Dear Baron Discovery Fund Shareholder:
Baron Discovery Fund (the “Fund”) achieved good relative performance in what proved to be a highly volatile first quarter. From the start of the year, the Russell 2000 Growth Index went in one direction – straight down. By the time the index bottomed on Feb. 11, it had vaporized 18.9% of its value. The rebound that we saw at the end of the quarter left the index down “only” 4.68% year to date. That our portfolio of smaller, earlier stage companies (we have a weighted average market capitalization of about $1.43 billion) kept up with the Russell 2000 Growth Index (weighted average market cap of about $2.03 billion) is a testament to how well we reconfigured the portfolio last year. With our emphasis on having larger position sizes geared to more established companies with higher cash flow and less revenue volatility while maintaining a number of positions in exciting earlier stage growth companies, we were able to achieve the right mix in the current environment. We believe that going forward we should be able to continue to perform well against the index in most environments, though we expect our smaller capitalization bias to perform better in up markets than in severe down markets. Still, we continue to target companies that we believe have the potential to provide at least a 15% annualized return over time. We continue to be excited by the Fund’s portfolio, and we have substantial investments in the Fund as evidence of our conviction.
Pinnacle Entertainment Inc. (PNK, Financial), an operator of regional casinos, was the top contributor in the quarter. The company is selling its underlying real estate to Gaming and Leisure Properties Inc. (GLPI, Financial). As a result of that sale, Pinnacle shareholders will receive stock in Gaming and Leisure at a fixed ratio of 0.85 shares for each Pinnacle share. This deal is expected to close in late April. During the quarter, Pinnacle’s stock benefited from both an improvement in the fundamentals of regional gaming and a rise in the stock price of Gaming and Leisure. We are still long-term believers in both Pinnacle and Gaming and Leisure and think we still have meaningful upside from these levels.
Mercury Systems Inc. (MRCY, Financial) is a provider of complex electronic subsystems to major defense contractors. Its devices allow Mercury’s defense contractor customers to develop their products more quickly and at lower risk. Such systems collect, process, store and send information from planes and UAVs (such as radar and image sensors), provide missile defense for ships and ground-based platforms and are integrated into electronic warfare systems (such as jammers).
In March Mercury made a significant acquisition of a defense unit that was part of Microsemi Corp. (MSCC, Financial). This unit added “embedded protection” capabilities that are like military cybersecurity as well as solid state storage capabilities for its systems (versus using hard disk drives). The market (correctly in our view) rewarded Mercury for this highly strategic, accretive acquisition by sending shares higher after it was announced. Still, its shares don’t yet trade at what we believe is an appropriate multiple of cash flow. As we noted last quarter, we think that Mercury deserves a premium multiple as we believe it has the potential to grow at more than double the rate of industry peers, has a large and visible backlog and in our opinion is an attractive take-out target.
Mellanox Technologies Ltd. (MLNX, Financial) is a company that produces hardware for the networking industry including chips (on an asset-light basis), interface cards, switches, routers and connectors. The company is at the upper end of its industry in terms of cutting-edge product that speeds data across large high-performance servers (for big data crunching) and data center Ethernet networks (typically large cloud businesses such as Amazon [AMZN], Facebook [FB] and Google). We have admired the company for some time and have even visited its headquarters in Israel. We got interested when the company announced the acquisition of EZchip Semiconductor (EZCH, Financial) in September 2015. We saw the merits of the combination, which added high speed, network processing units (that help optimize traffic flow on routers) to Mellanox’s existing network transport protocol chips. We purchased shares at about $40, when they were trading for only 10.5x our estimates of pro-forma EPS. Shares have appreciated since the EZchip deal closed without incident, and it appears that there will be a significant and long-running data center upgrade cycle that could lead to substantial growth in Mellanox’s business.
