Dear Baron Focused Growth Fund Shareholder:
Baron Focused Growth Fund (the “Fund”) performed well in the three months ended December 31, 2015. It increased in value 6.33% (Institutional Shares) during the period. The Russell 2500 Growth Index, the smid-cap benchmark Index against which we compare the performance of this Fund, rose by 3.81%. The S&P 500 Index, which measures the performance of large-cap companies, increased by 7.04%. For the full year, Baron Focused Growth Fund declined by 2.12%, the Russell 2500 Growth Index fell 0.19%, and the S&P 500 Index increased in value 1.38%.
Although most U.S. equity index returns were almost unchanged during 2015, those results overstated the performance of most stocks. Only a relatively narrow group of technology and biotech health care stocks performed very well in 2015. Many companies’ stocks had either lackluster or negative returns. Approximately 58% of the stocks in the Russell 2500 Growth Index lost money last year. The median return of those stocks was a negative 21.83%! Approximately 50% of the stocks in the S&P 500 also had negative returns last year. The median performance of those stocks was a negative 15.93%. This is also evidence that larger companies outperformed smaller ones last year. As a result of this two-tiered market, we believe many businesses are now priced at unusually attractive valuations relative to their fundamental prospects.
We provide the performance data in Table I to comply with FINRA and SEC regulatory disclosures. Regulators believe that if all mutual funds provide this information it will be easier for investors to compare the performance of mutual funds to their benchmarks and peer funds over the short and long term. We agree with this assessment.
We also believe investors would find it helpful to review information that permits them to see how their mutual funds, peer mutual funds and passive benchmark indices have performed through bull and bear market cycles. The performance data in Table II divides the 19½ years since Baron Focused Growth Fund’s inception as a partnership in May 1996 (Baron Focused Growth Fund converted into an open end mutual fund on June 30, 2008) through December 31, 2015 into three distinct periods. Such periods have generally resulted from events that could not be foreseen and significantly affected markets and economies.
“Yesterday” is the period from the Fund’s inception in May 1996 through December 31, 1999. Markets in this time period were exceptionally strong as the result of what many refer to as “The Internet Bubble.” Baron Focused Growth Fund outperformed its benchmark index during the period by more than 1000 basis points per year despite the fact that the Fund’s holdings in Internet stocks was negligible.
“The Long and Winding Road” from December 31, 1999, through December 31, 2008, was perhaps the most difficult period for financial markets in the history of the U.S. It included the bursting of the Internet bubble, 9/11, wars in Afghanistan and Iraq, a housing bubble and a financial panic. During this nine-year period, Baron Focused Growth Fund earned 2.72% per year while its benchmark index lost 3.99% per year! This means that if you were unlucky enough to invest in Baron Focused Growth Fund on December 31, 1999, at the worst possible time to buy, weeks before the Internet bubble burst and 20 months before 9/11, and redeemed your investment nine years later at the worst possible time to sell, in the midst of a financial panic, you would have earned a positive return of 27%. If you had invested in a passive index or ETF that mirrors our benchmark, you would have lost 31% of your capital!
Finally, “Here Comes the Sun” from December 31, 2008 through December 31, 2015 encompasses a slow and steady U.S. economic recovery. This recovery has been engendered by the initiation of the U.S. Federal Reserve’s quantitative easing programs. It is too early to see whether the recent Fed “tightenings” will produce a “bump in the road” for growth and, if so, whether the Fed will reverse course.
