Dear Baron Partners Fund Shareholder:
During the three-month period ended December 31, 2015, Baron Partners Fund (the “Fund”) advanced 2.84% (Institutional Shares). The Russell Midcap Growth Index, the benchmark against which we compare the performance of this Fund, increased 4.12%. The S&P 500 Index, which measures the performance of large cap companies, rose 7.04%.
For the full year 2015, the Fund underperformed its benchmark index and the S&P 500 Index. However, the Fund has outperformed both its benchmark index and the S&P 500 Index on an annualized basis since its conversion from a partnership to a mutual fund on April 30, 2003, as well as over the last 3 years, 15 years, 20 years and since its inception on January 31, 1992. Prior to the Fund’s conversion from a private partnership to a mutual fund on April 30, 2003, it paid substantially higher fees to Baron Capital Management, Inc., its manager. As a result, the Fund’s performance prior to that date would have been higher if its present fee structure had been in place.
U.S. market indexes rebounded in the quarter, fueled by large gains in a handful of stocks (Facebook, Amazon, Netflix, Google). These gains occurred despite several macroeconomic headwinds. In December, the Federal Reserve made the widely anticipated decision to raise interest rates by 25 basis points, the first interest rate increase in many years. Oil prices continued to fall, which caused stress in the high yield bond market due to the potential for energy company loan defaults. The Chinese economy deteriorated, leading to increased concerns about a global economic slowdown and currency devaluation with negative repercussions for global markets. Commodities continued their year-long sell-off.
Baron Partners Fund owns no Energy or commodities investments. Consumer Discretionary businesses benefit from low energy prices. The Fund has about 33% of its gross assets invested in the Consumer Discretionary sector. Companies in the portfolio generate minimal (about 2%) revenue from China. The Fund has about 23% of its gross assets invested in several Financials stocks that we believe will benefit if interest rates increase modestly. The Fund has about 17% of its gross assets invested in technology businesses that provide services to consumers and financial businesses.
Despite weak economic data in China and the sharp decline in oil prices, the U.S. economy appears to be stable. Jobless claims are in a range consistent with moderate growth and unemployment is holding steady at around 5%, the lowest level since the recession began in late 2007. Interest rates are still at historically low levels even with the Fed’s recent 25 basis point increase. Given this backdrop, in our opinion, stocks remain attractively valued, trading at 16.1 times next year’s earnings. Historically, stocks have provided protection against inflation, as well as better returns than other asset classes. We think that will continue to be the case.
Of the Fund’s average gross assets, 26.8% produced double-digit returns, 26.9% advanced by single digits and 46.3% declined based on their average weight. On average, 37.5% of the Fund’s average gross assets outperformed the benchmark. Notable contributors to performance included CoStar Group, Inc., ITC Holdings Corp., Vail Resorts, Inc., The Charles Schwab Corp., and Illumina, Inc. Notable detractors from performance included Dick’s Sporting Goods, Inc., Inovalon Holdings, Inc., CarMax, Inc., Arch Capital Group Ltd. and Zillow Group, Inc. We regard this quarterly underperformance as anomalous and believe all these investments will contribute positively to the Fund’s future performance, although we cannot guarantee it.
We try to explain the reasons certain stocks outperformed or underperformed during the period in the “Top Contributors” and “Top Detractors” sections. In many instances, we regard gains and losses in the short term as random. We continue to believe the businesses in which we have invested have the potential to double in size in four to five years. As a result, we believe the stocks that have recently underperformed will achieve above average returns and contribute positively to the Fund’s performance in coming quarters, although we cannot guarantee this.
