Dear Baron Growth Fund Shareholder:
U.S. stock markets experienced heightened volatility to start the year. The Russell 2000 Growth Index recorded 21 days during the first quarter of 2016 when markets changed more than 2.5% in a day. This compares to a total of just 16 days when markets changed more than 2.5% during all of 2015!
Further, during the first quarter, stocks experienced a “flash crash” – in which small cap indexes declined almost 20% peak to trough – followed by a “flash recovery” as signs emerged the U.S. economy was in better shape than many feared. Against this backdrop, Baron Growth Fund (the “Fund”) increased in value 0.31% (Institutional Shares), significantly outperforming the Russell 2000 Growth Index, the small-cap benchmark against which we compare the Fund. That index declined by 4.68% during the period.
Over the long term, Baron Growth Fund has significantly outperformed its benchmark. Baron Growth Fund’s performance exceeded that of the Russell 2000 Growth index by, on average, 5.7% per year since its inception on Dec. 31, 1994. Please see Table I. It has accomplished this with less “risk” than the market. We define “risk” as beta, a measure of the Fund’s volatility in comparison to the market. The Fund’s beta has been 0.68, on average, over 21 years. This means the Fund has been 68% as volatile as its benchmark. Please see Table III. Due to Baron Growth Fund’s unusually low volatility and strong relative and absolute performance, the Fund has achieved 7.3% annual “alpha” since its inception. Alpha is a measure of performance on a risk-adjusted basis.
When compared to the 52 funds currently in Morningstar’s Small Growth Category for the over 21 years since its inception, Baron Growth Fund ranks as the No. 1 performing fund in that category. Although Baron Growth Fund purchases only small-cap growth companies, since the Fund holds its investments on average for 12 years because many of its companies continue to have favorable growth prospects, approximately 60% of Baron Growth Fund’s holdings have grown to become midcap stocks.
As a result, in 2011 Morningstar reclassified Baron Growth Fund as a midcap growth fund. Since Baron Growth Fund only purchases small-cap companies, we strongly disagreed with that characterization and have made that point to Morningstar on numerous occasions. On one of those occasions, I told a senior Morningstar executive who had a large part in developing its nine style “boxes” system that we had considered having somewhat higher turnover to remain compliant with its categorization of Baron Growth Fund as a small-cap growth fund. “Ron, it would break my heart if you changed the way you invest because of us.”
We haven’t changed the way we invest since inception and have no intention to do so. We now advise investors and my friends that, if they want to invest in small companies that remain small, they should buy a small-cap index. This is because whenever a component company in that index becomes successful it is sold so that the index will remain invested only in small companies. If my friends instead want to buy a fund that invests only in small companies, sell the companies that are not successful and keep the ones that are successful for an average of 12 years, I advise them to invest in Baron Growth Fund or Baron Small Cap Fund.
Oh, by the way. Baron Growth Fund is in the top 6% of midcap growth funds for the past 21 years that are ranked by Morningstar. Not the No. 1 ranking to which we believe we are entitled as a small-cap growth fund. But obviously pretty good, nevertheless.
Please see the Chart below titled “Baron Growth Fund Historical Weighted Average Market Capitalization vs. Morningstar Breakpoints” which shows Baron Growth Fund’s portfolio has a weighted market cap just above the Morningstar’s small-cap break point and is only about 25% as large as the Morningstar midcap break point of almost $18 billion!
We hope to continue to meet our objective of doubling the per share value of Baron Growth Fund every five or six years. Of course, we cannot assure you that we will achieve this goal.
We provide the information in Performance Table I to comply with FINRA and SEC performance advertising rules. However, we believe it is more relevant to divide the over 21 years since Baron Growth Fund’s inception on Dec. 31, 1994 into four periods. This is to more accurately depict how the Fund has performed during periods of euphoria and stress. Such periods have generally resulted from political and economic events that, we believe, could not be predicted. Please see Performance Table
The three months ended March 31 are the beginning of what we call “Helter Skelter,” a period that includes the initiation of a Fed “tightening.”
The period from the depths of the 2007-08 financial crisis through Dec. 31, 2015 is what we call “Here Comes the Sun” years. Baron Growth Fund earned annualized returns of 15.32%, for the seven years, 171.17% appreciation in total. During this time of easy money and low-cost credit, stock prices were highly correlated. Further, highly leveraged, cyclical businesses, often with modest earnings, often outperformed businesses with favorable noncyclical growth prospects. Baron Growth Fund was in the 51st percentile during this period and trailed its benchmark by 1.01% per year annualized after all fees and expenses. Since the Fund was less volatile than its benchmark, it achieved 2.41% “alpha,” excess return relative to risk assumed during the period. The most important development during this period was an economic recovery driven by the Federal Reserve’s “quantitative easing” monetary policy.
