Dear Baron Small Cap Fund Shareholder:
Performance:
The stock market swung wildly in the first quarter, down dramatically for the first six weeks and recovering almost back to even during the second half of the quarter. Baron Small Cap Fund (the “Fund”) declined 2.75% (Institutional Shares) for the quarter. This compared favorably to the Russell 2000 Growth Index, which declined 4.68%. The Standard & Poor's 500 Index was up 1.35%.
Stock markets around the world fell sharply at the beginning of the year based on a variety of factors, most important being the continued drop in the price of oil (from $40 per barrel to $26 per barrel), fears that the Chinese economy would suffer a hard landing and further devalue its currency and concern that U.S. interest rates would be rising in the face of economic uncertainty.
Though U.S. economic indicators remained firm, the panicky market left participants nervously wondering if weak stock prices foretold a coming recession or financial crisis. What did the market know? When we spoke to our companies, we heard that business was actually solid and on course and the outlook for future growth was fine. This reinforced our confidence and confirmed our belief that, especially these days, the market is not to be trusted and does not know more than fundamental investors who are close to their companies. It’s just a barometer of investor sentiment, which seems to be often out of whack with reality.
Oil bottomed, the dollar declined, high yield bonds recovered, emerging markets turned and U.S. stocks acted strong in the back half of the quarter. The Federal Reserve also waved a cautious flag and set a more patient course on raising interest rates, which was positively received by investors.
Our best performers in the quarter reported positive developments or were in out-of-favor sectors that bounced back.
Shares of Waste Connections Inc. (WCN, Financial), a leading solid waste company focused on secondary markets in the U.S., rose on the announced combination with Progressive Waste Solutions. We see this as a home run deal for shareholders, given the significant immediate synergies, cash flow benefits and foot print expansion that the acquisition brings. More exciting, we think, is the long-term opportunity to instill Waste Connections’ corporate culture, safety, focus and operational excellence in Progressive’s complementary but mismanaged U.S. markets and gain the lead position in major Canadian markets. We expect the larger company to generate significantly more free cash flow per share, which will be used for continued growth and return of capital to shareholders. In our seven years as Waste Connections shareholders, we have made more than three times our money, thanks to our investing with these tremendous operators and savvy deal makers. We believe this deal will be a great triumph.
Gaming and Leisure Properties Inc. (GLPI, Financial), the gaming REIT that was created with the splitup of Penn National Gaming (PENN, Financial), rose in the quarter as the company raised equity and closed its acquisition of Pinnacle Entertainment’s real estate assets. We have previously discussed the merit and accretive nature of the acquisition, but substantial equity was needed to be raised, which was an overhang and hindered the stock’s performance. During the quarter, the stock traded down to almost a 10% yield in the pro forma dividend, only to rise 20% when the deal was priced. GLPI is now the third-largest triple net REIT and trades about an 8% yield. We think that is still too cheap, and the stock is mispriced so we expect further appreciation.
A bunch of our industrial stocks acted better in the quarter and added to our returns. These include Nordson Corp. (NDSN, Financial), a leading manufacturer of adhesive and coating equipment; Cognex Corp. (CGNX, Financial), which sells machine vision equipment; FEI Company (FEIC, Financial), the manufacturer of high-performance microscopes, and RBC Bearings Incorporated (ROLL, Financial), which makes highly engineered precision components and bearings. We have long invested in a group of what we believe are super high-quality industrial businesses all with strong market positions, high margins, lots of recurring revenue and proven management teams. There have been headwinds to these businesses over the last few years – slowing industrial growth, weakening international economies and foreign earnings translations hurt by the strength of the U.S. dollar – and the stocks have drifted while the businesses continued to grow. The stocks traded to lower than normal valuations. Now that the outlook is modestly improving and earnings should be helped by the reversal of the dollar, the stocks are recovering.
The Chef’s Warehouse Inc. (CHEF, Financial), the leading food service distributor to high-end independent restaurants, reported significant improvement in its sales and earnings in the quarter, and the stock responded. Organic growth was 6% and earnings grew 19%. CHEF has done a series of acquisitions of meat distributors and added new management for this division, which is now operating well. We believe the company is poised to resume its plan to consolidate the fine dining distribution business and create a company many times as large as it is now.
Other stocks that rose about 15% or more in the quarter include Party City Holdco Inc. (PRTY, Financial), The Cheesecake Factory Inc. (CAKE, Financial) and Cantel Medical Corp. (CMN).
On Assignment Inc. (ASGN), the second-largest U.S. staffing firm and leader in high-end placements for the IT industry, delivered strong earnings (double-digit organic growth) and guidance, but its stock still fell in the quarter. The shares fell early in the quarter because of the dual fears of a potential economic slowdown and its leveraged balance sheet. We believe temporary staffing trends remain healthy, and IT staffing is the fastest-growing sector because of the velocity of technological change and the shortage of qualified workers so the macro backdrop is still positive. The company took on debt last year to make a large accretive and strategic acquisition and is reducing its leverage with free cash flow generated.