Shares of CoStar Group, Inc., 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. We believe 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)
ITC Holdings Corp. 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. We believe ITC’s value is above its current share price. We think ITC’s stable regulatory structure, ability to earn after tax rates of returns on equity at the mid-tohigh teens level, and above-average growth rate will appeal to buyers. (Rebecca Ellin)
Shares of Vail Resorts, Inc., 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 recently again begun to repurchase stock. (David Baron)
Shares of the leading sporting goods retailer Dick’s Sporting Goods, Inc. fell in the fourth quarter on reports of a weak third quarter and lowered guidance for the key holiday season. Unseasonably warm weather has impacted results. While we feel that demand for sporting goods is strong, consumers seek deals and discounts and are migrating incremental purchases to e-commerce where Dick’s locations and merchandise are not as competitively advantaged. Dick’s e-commerce 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. We think Dick’s is very attractively priced. (Michael Baron)
Shares of health care data and analytics vendor Inovalon Holdings, Inc., fell in the fourth quarter. Organic financial results were slightly below Street expectations, although we were encouraged by Inovalon’s 18% organic revenue growth. While recent financial performance has been disappointing, we remain optimistic about the company’s ability to compound revenue at mid-to-high-teens rates and drive sustained margin expansion. We believe if the company can achieve these financial targets, the stock will also benefit from meaningful multiple expansion. (Neal Rosenberg)
Shares of CarMax, Inc., the country’s leading used car retailer, detracted during the fourth quarter after reporting weaker sales and earnings growth owing to a variety of factors we believe are transitory, including inventory mix and heavier than usual new car incentives. We maintain our positive outlook on CarMax’s business. With low single-digit share of a vast and fragmented market, a young and growing store base, and pent up industry demand, we believe CarMax is poised to deliver double-digit earnings growth over the next several years. (Matt Weiss)
Investors’ angst around Tesla Motors, Inc.’s delivery numbers for the fourth quarter have increased, and we used the weakness to add to our position. As the quarter came to a close, Tesla reported very strong growth for Model S deliveries. We continue to see production and scale as Tesla’s main challenge, while demand for Tesla’s products continue to outstrip supply. Tesla’s drivers around the globe are delighted with their continuously improving cars, as features like auto-pilot are sent over-the-air and upgrade the car after its purchase. While paving the way for transformation of the auto industry in areas like electrification, safety, self-driving, connectivity and more, Tesla has built an impressive brand awareness that will serve it for years to come. We believe that over the next decade, electric vehicles will be cheaper, better and safer. Gasoline driven cars will be a thing of the past or a collector’s item. Tesla is enabling the ride to this future and with its first mover advantage, human capital and a visionary leader, and we believe it will take a significant share of this trillion dollar industry sea change. (Gilad Shany)
AO World Plc is the leading online seller of major domestic appliances (MDA) in the U.K. The company is benefiting from the growth in online purchasing, where it has more than 30% market share in the online MDA category. AO’s competitive advantages are a result of best in class customer service, differentiated video and editorial content, which make for easier purchase decisions by consumers, and an extremely efficient supply chain. The company continues to expand rapidly in its core U.K. market, while making significant progress in Germany, a new market for the company that is twice as large as that of the U.K. We believe that the company has a substantial runway of growth with plans to enter several more countries in Europe over the next few years. While AO estimates the U.K. MDA market to be $4.5 billion, the new markets the company plans to enter including Germany are more than five times larger than the U.K. (Ashim Mehra)
Douglas Emmett, Inc. is a REIT that owns and manages an exceptionally high quality portfolio that includes 15.5 million square feet of Class A office space and 3,300 apartment units in the premier coastal submarkets of Los Angeles and Honolulu. We think the long-term fundamental outlook for Douglas Emmett’s submarkets is favorable. Demand is being driven by continued job growth, as well as employees’ propensity to work close to where they live (thereby avoiding heavy traffic). Supply is constrained as a result of significant barriers to new construction that include zoning restrictions, height limitations and outspoken homeowner groups. The company has dominant positions, with an average 25% market share in its Los Angeles submarkets and 34% in Honolulu, resulting in strong tenant relationships, economies of scale and pricing power. The company has attractive growth prospects via leasing up vacant space and raising rents in the existing portfolio, complemented by an active acquisition and development strategy. We are investing alongside a management team that we respect and who together own over 20% of the company. (David Kirshenbaum)
Investment Strategy
We invest for the long term in a non-diversified portfolio of what we believe are competitively advantaged, well-managed, growing businesses at what we think are attractive prices. Often, we have opportunities to purchase stocks of businesses we have researched extensively, which we believe are mispriced or have fallen in price due to what we perceive to be temporary issues. This quarter, we bought AO World plc and Benefitfocus, Inc., two holdings in our other mutual funds, and added to current holdings Tesla Motors, Inc. and Douglas Emmett, Inc. Our objective is to purchase shares of what we believe are well-established, appropriately capitalized, growing companies, with strong positions in markets with growing demand for their products and services. The Fund uses leverage with the goal of enhancing its investment returns. Leverage also increases risk, of course.
