Baron Focused Growth Fund’s (the “Fund”) performance modestly exceeded that of its benchmark in the first quarter of 2016. This is although its per share value at the end of the period was slightly lower than its value at December 31, 2015. The Fund decreased in value by 0.83% (Institutional Shares) during this quarter while the Russell 2500 Growth Index, the benchmark against which we compare the performance of the Fund, declined 2.66%. The S&P 500 Index, which measures the performance of large cap companies, increased by 1.35%. The Morningstar US OE Mid-Cap Growth Average, measuring the performance of all U.S. open end, mid cap growth funds fell by 1.84% for the three months ending March 31, 2016.
The market experienced significant volatility during the period. Concerns about tightening credit, slowing global growth and the possibility of energy prices declining further created a three week “flash crash” in January. Investors’ angst did not match reality though. Improving domestic job growth along with modest wage improvements, stabilizing oil prices and a Federal Reserve that suggested delaying future interest rate increases led to a “flash recovery” in the second half of the quarter. If you had not paid close attention to the markets during the three month period, from its start to finish, it would appear to have been an uneventful quarter. For those who witnessed the daily market volatility, I can assure you, it was anything but pedestrian.
While the volatility may concern many, we believe this environment is favorable for long-term growth-oriented investors like us with high “active share,” i.e., who invest differently than indexes. We believe this bodes well for Baron Focused Growth Fund. While external factors will inevitably affect businesses in which the Fund has invested, we limit investments in cyclical companies dependent on factors we feel are unpredictable such as interest rates, commodity prices and currency fluctuations. Stocks that have fallen due to sector rotation or “risk off” trading often allow us to invest in attractive companies at favorable prices. Financial services companies are one such example. With global economic slowdown concerns and uncertainty over interest rates, many financial firms saw their stock price fall more than 50% in 2015. Baron Focused Growth Fund, however, now has a significant overweighting in this sector compared to its benchmark index. Companies like Carlyle Group have fallen due to short-term performance issues at select minor products. We believe Carlyle has strong growth prospects due to its significant distribution capabilities and historical reliable product performance. The stock recovered considerably in the period as these issues were not systemic and did not meaningfully impact fund raising efforts. The Fund also has substantial holdings in financial sector companies FactSet Research, Arch Capital and Financial Engines. We believe these businesses offer superior products at competitive price compared to incumbent competitors. FactSet Research, for example, continues to add clients due to its intuitive interface, deep capabilities and favorable pricing, while still producing enviable margins due to its scalable platform. We believe FactSet will continue to take share in the substantial investment research and analytics industries.
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 Vail Resorts, Inc. (MTN, Financial), an operator of ski resorts in the U.S. and Australia, increased in Q1 on strong earnings increases. Good ski conditions drove visitation and increased spend at its resorts. This led to improved cash flow, which the company used to improve its industry-leading balance sheet as well as to increase its dividend by 30%. This robust growth led to an increase in season pass sales. Pricing for next ski season improved mid-single digits over the prior year. (David Baron)
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)
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 sold off. 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)
The stock price of CaesarStone Sdot-Yam Ltd. (CSTE, Financial) detracted from performance during the first quarter. CaesarStone is a leading global manufacturer of quartz surfaces for kitchens and bathrooms. The stock price fell over concerns that a recently constructed manufacturing facility was taking longer than expected to ramp up production. We remain positive on our investment in CaesarStone, as earnings growth continues to accelerate from successful new product launches and quartz market share gains vs. other countertop materials, such as granite and marble. (David Kirshenbaum)
In the quarter, we increased our investments in Hyatt since we believe the favorable lodging cycle will not likely end soon. Macro-economic worries had led to its stock trading near its historical trough multiple. We continue to believe Hyatt will benefit from its strong pipeline of hotels and industry-leading balance sheet, which should give the company the ability to weather any downturn. Hyatt’s brands remain strong and it continues to enter new markets and take share from its competitors, which should lead to further margin expansion and cash flow growth. The company continues to repurchase its stock. (David Baron)
The Fund added to its position in Inovalon Holdings, Inc. (INOV, Financial), a health care data and analytics company in the period. 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)
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 objective of the Fund is to double its value per share within five years, and double it again the following five years although we cannot guarantee this. Our strategy to accomplish this goal is to invest for the long term in a focused portfolio of appropriately capitalized, well-managed, small and mid-cap businesses at attractive prices. We attempt to create a portfolio of less than thirty 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 well-managed businesses in which the Fund has invested have sustainable competitive advantages and strong, long-term growth opportunities. Considering current stock price valuations, we believe we have an opportunity to meet our performance goals during the next decade, although there is no guarantee that we will do so.
As of March 31, 2016, the Fund held 20 investments, a decrease from 21 at the end of 2015. The weighted average market capitalization of those small and mid-sized growth companies was $8.3 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). And they are more conservatively financed (lower debt to market capitalization ratio) and more consistent (lower standard deviation of earnings growth and lower beta). While not purposefully setting out to achieve a portfolio with these characteristics, it is our investment criteria and research process that have produced such a portfolio. We find these metrics important in limiting risk for a non-diversified portfolio and believe Baron Focused Growth Fund has potential to outperform comparable benchmarks over an extended period.
The market volatility in the quarter gave the Fund an opportunity to increase its investments at favorable prices in companies with unique products and defensible niches. The Fund increased its investments in Hyatt Hotels, Inovalon, Tesla Motors, CaesarStone and Virtu Financial, Inc.
Hyatt’s stock price had declined on concerns regarding a potential recession’s impact on pricing and occupancy. Hyatt is a well-capitalized and has the ability to grow its room base while not facing additional supply issues in its key markets.
The health care data and analytics company, Inovolan, had been under pressure due to concerns regarding consolidation at the payer end markets. However, we believe the company is expanding its reach beyond health care payers to the provider and post-acute care markets through partnerships with Quest and Kindred. The company’s valuable analytics and insights should improve health care outcomes throughout multiple channels. Inovalon is in its early stages of market penetration.
CaeserStone’s stock price had been weak due to concerns that a new manufacturing facility will take slightly longer to ramp up production. While disappointed with the temporary delay, we believe the company’s superior product, non-porous material that is scratch, stain and heat resistant, will continue to gain share in new home construction and remodeling.
Finally, we increased our investment in Tesla when the company’s share price was weak. Traders speculated that the company would delay its mass market model 3 priced vehicle introduction and/or demand would not be robust. We believed the company’s “S” and “X” vehicles provided the cumulative knowledge and scale to execute a car with mass appeal. After its introduction on March 31, the company received about 400,000 orders with $1,000 deposit for a car that will not be available for almost two years! We regard these results as astonishing! The stock has subsequently rallied, and we believe it has substantial potential given the size of the global market and its superior technology that others cannot quickly duplicate.
Thank you for investing in Baron Focused Growth Fund.
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,
Ronald Baron
CEO and Portfolio Manager
April 20, 2016
The discussions of the companies herein are not intended as advice to any person regarding the advisability of investing in any particular security. The views expressed in this report reflect those of the respective portfolio managers only through the end of the period stated in this report. The portfolio manager’s views are not intended as recommendations or investment advice to any person reading this report and are subject to change at any time based on market and other conditions and Baron has no obligation to update them.