Early in the first quarter any company with over three times leverage got dinged. We think such a blanket market reaction is foolish. In the case of On Assignment, the modicum of debt is appropriate since the business is stable and very cash generative. We expect the company’s business to continue to perform and the stock to return to prior levels as it regains a reasonable multiple that reflects the quality of its business and its growth prospects.
High-growth stocks, which were the darlings of 2015, fell in the first quarter as the market sold winners and multiples contracted. DexCom Inc. (DXCM), which sells continuous glucose monitoring devices for insulin-dependent diabetics, reported another stellar quarter with revenues up 55%, yet the stock declined. We had reduced our position into its runup last year. We retain our conviction that the company’s technology is ground breaking and still in the early stages of adoption in a very large market.
Shares of TransDigm Group Inc. (TDG), the manufacturer of proprietary aircraft parts with a focus on the aftermarket, fell in the quarter as reported earnings missed consensus estimates. TransDigm stock was hurt by trends mentioned above – leveraged companies and high multiple stocks were out of favor. The stock initially traded down over 20%, which was very harsh, but rallied back near prior highs by the end of the quarter. We remain enamored with the business and management and believe the company will continue to grow organically and add value through its use of free cash flow and leverage to make additional acquisitions and/or return capital to shareholders.
Flotek Industries Inc. (FTK) is the supplier of proprietary chemical additives to oil and gas drillers that dramatically increase well productivity. U.S. drilling activity fell 75% in the first quarter as oil prices fell to under $30 per barrel. The company’s data on improvements has also been questioned, which continues to weigh on the stock. Our due diligence leads us to believe that the CNF product is very effective, and we believe in the company’s long-term value proposition. Our other energy holdings were down in the quarter as well but acted better as commodity prices improved.
Portfolio Structure
As of March 31, the Fund had $3.6 billion under management. There were 72 stocks in the Fund, as we continued our stated plan to reduce the number of positions held, which we believe will help enhance performance. We are probably now close to what we think is an optimal number. The top 10 stocks in the portfolio make up 35.5% of the Fund’s assets.
The Fund’s largest exposures are Information Technology, Consumer Discretionary, Health Care and Industrials, all with relatively equal weightings. Compared to the Russell 2000 Growth Index, we are underweight in Health Care and Information Technology, relatively equal in Consumer Discretionary and overweight in Industrials. Our portfolio is created from the “bottom up” meaning the outcome of our individual stock picks. We do not consider the benchmark in making and holding our investments. We seek to own a diversified set of high quality, well managed, small growth businesses across industries and be long-term investors in these companies. We do not try to rotate into what we believe will be hot sectors, nor buy lower quality companies because we suspect they will be in vogue.
The median market cap of the Fund is $2.5 billion. This is higher than that of the Index to which we are compared because of our time-tested and often articulated approach of buying companies when they are small but holding on to our “winners” as the companies blossom and prosper.
Though we own growth businesses that often trade at high multiples (always deserved in our mind), we are valuation conscious in our holdings. We shy away from very high multiple stocks and businesses that are not yet profitable or that we deem speculative. We prefer to buy into businesses after they are “baked,” meaning we believe that the company and management are already well established, that their market positions and competitive advantages are already entrenched, and we can reasonably foresee the path to growth and value creation because of trends that are already in place. Not many companies have these characteristics. They are very hard for businesses to create. Our research effort is trained to look far and wide to identify companies that fit these high standards and, once owned, to monitor holdings to confirm the conditions that cause us to invest, continue going forward.
During the quarter, the Fund established three new positions and added to 13 others. We sold out of 10 positions and trimmed many others.
Wingstop Inc. (WING) and Habit Restaurants Inc. (HABT) are new positions in the Fund. We have a long history of investing early on in fast-growing restaurant companies that are innovative, differentiated and offer the potential to grow units and profitability for many years. We believe these two restaurant chains fit that description. Both are fast casual chains, very much on trend with increasing consumer demand for fresh, made-to-order, quality quick service food as an alternative to casual dining or old school fast food operators. We actually seek to invest in these restaurant brands, not trade their stocks based on data points, which seems now to be most prevalent.
Wingstop is the franchisor and owner of Wingstop Restaurants. The chain has established itself as the leader in the QSR wings segment, just as wings have become popular as a meal in themselves. The business was started in Texas in 1994 and has since grown to over 850 locations across the country. The company came public last year, and the stock spiked up. We bought our position this quarter after the stock had declined to what we believe was a good entry point.