Although Baron Focused Growth Fund was founded as a private investment partnership in 1996, it was not converted into an open end mutual fund until June 2008. This Fund’s objective is to invest for the long term in fewer than 25 small and mid-sized, well managed, competitively advantaged, growth companies. As of December 31, 2015, 12 stocks, 57.6% of Baron Focused Growth Fund’s portfolio is less than five years old. Ten stocks, 50.1% of Baron Focused Growth Fund’s investments, have been owned for less than three years. We believe investments owned for a short period make this Fund riskier but offer significant potential. Only five of those investments, ski resort Vail Resorts, Inc., human resource provider Benefitfocus, Inc., financial services firm Virtu Financial, Inc., insurance software provider Guidewire Software, Inc. and satellite communications company Iridium Communications Inc., have outperformed their benchmark during that period. We regard these and the seven other newer investments as “seed corn” that has potential to grow significantly and produce strong returns in future years. Such investments often do not earn strong returns in early years since they generally are investing heavily in their businesses when we make initial purchases. Those businesses’ capital investments generally penalize their current profits which, as a result, often adversely impact their current stock prices. This is what often gives us an opportunity to purchase such businesses at attractive prices. These growth companies are making investments in order to become much larger and more profitable companies over the next several years…which should benefit the Fund’s shareholders over the next several years. The unusually large percentage, 57.6%, of the Fund’s portfolio invested in small and midsized, less well-known companies that have been owned for less than five years, makes this Fund riskier than Baron Growth Fund. It also, in our opinion, offers this Fund’s shareholders significant growth potential.
Only 35.6% of the Fund’s investments were purchased more than five years ago (before December 31, 2010). As you might expect, all of these nine investments have achieved positive returns; eight of the nine have achieved returns in excess of the Fund’s benchmark for the relevant periods. The three strongest cumulative returns were achieved by property and casualty insurer Arch Capital Group Ltd., which is now worth 6.4 times its original purchase price; consumer products company Church and Dwight Co., Inc., 4.1 times; and financial services provider FactSet Research Systems, Inc., 3.5 times.
We think it is interesting to compare Baron Focused Growth Fund’s portfolio to that of Baron Growth Fund, our 21-year-old, small cap growth, mutual fund. Baron Growth Fund also invests for the long term in well managed, competitively advantaged growth companies. That Fund has an average holding period of almost 11 years and has owned only about 33% of its portfolio for less than five years. The 66% of its portfolio that has been owned for more than five years are where Baron Growth Fund has produced its most significant returns.
We expect the same to ultimately be the case for Baron Focused Growth Fund, since Baron Focused Growth Fund has almost twice as many companies in which it has invested that are relatively recent.
Not surprisingly, the top three contributors to the Fund’s performance in the quarter, Vail Resorts, CoStar Group and CaesarStone, are in the Consumer Discretionary, Information Technology and Industrials sectors. These businesses are relatively insulated from the short-term macro implications of falling energy prices. Each has invested significantly over many years to improve its products and increase its competitive advantages. Vail has spent years improving its ski mountains and town amenities to drive traffic to its resorts. CoStar has amassed an unrivaled database of information valued by real estate investors and developers. And CaesarStone’s investment in research and development has resulted in a superior home furnishing product at a fraction of incumbents’ prices. This continuously improving characteristic is a crucial criterion in evaluating our holdings. While it often brings near-term earnings pressure when these investments are being made, the long-term outcome often results in superior returns for shareholders. Additionally, Air Liquide announced its intent to purchase Airgas. Airgas was an attractive acquisition candidate due to its distribution network that others feel is nonreplicable.
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 started to use it to repurchase stock. (David Baron)
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)
Shares of quartz countertop manufacturer CaesarStone Sdot-Yam Ltd. contributed in the fourth quarter, recapturing some of the ground it lost in the third quarter that resulted from second quarter financial results that, while impressive, fell short of Street expectations. A negative report by a short seller also pressured the stock in the third quarter. We remain positive on our investment in CaesarStone, as earnings growth continues to accelerate from successful new product launches and quartz market share gains over other countertop materials such as granite and marble. (David Kirshenbaum)
The top three companies that detracted from performance were Dick’s Sporting Goods, Tesla Motors and CarMax. These companies were perceived as exhibiting signs of increased competition. We still believe Tesla is competitively advantaged in the electric vehicle space and rival auto companies cannot surpass its technology. Dick’s remains the largest distributor in its space and can command superior products at better prices than its rivals. But given increased competition from e-commerce, we have taken steps to reduce exposure to the company. Over the course of the year, we also sold companies that were reliant on commodity-oriented firms. These sales include Colfax and Genesee & Wyoming.
