Dear Baron Partners Fund Shareholder:
During the three-month period ended March 31, 2016, Baron Partners Fund (the “Fund”) declined 2.66% (Institutional Shares). The Russell Midcap Growth Index, the benchmark against which we compare the performance of this Fund, increased 0.58%. The S&P 500 Index, which measures the performance of large cap companies, rose 1.35%.
Over the long term, the Fund has outperformed its benchmark on average by 1.67% per year annualized since its conversion from a partnership to a mutual fund on April 30, 2003, and by 3.11% per year annualized since its inception on January 31, 1992. When Baron Partners Fund is compared to the 38 funds currently in the Morningstar Mid-Cap Growth Category since the Fund’s inception in 1992, Baron Partners Fund would be the #1 performing fund in that category
We provide the information in Table I above to comply with FINRA and SEC performance advertising rules. Regardless, we believe the over 24 years since the Fund’s inception divided into the four periods described in Table II below are more relevant in depicting 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. We try to describe these four periods in the following paragraphs.
We refer to the period from the Fund’s inception on January 31, 1992 to December 31, 1999 as “Yesterday.” This period included the “Internet bubble.” The Fund (Retail Shares) outperformed its benchmark by 3.19% per year annualized during this period.
We call the period from December 31, 1999 to December 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. During this period, the Fund (Retail Shares), unlike the market, had positive returns and outperformed its benchmark by 6.23% per year annualized.
We call the period from December 31, 2008 to December 31, 2015 the “Here Comes the Sun” years. The most important development during this period was an economic recovery driven by the Federal Reserve’s “quantitative easing.” The Fund (Retail Shares) trailed its benchmark by 1.44% per year annualized during this period but outperformed the large-cap S&P 500 index by 1.79% per year annualized. The Fund earned annualized returns of 16.60% Although the Fund underperformed in the first quarter, the Fund’s consistent long-term approach of investing in what we believe are high quality, competitively advantaged, mid-cap growth businesses run by exceptional managers has generated substantial excess returns since inception, the period we call “Any Time at All.” We think we can continue to achieve substantial excess returns per year, on average, though there can obviously be no guarantee we can achieve our goals.
Despite weak economies abroad, 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 25 basis point increase in December and we believe rates are likely to remain low for the foreseeable future. Given this backdrop, in our opinion, stocks remain attractively valued, trading at 16.6 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.
Dick’s Sporting Goods, Inc. (DKS, Financial) is the country’s largest sporting goods retailer. After a major competitor revealed it was filing for bankruptcy and closing a third of its stores, shares of Dick’s increased on expectations that the competitor’s exit will result in increased sales at Dick’s. While the space is facing increased competition from e-commerce sellers, we think Dick’s is better positioned among traditional sporting goods retailers as an omni-channel retailer, and is improving the management of its online channel. (Michael Baron)
Shares of global hotelier Hyatt Hotels Corp. (H, Financial) increased in the first quarter on revenue per available room (RevPAR) and margins that beat analyst predictions and 2016 RevPAR guidance of 3–5%. The company continues to generate strong free cash flow that it is using to buy back its stock and invest in its hotels. In our opinion, Hyatt still has one of the strongest balance sheets in the industry. We think it will continue to buy strategic assets as they become available. We also think Hyatt is well-positioned to weather a downturn. (David Baron)
Shares of Fastenal Co., (FAST, Financial) a leading distributor of industrial supplies, rose during the first quarter after reporting improving sales trends to start the year. We view the sequential strengthening of sales as evidence of abating energy and F/X headwinds as well as share gains in manufacturing and construction end markets. Based on several growth initiatives, including Vending and On-Site programs, we believe Fastenal is poised to deliver outstanding customer service to its key accounts and generate accelerating earnings growth over the next two years. (Matt Weiss)
Shares of The Charles Schwab Corp., (SCHW, Financial) an investment brokerage firm, declined in the first quarter due to the extreme downward pressure on the equity markets to start the year as a result of signs of a slowing Chinese economy and falling energy prices. Higher market volatility led to a decline in trading activity. Finally, shares were pressured by investor concerns that interest rate hikes will be paused (or reversed), causing net interest margins to remain low and money market fee waivers to persist. We believe Schwab will continue to experience growth in accounts as brokers leave traditional wirehouses. (Michael Baron)