Wingstop is an asset-light growth company, uniquely positioned as the owner of an emerging national brand that will be developed in a nearly all franchised fashion. We think this will deliver high earnings growth and generate significant free cash flow since it will require limited corporate capital. Wingstop franchisees earn sensational development returns because of the low costs to build the stores, high unit volumes and great margins they generate since the limited menu is easy to operate and because stores are often developed in existing secondary sites with cheaper rents.
We think Wingstop can triple its current restaurant chain in the U.S. and augment growth with international expansion in time. This leads to double-digit earnings growth for over a decade. And that’s quite a statement! Comp store sales have averaged over 10% per year over the last three years, which is very impressive, although we expect that to slow.
Wingstop’s equity value is about $700 million now, and we expect the company to return about 15% of that to shareholders via a special dividend later this year. We believe cash flow will grow from under $30 million in 2015 to over $120 million in eight years. Applying what we consider an appropriate multiple, we think we can make four times on our investment over that time frame.
Habit Restaurants is the owner-operator of the Habit Burger Grille chain of fast-casual burger-centric restaurants. Like Wingstop, Habit was a high flyer IPO from 2014 that we have been tracking and made our investment after the stock sold off over short-term concerns about an increased promotional environment and upcoming minimum wage increases. We believe Habit will be able to navigate these issues, and we are excited to invest in this high growth, differentiated chain at a reasonable multiple.
Habit is a “better burger” chain that was started in California in 1969. Habit offers great quality food (voted Best Burger by Consumer Reports in 2014) at low prices in upscale stores with exceptional service. New management, who joined from The Cheesecake Factory, took over last decade and has dramatically expanded the restaurant base from 17 to 142 stores, growing at 35% per year over the last five years. It has posted 43 consecutive quarters of positive same-store sales. We believe the long-term potential for the chain is over 2,000 units so the opportunity is huge. Unit economics are highly attractive; the current business model generates $1.7 million in sales per unit, does 22% store level margins and generates cash on cash returns of over 45% – industry leading metrics. The majority of Habit Restaurants are in California, but new units have opened to great success in the Southwest and on the East Coast, which bodes well for national expansion. We believe the company will grow its profits rapidly and now trades at about 11 times our estimate of next year’s EBITDA. We expect earnings to grow at 25% plus for years, and the stock multiple to expand, which we believe could lead to great returns for shareholders.
During the quarter, we sold out of 10 stocks. Long-time holding ITC Holdings Corp. (ITC) was acquired by a Canadian utility at a nice premium. We sold some stocks (Builders FirstSource Inc. [BLDR], Platform Specialty Products Corp. [PAH], Iconix Brand Group Inc. [ICON]) because we deemed them too highly leveraged for the current uncertain economic and financing environment. We reduced our energy exposure by selling out of Core Laboratories N.V. (CLB) and MLPs Columbia Pipeline Partners LP (CPPL) and Western Refining Logistics, LP (WNRL).
We trimmed our holdings of some of our higher market cap stocks as they performed well – Equinix Inc. (EQIX), Acuity Brands Inc. (AYI) and Berry Plastics Group Inc. (BERY). This is in keeping with our mandate to maintain the overall small-cap nature of the Fund.
Outlook
The market has recovered as the causes for despair have dissipated. Oil and commodity prices have firmed, the dollar has declined, China has not suffered a hard landing, and the Federal Reserve has delayed increasing rates. Though the U.S. GDP is expected to grow only about 1% in the first quarter, we expect growth to pick up, and we view the U.S. economy as relatively healthy. Global growth appears to be improving aided by the monetary easing that has been going on for the last year.
Stocks have rebounded from being cheap in the middle of the quarter to being reasonably valued now. We are heartened by the market action of the quarter, which was led by quality companies and oversold stocks at the expense of highly valued momentum stocks (which is not our gig). As we enter earnings season, we believe that particular results of individual companies will be most important to future price action.
A new concern that has our attention is the increase in wages as more companies warn that it is hard to find qualified employees without paying up and more states pass increases in minimum wages. Unlike many others, we do not believe that gains in profit margins are in jeopardy. We see earnings tailwinds from the decline on the dollar and hope the new exchange rates hold because this would reverse negative impacts many of our investments have suffered the last couple of years.
Many commentators rail against “financial engineering” as the primary reason for earnings growth. We are not seeing that in our holdings. We have many companies that are supplementing organic growth with spending excess capital on accretive acquisitions, share repurchase and/or dividend payments, all of which enhance shareholder return. With our holdings, this is always gravy since we mostly own special companies that have shown that they can grow organically at attractive rates even in the slow growth periods.
Thank you, my fellow shareholders, for your investment in the Fund and faith in us as your managers. We think our approach of investing for the long term in what we consider exceptional, small growth businesses is a well-positioned strategy. I can still recall a moment at the depths of the market correction in February when other portfolio managers implored each other to “stay the course.” We have the benefit of a proven long-term record to give us the confidence to do just that.