Shares of 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. While we feel that demand is strong, consumers seek deals and discounts and are migrating incremental purchases to ecommerce where Dick’s locations and merchandise are not as competitively advantaged. Adding to these pressures has been unseasonably warm weather, resulting in excess inventory. (Michael Baron)
Shares of electric vehicle company Tesla Motors, Inc. fell in the fourth quarter due to skepticism about the sustainability of demand and its ability to meet annual goals. The Model X launch was met with customer enthusiasm, but the ramp seemed slower than initially hoped for. Tesla has successfully executed on two top-of-the-line cars in an impressively short time frame. As it moves down market in its price point, we think operation will be a bigger challenge than demand. We look forward to the expected introduction of Model 3 in the spring of 2016. (Gilad Shany)
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)
CaesarStone Sdot-Yam Ltd. is an Israeli-based manufacturer of engineered quartz surfaces, which are used predominantly for kitchen countertops and bathroom vanities in place of other materials, such as granite and marble. CaesarStone invented the first quartz surface over 25 years ago and today has leading market positions in 42 countries, including the U.S., Australia, Canada and Israel. Quartz countertops represent an exciting growth story, having outgrown the $33 billion global countertop market by four-fold over the last decade, yet is underpenetrated at 10% of the market, vs. granite at 27%. Consumers have favored quartz relative to granite for its superior scratch and stain resistance, variety of design options and comparable price point. We think CaesarStone can double its revenues and expand margins over the next five years, as construction activity rebounds (particularly in the U.S.), quartz penetration increases, and CaesarStone introduces new, higher priced products. Management is making significant investments to expand its manufacturing capacity in anticipation of demand. (David Kirshenbaum)
Portfolio Structure
The objective of the Fund is to double its value per share within five years. Our strategy to accomplish this goal is to invest for the long term in a focused portfolio of appropriately capitalized, well-managed, competitively advantaged, small and mid-cap growth businesses at attractive prices. We attempt to create a portfolio of fewer than 25 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 the businesses in which the 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 December 31, 2015, Baron Focused Growth Fund held 21 investments. The weighted median market capitalization of those small and mid-sized growth companies was $8.2 billion. Compared to its benchmark, the Fund’s investments have higher profitability (as exhibited through greater net margins). They also exhibit better internal returns (return on equity). They are also more conservatively financed (lower debt to market capitalization ratio) and they have more consistent earnings (lower standard deviation of earnings growth and lower beta). We believe these metrics are important to help limit risk for this concentrated portfolio.
The Fund has had less exposure to the Health Care sector than its benchmark index. The Fund recently made its first Health Care investment since mid-2014, by purchasing Inovalon. We believe Inovalon is competitively advantaged by its enormous health care database that would be difficult for others to replicate, proprietary analytics and connectivity with payors and increasingly with providers. We believe this fast growing, profitable business can help improve health outcomes while providing value to providers and payors. The Health Care sector, particularly biotechnology stocks, has been an extremely strong performer during the past few years.
This performance was achieved in our opinion because investors were often speculating on biotech drugs not yet approved and their potential profitability if they did obtain regulatory approvals. We believed such companies were not appropriate investments for the Fund since the risks were too great for a non-diversified portfolio.
Instead, the Fund has invested in businesses with multiple growth opportunities that are not reliant on binary outcomes. Examples include businesses like retirement advisory firm Financial Engines, Inc. The company continues to increase its total assets under contract through winning new large plans and improving enrollments through targeted marketing campaigns and outcomes for clients. Additionally, the company recently announced the pending acquisition of The Mutual Fund Store, which will supplement its growth by opening new client channels and increasing support to existing customers. Another example is Benefitfocus, Inc., a provider of cloud-based benefit software for employers and employees to manage their programs better. The business is only 3% penetrated on its core product and has already released new modules that expand the addressable market and enhance cross-selling capabilities.
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.
Respectfully;
