Baron Asset Fund 1st Quarter Commentary

Review of performance and holdings

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Apr 26, 2016
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During the three-month period ended March 31, 2016, market indexes experienced substantial volatility, dropping approximately 10% through mid-February, and then rebounding to finish the quarter modestly higher. The market downdraft was driven by several factors, including data points signaling a slowdown in the Chinese economy, the continued drop in energy prices, widespread dislocation in the credit markets, and general fears of global political instability. Later in the quarter, oil prices rebounded, credit spreads narrowed, positive data points emerged concerning U.S. employment and housing trends, and the equity markets recovered.

Against this backdrop, investors sought a “flight to safety” early in the quarter. Companies that suffered included those with outsized exposure to China, exposure to commodity end-markets, reliance on credit markets for access capital, or those with leverage on their balance sheet. Defensive areas generally did best, and Utilities was the best-performing sector in the index. Many higher growth stocks fared poorly in this environment, and “value” indexes generally outpaced “growth” indexes during the quarter – this was most pronounced in the mid-cap space, where the Russell Midcap Value Index outperformed the Russell Midcap Growth Index by 334 basis points. Baron Asset Fund (the “Fund”) Retail Shares fell 1.59% and the Institutional Shares fell 1.52%; the Russell Midcap Growth Index (the “Index”) gained 0.58%, and the S&P 500 Index gained 1.35%.

As discussed below, the investments that had the most significant positive impact on performance included Health Care sector companies like Idexx Laboratories, Inc., a veterinary diagnostic firm, West Pharmaceutical Services, Inc., a drug packaging firm, and distributor Henry Schein, Inc. All benefitted by not being directly exposed to the headlines that jolted much of the health care industry during the quarter. These included questions about the sustainability of ever-escalating drug prices, the “true value” that had been created by serial acquirers, such as Valeant Pharmaceuticals International, Inc., renewed talk among presidential candidates of dismantling Obamacare, and the widespread sell-off in many expensive biotechnology stocks. Several Industrial sector companies also gained on encouraging signs that the domestic industrial economy was improving, coupled with the stabilization in energy prices during the quarter. These companies included distributor Fastenal Co., Westinghouse AirbrakeTechnologies Corp., which makes various components for locomotives and railcars, and IDEX Corporation, which makes various fluid and metering technologies.

The worst performers included stocks that were hurt by declining interest rates and more general concerns over the health of credit markets. These included brokerage firm The Charles Schwab Corp. and real estate firm CBRE Group, Inc. Fast-growing technology companies with expensive near-term valuations, including Guidewire Software, Inc. and Mobileye, N.V., sold-off amidst the volatile market environment. DNA sequencing company Illumina, Inc. was swept up in the widespread selloff of biotechnology shares. Finally LinkedIn Corp., the world’s largest online professional network, dropped meaningfully after management offered a weak growth outlook for 2016.

Shares IDEXX Laboratories, Inc. (IDXX, Financial), the leading provider of testing and diagnostics to veterinarians, gained after the company reported healthy financial results. We believe that IDEXX’s business trends are improving and that its competitive position is becoming increasingly unassailable. The company’s placements of new diagnostic instruments in veterinary hospitals grew by almost 50% in its recent quarter. We expect this to be a key driver of future growth because these instruments require the ongoing purchase of high-margin consumables to perform in-clinic tests. In addition, the company’s network of domestic testing laboratories grew at more than twice the rate of its main competitor. We also observed rising productivity of its field salesforce, and a rebound in its rapid assay products. We believe that these trends, coupled with a number of new tests that should emerge from its meaningful research and development effort, will drive increased organic revenue and earnings growth during the next few years.

West Pharmaceutical Services, Inc. (WST, Financial) manufactures components and systems for the packaging and delivery of injectable drugs. West’s shares gained during the quarter after reporting strong financial results and providing solid earnings guidance for 2016. West’s products are frequently “designed in” as part of the regulatory approval process for its clients’ drugs, which makes it quite difficult for West’s products to be displaced throughout a drug’s lifecycle. There is a substantial development pipeline of injectable biologic drugs, and we believe this will allow West to experience double-digit growth rates in its main market for at least the next several years. We also believe that West will benefit from the increased sale of high-margin proprietary products, including newly-developed plastic syringes and wearable injectors for a new generation of high volume, high viscosity drugs. As a result, we believe that company has the potential to double its earnings during the next five years.

Shares of Fastenal Co. (FAST, Financial), a leading distributor of industrial supplies, rose after reporting improving sales trends to start the year. We view the sequential strengthening of the company’s sales as evidence of some abating headwinds its business, notably in its energy-related end-markets. In addition, Fastenal displayed encouraging sales traction, and evidence of ongoing market share gains, in its manufacturing and construction end-markets. Based on several of its internal growth initiatives, including the installation of vending machines at certain customers’ worksites and the placement of full-time Fastenal employees at other customers’ sites, we believe the company is poised to generate accelerating earnings growth during the next several years.

LinkedIn Corp. (LNKD, Financial) is the world’s largest online professional network, with three business segments - Hiring Solutions, Marketing Solutions, and Premium Subscriptions - each serving a different customer base. Despite strong fourth quarter results, its shares dropped dramatically based upon its weak growth outlook for 2016. After reporting several quarters of inconsistent results, we believe management is finding it increasingly difficult to manage the complexity and generate growth across its three segments. We were sufficiently concerned about these results that we chose to exit the position.