Another common investment theme for Baron Partners Fund is to invest in businesses investing for growth, often at the expense of short-term profits. These businesses are investing in order to become much larger, more profitable businesses in the future. Virtually all the businesses in which we have invested are making such capital commitments. Verisk Analytics, Inc.’s startup investments in real estate data services, CarMax, Inc.’s line of new stores coupled with efforts to grow sales in existing stores, and Hyatt Hotels Corp.’s investment in hotel renovations and improved guest services, as well as its ongoing expansion in Asia, are noteworthy in this regard. As long-term investors who hold stocks for an average of nearly five years, we expect to benefit from these expenditures. In contrast, most mid-cap mutual funds are trading oriented, turning over their entire portfolios on average nearly every 18 months. Since these funds, in general, will not care about or benefit from such long-term strategic investments by businesses, they accord them little or no value. This allows us to invest in these companies at prices we feel are especially attractive.
Baron Partners Fund also has significant investments in growing “C” corporations like Vail Resorts, Inc., and ITC Holdings Corp., whose shares we believe are undervalued when compared to similar businesses structured as REITs or master limited partnerships. We expect alternative money manager The Carlyle Group and financial intermediary The Charles Schwab Corp. to benefit as interest rates increase.
Managing risk is a key part of our investment process. We help manage risk from a company perspective by investing in businesses that we believe are conservatively financed with high barriers to entry. Our proprietary research regarding business’ long-term growth opportunities, competitive advantages, management teams and risks determines how much we allocate to individual securities. We invest in different industries that are affected differently in the short term by unpredictable events. This is to achieve a portfolio of investments with risks that are not correlated. This is part of our effort to help reduce the volatility of this non-diversified portfolio. Further, the underlying businesses in which the Fund has invested historically have less volatile earnings than the benchmark index.
Portfolio Structure
The portfolio is currently invested in 31 businesses, principally in mid-cap companies. As of December 31, 2015, the weighted average market capitalization its portfolio investments was $11.8 billion, compared with $13.3 billion for the Russell Midcap Growth Index. The Fund currently has significantly larger investments in Consumer Discretionary, Financials, Utilities and Information Technology sectors than the benchmark. The Fund’s investments in Health Care and Industrials are weighted less than the index. The Fund does not have investments in Consumer Staples, Materials, Energy, or Telecommunication Services. We are not attempting to mirror our benchmark or any other index with the Fund’s portfolio.
We think the businesses in which the Fund has invested have the potential to double in size within four to five years, although there is no guarantee that will be the case. We think because of the competitive advantages of those businesses, it would take many years or cost a lot of money, and, therefore, not be economically feasible, for new entrants to compete against them. We think these barriers enable our companies to generate strong returns on capital and provide them with the ability to grow consistently over the long term.
Thank you for joining us as fellow shareholders in Baron Partners Fund. We believe the growth prospects for the businesses in which Baron Partners Fund has invested are favorable and improving. Since, in our opinion, the share prices of our businesses do not reflect their prospects, we believe they remain attractive. Of course, there can be no guarantee this will be the case.