We call the period from Dec. 31, 1999 through Dec. 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. If you were unlucky enough to purchase Baron Growth Fund at the worst possible time in our nation’s modern financial history before the Internet bubble burst in December 1999 and sell at the bottom of the market nine years later, December 2008, the worst possible time to sell, you would have earned 24.48%, or 2.46% per year annualized.
However, if instead you had invested in a passive index fund or an ETF that performed similarly to the Fund’s benchmark index, you would have lost 35.24% of your money during the period, a decline of 4.71% per year annualized! This represents a 7.17% per year excess return for Baron Growth Fund compared to a passive index investment! We think this is a pretty strong argument for an active manager who bases long-term investment decisions on company fundamentals and not whether they are in an index.
We refer to the period from Baron Growth Fund’s inception on Dec. 31, 1994 through Dec. 31, 1999 as “Yesterday.” This period included the “Internet bubble.” Baron Growth Fund outperformed the Russell 2000 Growth Index by 10.91% per year annualized during the period, despite owning virtually no Internet or technology stocks.
For many reasons, we believe stock prices are likely to be less correlated in the near future than they were in the recent past. In such environments, based on Baron Growth Fund’s present portfolio, as well as due to our consistently growing staff of 33 Baron research analysts and portfolio managers (three more research analysts will start this summer), we think Baron Growth Fund will continue to achieve strong relative performance although there is no guarantee that this will be the case. Please see Table II to study Baron Growth Fund’s relative and absolute performance during the four distinct periods during Baron Growth Fund’s more than 21-year history.
Much of the first quarter’s price volatility, we believe, can be attributed to the Energy sector. The price of crude bottomed in February at $26 per barrel, a nearly 80% decline from its June 2014 peak of $115. As a result of the collapse in oil prices and other commodities, energy company earnings have declined from the September 2008 high of $19.70 per share to $14.21 per share in December 2015. Energy capital expenditures, already significantly reduced, are forecasted to decline about 25% to 30% year over year in 2016, bringing the total decline since the peak in 2014 to nearly 50%.
As a result, share prices of energy-related businesses have fallen dramatically. Persistent low oil prices have also affected adjacent industries, including many industrial and manufacturing businesses that supply and service energy end markets. In other words, we are experiencing a most unusual energy crisis caused not by high prices but by low ones. Baron Growth Fund owns no energy stocks and has underinvested in cyclical industrial-related businesses for some time.
While we believe low oil prices may constrain economic growth in the short term, we expect lower energy prices to deliver a substantial boost to the economy over the long term, as capital previously allocated to pay for energy is redeployed. We also think oil prices have begun to stabilize, evidenced by crude’s recent rally to $40 per barrel. This is because many energy businesses are not profitable at these prices and, as a result, are reducing production (i.e., supply). Additionally, signs are increasing that suggest weakness in manufacturing and industrial sectors is starting to fade.
Overall, we think the U.S. economy is doing well. Jobless claims continue to fall while wages increase moderately. Low fuel prices are providing consumers with the equivalent of a tax cut. Interest rates remain low, and we do not expect the Federal Reserve to raise them significantly any time soon.
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 one-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 ecommerce sellers, we think Dick’s is better positioned among traditional sporting goods retailers as an omnichannel retailer and is improving the management of its online channel. (Michael Baron)
Shares of Under Armour Inc. (UA, Financial), a manufacturer and distributor of sports apparel and footwear, performed well in the first quarter on strong financial results that exceeded Street expectations, including topline growth of 29%, despite indications of a difficult Christmas period due to warm weather and low consumer confidence. Growth was led by newer categories, including footwear, international and direct-to-consumer sales. Men’s and Youth categories remained strong while Women’s appears to be resonating better with buyers. (Michael Baron)
Shares of Marriott Vacations Worldwide Corp. (VAC, Financial), an operator, developer and seller of timeshare resorts, increased in the first quarter as timeshare sales for the fourth quarter exceeded analyst estimates. The uptick in sales boosted cash flow, which management used to accelerate the buyback of its stock. The company’s forecasted increase of 4% to 8% in timeshare sales for 2016 due to the opening of six new sales centers also beat industry estimates. (David 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 rollout 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)
Shares of ConforMIS Inc. (CFMS, Financial) detracted from performance in the first quarter. ConforMIS makes custom knee implants for joint replacement procedures. The company’s revenue guidance for 2016 missed Street forecasts due to continued disruption related to an August 2015 product recall. In addition, a short report claimed ConforMIS’s products have design defects and a high adverse event rate. We disagree with the short report and continue to believe the company can capture meaningful share of a large addressable market over time. (Neal Kaufman)
Portfolio holdings
Due to Baron Growth Fund’s long-term, low-turnover approach, the Fund often holds a significant percentage of its assets in securities that have appreciated beyond their market capitalizations at the time of the Fund’s initial investment. The Fund’s three-year average turnover is 8.53%, which means we hold investments on average for almost 12 years.