Shares of Illumina, Inc. (ILMN, Financial), the leading provider of DNA sequencing technology to academic and commercial laboratories, fell during the quarter. Although Illumina reported solid fourth quarter financial results, management tempered the market’s expectations for sales of its HiSeq X and benchtop instruments during early-2016, and shares reacted negatively. We continue to believe that Illumina has a long runway for growth, driven by the increased adoption of DNA sequencing in large clinical markets, such as those for cancer screening, diagnosis, and treatment.

Shares of brokerage firm The Charles Schwab Corp. (SCHW, Financial) declined as a result of the cyclical challenges to its earnings caused by lower equity market indexes and lower long-term interest rates. Lower equity markets result in lower asset-based fees to Schwab, and lower interest rates result in a lower net interest margin and the prospect of its money market fee waivers persisting for a longer period. Higher equity market volatility also resulted in a decline in trading activity by its clients.

CBRE Group, Inc. (CBG, Financial) is a global commercial real estate (CRE) services company that maintains a leading position in its major businesses segments, including leasing, investment sales, outsourcing, project and development services, advisory services, and CRE investment management. Its shares fell over lingering concerns that capital markets activity may slow dramatically and that the commercial real estate cycle may be nearing a peak. We believe the market’s concerns are overstated and that CBRE’s earnings would be resilient in a more challenged real estate cycle.

Shares of Guidewire Software, Inc. (GWRE, Financial), a property and casualty (P&C) insurance software vendor, fell as high-growth, high-multiple technology stocks sold off aggressively during the quarter. We continue to believe that Guidewire is the leader among P&C core IT systems vendors, as evidenced by near-perfect retention rates, growing installed base, and accelerating adoption of its complete suite. We believe that the P&C industry is in the early stages of a very large replacement cycle of its core systems, and Guidewire should be an important beneficiary of this cycle. We think that the company’s recent deals with six Tier 1 P&C firms are indicative of the demand for its software.

Portfolio Structure

At March 31, 2016, Baron Asset Fund held 57 positions. The Fund’s 10 largest holdings represented 38.5% of assets, and the 20 largest represented 61.6% of assets. The Fund’s largest weighting was the Health Care sector at 24.2% of assets. This sector includes life sciences companies, health care equipment and supplies companies, and health care technology companies. The Fund held 22.0% of its assets in the Information Technology sector, which includes investments in software companies, IT consulting firms, and credit card processors. The Fund held 21.2% of its assets in the Financials sector, which includes investments in insurance companies, investment brokers and specialized finance firms. The Fund also had significant weightings in Industrials at 14.2% of assets and Consumer Discretionary at 12.1% of assets.

Recent Activity

During the past quarter, the Fund established five new positions and added to 12 others. The Fund also sold five positions and reduced its holdings of 23 others.

Vantiv, Inc. (VNTV, Financial) is a leading domestic payment processor. Its core systems enable merchants to accept and process credit and debit card payments. Vantiv operated as a business unit within Fifth Third Bancorp until it was spun off as a separate company in 2009 and went public in 2012. The company is the second-largest merchant acquirer in the U.S. with 19 billion processed transactions across 800,000 merchant locations in 2015. Vantiv’s diverse merchant base is weighted toward non-discretionary everyday spend categories, such as grocery and pharmacy, and it includes ten of the top 25 national retailers by revenue.

Vantiv also provides its merchant clients value-added services, such as solutions to enhance their security standards and solutions that enable the acceptance of cards in e-commerce applications. Vantiv also provides payment services to financial institutions, such as card issuer processing and payment network processing.

Vantiv directly benefits from growth in consumer spending and the secular shift from cash and checks to electronic payments. In 2015, Vantiv earned just $0.07 per transaction across 23 billion transactions without taking consumer credit risk. Vantiv’s integrated technology platform is differentiated from competitors’ multi-platform architectures, and it enables the company to quickly deploy new services while providing significant economies of scale and superior margins. We believe that Vantiv is gaining market share because of its investments in integrated payments technology and higher-growth distribution channels, which should also promote better retention rates and cross-sales of its value-added services.

We believe that a meaningful industry shift toward chip-based, EMV-compliant payment cards should help drive continued strong organic growth. The company generates significant free cash flow, which is being used for accretive acquisitions, share repurchases, and purchases of tax receivable agreements from pre-IPO shareholders that effectively reduce its cash tax rate. We believe that Vantiv enjoys significant competitive advantages from its single technology platform, large entrenched customer base, and unique exposure to the integrated payment market.

In order to manage to an appropriate position size, we reduced our position in long-time holding Vail Resorts, Inc. after the stock’s recent significant appreciation. As discussed, we exited our remaining position in LinkedIn Corp. after the company meaningfully reduced its expectations for growth. We reduced our position in specialty pharmaceutical company Perrigo Co. Plc on general concerns about the durability of their acquisition-driven growth, in light of the high-profile collapse in Valeant Pharmaceuticals International, Inc. We exited our position in MLP Shell Midstream Partners, L.P. in the face of volatile commodity prices and the impact of uncertain credit markets on its business model. We reduced our position in Hyatt Hotels Corp. on concerns about global travel trends.

Outlook

Despite the ongoing stock market volatility, we continue to believe that high-quality, mid-sized growth stocks represent an attractive long-term investment opportunity. The U.S. economy is among the world’s healthiest, cannot guarantee that they will.

Thank you for investing in Baron Asset Fund.

Our entire Firm and our research department, in particular, are committed to justifying your ongoing confidence and support. I remain a significant investor in the Fund alongside you.

Sincerely,

Andrew Peck

Portfolio Manager

April 20, 2016