs and a product mix shift led to a temporary slowdown in income growth. Additionally, unseasonably warm weather during the important holiday season raised concerns around softer sales and discounting. (Michael Baron)
Shares of the leading sporting goods retailer Dick’s Sporting Goods Inc. (DKS, Financial) fell in the fourth quarter on reports of a weak third quarter and lowered guidance for the key holiday season. Unseasonably warm weather also impacted results. While we feel that demand for sporting goods is strong, consumers are seeking deals and discounts and migrating incremental purchases to ecommerce where Dick’s locations and merchandise are not as competitively advantaged. Dick’s ecommerce business is strong, its high margin private label opportunity is large, its chance to expand its profitable stores is good, and a larger competitor is doing so poorly it may close stores. Dick’s is very attractively priced. (Michael Baron)
Shares of hospital operator Community Health Systems Inc. (CYH, Financial) fell in the fourth quarter on an earnings miss driven by lower volumes and deteriorating payor mix. Concerns that the Affordable Care Act tailwind is largely over and leveraged companies will be hurt by rising interest rates also brought out sellers. The spinoff of Quorum Health will create value, HMA synergies will exceed initial guidance, record numbers of recruited doctors will boost admissions, more states will expand Medicaid, and deleveraging will strengthen the balance sheet. (Susan Robbins)
Portfolio holdings
“If I had known what would happen in 1973 and 1974, I wouldn’t have bought any stocks in 1973 and 1974. I did buy stocks in 1973 and 1974.” Warren Buffett (Trades, Portfolio), chairman, Berkshire Hathaway.
Buffett also bought stocks in 2008, before and during the financial crisis. We, like Buffett, and my friends, Fidelity’s legendary managers Peter Lynch and Will Danoff, try not to worry about things you cannot predict or control. This is not always easy if you live anywhere you can watch television, read newspapers or get news on your iPad. Instead of reacting to news and trying to predict macro events, we try to adhere to Buffett’s dictum: “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.”
Sixty-six percent of Baron Growth Fund’s current portfolio investments were purchased more than five years ago. All those investments have had positive returns: 31 of 37 holdings, 83.8%, achieved returns in excess of Baron Growth Fund’s benchmark Russell 2000 Growth Index for the comparable period.
Due to Baron Growth Fund’s long-term, low turnover approach, the Fund often holds a significant percentage of its assets in securities that have appreciated beyond their market capitalizations at the time of the Fund’s initial investment. The Fund’s three-year average turnover is 9.03%, which implies that the Fund’s average holding period is about 11 years. About 50% of the investments that have been held for more than five years have realized approximately four- to fivefold increases so far. Six have achieved returns of seven to 13 times since their date of purchase.
The remaining one-third of Baron Growth Fund’s portfolio was purchased during the past five years. Over this span, eight out of 37 investments have already more than doubled. We regard these investments as “seed corn” which offer potential to grow significantly. It is our view that all of the investments purchased in the past five years have the potential to double in value again over the next five years. Of course, we cannot assure you this will be the case.
Portfolio structure and strategy
Baron Growth Fund is different than most other small-cap growth funds. This Fund’s objective is to outperform its benchmark index over the long term by investing in businesses seeking to grow significantly faster than the economy and the market. These companies often accomplish their objectives by investing in their businesses and penalizing their profits in the short term. As they build competitive advantages and address their growth opportunities, the lower-than-normalized profitability of many of these companies often depresses their share prices in the short term. It is also what gives Baron Growth Fund a chance to make investments in those businesses at prices that we believe do not reflect their long-term profit prospects.
As of Dec. 31, 2015, Baron Growth Fund held 75 investments. The top 10 holdings comprised 37.1% of the Fund’s portfolio. All these investments have been successful and were purchased when they were smaller and met the Fund’s strict small-cap criteria. They all offer significant further appreciation potential although we cannot guarantee that will be the case. The median market capitalization for Baron Growth Fund’s entire portfolio is $2.92 billion. All companies that Baron Growth Fund owns were also purchased when they met strict small cap criteria. The Fund’s diversified portfolio offers investors potentially better than market returns with less “risk” than the market. Compared to the companies in its benchmark, Baron Growth Fund’s investments possess higher levels of profitability (as defined by average gross and operating margins) and greater returns on capital.
The Fund’s average portfolio turnover for the past three years was 9.03%. This means the Fund has an average holding period for its investments of 11 years. This contrasts sharply with the average small-cap mutual fund which typically “turns over” its portfolio every 15 months. At time of purchase, we invest in small companies that have the potential to double in size within five years.
Thank you for joining us as fellow shareholders in Baron Growth Fund. The growth prospects for the businesses in which Baron Growth Fund has invested continue to be favorable.