This is very different than other funds in our peer group that turn over portfolios on average every 19 months. Instead, we often hold these securities after they have doubled or tripled if their growth prospects and competitive advantages remain strong. For new investments, we continue to exclusively purchase small capitalization companies that we think can double in size in five years and then still become much larger.
Most investments that have been held for more than five years have realized approximately threefold to fivefold appreciation so far. Six have achieved returns of seven to 14 times since their initial date of purchase. As a result of owning stocks that have generated outsized returns over a longer holding period, the market caps of approximately 60% of the Fund are above Morningstar’s breakpoint classification of small-cap stocks. Over the last five years, Baron Growth Fund’s weighted average market cap has moved in line with the Morningstar Small Cap Breakpoint of $3.5 billion to $4.0 billion and remains far below the highest market capitalization limit for mid cap stocks of $18 billion.
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 that 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 it three to four times. We are excited by a new relationship with Quest Diagnostics (DGX, Financial), 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)
AO World PLC (AO., Financial) is the leading online seller of major domestic appliances (MDA) in the U.K. The company is benefiting from the growth in online purchasing, where it has more than 30% market share in the online MDA category and approximately 15% of the offline MDA category. AO’s competitive advantages arise from its best-in-class customer service, differentiated editorial and video content which make for easier purchase decisions by consumers and a proprietary supply chain. The company continues to expand rapidly in its core U.K. market while making significant progress in Germany, a new market for the company that is twice as large as the U.K’s. We believe that the company has a substantial runway of growth with plans to enter several more countries in Europe over the next few years. While AO estimates the U.K. MDA market to be $4.5 billion, the broader European markets including Germany are more than five times larger than the U.K. and represent a substantial opportunity for growth. (Ashim Mehra)
We began to invest in Littelfuse Inc. (LFUS, Financial), the world leader in circuit protection products, during the quarter. The company’s fuses, power control and sensing products are present in virtually every market that uses electrical energy, from consumer electronics to automobiles to industrial equipment, and are critical components of the electrical systems in those devices. With a trend toward the “electrification of everything,” we expect Littelfuse to continue to grow in excess of its end markets. Littelfuse has 50% global market share in automotive fuses, and we expect continued content penetration to drive growth in that segment, with one driver being the adoption of electric vehicles. Littelfuse is in the middle of a five-year plan to double the company through both organic and acquisition-driven sales growth and margin expansion. We expect Littelfuse to continue to deliver on its strategic plan and generate substantial value for shareholders. (Rebecca Ellin)
Portfolio structure and strategy
Baron Growth Fund is different than most small-cap growth funds. The Fund’s objective is to outperform its benchmark index over the long term by investing in businesses seeking to grow significantly faster than the economy and the market. To accomplish this, we look for businesses that we believe have significant opportunities for growth, sustainable competitive advantages, exceptional managements and attractive valuations. These growth-oriented companies often accomplish their objectives by investing in their businesses and penalizing their profits in the short term. As they build competitive advantages and address their growth opportunities, the lower-than-normalized profitability of many of these companies often depresses their share prices in the short term. It is also what gives Baron Growth Fund a chance to make investments in those businesses at prices that we believe do not reflect their long-term profit prospects.
As of March 31, Baron Growth Fund held 63 investments. The top 10 holdings comprised 37.8% of the Fund’s net assets. All these investments have been successful and were purchased when they were smaller. We believe they all offer significant further appreciation potential although we cannot guarantee that will be the case. The median market capitalization for Baron Growth Fund’s entire portfolio is just over $3 billion. We believe the Fund’s diversified portfolio offers investors potentially better-than-market returns with less “risk” than the market.
Thank you for joining us as fellow shareholders in Baron Growth Fund. We believe the growth prospects for the businesses in which Baron Growth Fund has invested continue to be favorable.
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