Manchester United plc (MANU, Financial) is an English Premier League professional sports team that generates revenue from broadcasting, sponsorship, and licensing. Shares declined in the first quarter over concerns that Manchester United will not qualify for the Champions League next season. We believe the team still has a chance to qualify, and even if it does not, the financial impact will be modest. We expect the company to continue to benefit from future sponsorship deals, the roll-out of new merchandise agreements, and a new digital offering under development. (Ashim Mehra)
Shares of CoStar Group, Inc., (CSGP, Financial) a real estate data and marketing services company, fell in the first quarter as high-growth, high-multiple technology stocks declined. The company reported financial results that were ahead of Street expectations, particularly on margin expansion. Bookings growth was strong. We believe that CoStar has potential to generate accelerating organic revenue growth and significant margin expansion as it leverages the multifamily marketing investments it has made over the last 18 months. (Neal Rosenberg)
Marketplace. The company also owns and operates Street Easy, the leading real estate site for New York City and the Hamptons. Zillow continues to invest in its brand as the leader in the $11 billion real estate advertising market. With the acquisition and integration of Trulia behind the company, Zillow is seeing the benefits of accelerated product development in consumer engagement. We expect that introduction and roll-out of these new products will aid Zillow by accelerating revenue growth while continuing to provide agent customers with compelling return on investment. Given that Zillow captures less than 5% of the $11 billion that real estate professionals spend on marketing each year, we believe there is ample room for future growth. (Ashim Mehra)
We had an opportunity to add to our investment in Tesla Motors, Inc. (TSLA, Financial) earlier this year. We had never previously invested in a car manufacturer. Tesla is not a traditional car manufacturer. We think that the Model 3 launch that occurred several weeks ago can show you why. On the last day of the quarter, Tesla launched Model 3, a car intended to bring the EV promise to the mass market. Its starting price is $35,000. One of our analysts attended the event and returned eager to own one. During the first week, Tesla received 325,000 orders for this car with no sales and marketing efforts. The number now is closer to 400,000 (or $18 billion of order backlog). This is equivalent to 24 million people around the world ordering an iPhone they will get in two years and never had an opportunity to see first hand. This is the biggest product launch in history. It is rare to find a company that is transforming the face of a large industry and Tesla is doing just that, taking the car industry into the 21st century, making cars better, safer and cheaper all at once. (Gilad Shany)
The Fund added to its position in Inovalon Holdings, Inc. (INOV, Financial), a health care data and analytics company. The foundation of the company is a proprietary data set which contains more than 9.2 billion medical events from 130 million unique patients. This data powers Inovalon’s advanced analytics, which help insurers identify gaps in care, quality, data integrity and financial performance. Clients leverage Inovalon’s intervention platforms to drive improvement in clinical and quality outcomes, utilization, and financial performance across the health care landscape.
Inovalon serves a vast addressable market. The company addresses a $14 billion annual opportunity, and we believe that logical adjacencies can increase the total addressable market by 3–4 times. We are particularly excited by a new relationship with Quest Diagnostics, which can bring Inovalon’s analytics to the commercial market. Secular drivers, particularly the need to reduce inexorable health care cost inflation and a shift to value based from consumption based health care, will help to sustain Inovalon’s growth. (Neal Rosenberg)
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 added to current holdings Zillow Group, Inc., Tesla Motors, Inc., Inovalon Holdings, Inc., Douglas Emmett, Inc., and Benefitfocus, 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 may use 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 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 four years, we expect to benefit from these expenditures. In contrast, most mid-cap, growth company mutual funds are trading oriented, turning over their entire portfolios on average every 19 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., 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.
Portfolio Structure
The portfolio is currently invested in 27 businesses, principally in mid-cap companies. As of March 31, 2016, the weighted average market capitalization of its portfolio investments was $11.2 billion, compared with $13.5 billion for the Russell Midcap Growth Index. The Fund currently has significantly larger investments in the Consumer Discretionary, Financials, and Information Technology sectors than the benchmark. The Fund’s investments in Industrials and Health Care sectors are weighted less than the index. The Fund does not have investments in Consumer Staples, Energy, Materials, Telecommunication Services, or Utilities. 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.
We are continuing to work hard to justify your confidence and trust in our stewardship of your family’s hard-earned savings. We also remain dedicated to continuing to provide you with the information I would like to have if our roles were reversed. This is so you will be able to make an informed decision about whether this Fund remains an appropriate investment for you and your family.