M/A-COM Technology Solutions Holdings Inc. (MTSI, Financial) is a company that designs and manufactures high-end analog semiconductors used for industrial, military and communications end markets. It has large opportunities in optical networking (upgrades that drive higher data transport speeds for telecommunications networks and for high-speed data centers), cellular base station towers (its unique technology will help to enable next generation cell phone speeds) and radar programs (for both military and civil applications). M/A-COM’s ability to execute against these opportunities was the direct result of a smart strategic acquisition plan that spanned the last three years. Shares rose in the quarter as the company continued to penetrate these key markets. In addition, at a well-attended investor day in March, M/A-COM laid out how it had four distinct opportunities that could each double its current $500 million revenue base over the next three to five years. We believe M/A-COM has many years of 20% revenue growth ahead of it and that it can significantly expand its margins as well.
Education Realty Trust Inc. (EDR, Financial) is a real estate investment trust that focuses on the development of collegiate student housing communities. During the quarter, the company continued to announce new on-campus greenfield developments, acquisitions and dispositions of noncore (and less desirable) assets. We still expect the company to be able to grow given its two-year construction backlog
Just Eat PLC (JE, Financial), an online marketplace for restaurant delivery in Europe, Latin America, and Canada, was a detractor in the quarter despite reporting better-than-expected results for the second half of 2015. Potential entry by Uber into restaurant delivery in the U.K. is driving heightened concern among market participants that competition will put pressure on Just Eat’s growth in the U.K., its largest market. We remain positive on the investment as we believe Just Eat competes in a winner-take-most/all business that will not be meaningfully disrupted by new competitors and that the company competes primarily in a different market segment from more delivery-oriented competitors (who are more focused on fine dining restaurants as opposed to the delivery-focused restaurants that Just Eat targets)
Pacira Pharmaceuticals Inc. (PCRX) had what we believed was a watershed event in mid-December 2015. At that time, the company announced an extremely favorable legal settlement with the FDA relating to the contention that Pacira was marketing its drug beyond what the FDA had approved. Pacira argued that such marketing was allowed and as litigation progressed, the FDA ultimately agreed. In the settlement agreement that ended the litigation, Pacira received broad, definitive labeling for many major surgical uses plus the ability to claim significant effect versus placebo for up to 72 hours. Immediately after the resolution was announced, shares moved from $62 to $71, before ultimately reaching $80 in late December. Since that time, due largely (in our opinion) to broader concerns in the Health Care sector, shares dropped from approximately $77 at the start of the year to approximately $53 at the end of the quarter. We purchased incremental shares at around $50 (about 20 times our 2017 EPS estimates) as we continue to believe that this will be a fantastic multiyear story with 25% to 35% top-line growth for years to come.
Shares of ClubCorp Holdings Inc. (MYCC), an operator and manager of golf courses across the U.S., declined in the first quarter due to concerns that lower oil prices would hurt business at its golf clubs that serve Texas, which comprise 35% of its EBITDA. We exited the position during the quarter.
Flotek Industries Inc. (FTK) is primarily a supplier of chemical additives to the global oil and gas industry with some other ancillary oilfield service operations. The company has a proprietary product dubbed the “complex nano-fluid” (CnF) that is proving to be extremely effective at increasing oil and gas shale well productivity. The company’s shares fell due to the sharper-than-expected decline in drilling and completions activity that has particularly affected non-CnF product sales. FracMax data issues that cropped up in the fourth quarter of 2015 continued to weigh on shares. The company continued to pursue additional independent analyses of production data to demonstrate the positive impact CnF is having on customer well productivity. Given ongoing declines in drilling and completion activity in the U.S., the near-term outlook remains a challenge. We believe in the company’s long-term value proposition, though we reduced the position.
Qualys Inc. (QLYS) is a cloud-based cybersecurity services provider that specializes in assessing software vulnerabilities of hardware attached to Internet networks. Shares were hurt in the quarter by the general market decline as well as concern that top-line growth would slow. From Dec. 31, 2015 until the stock bottomed out in mid-February, shares dropped from $33 to $17, or nearly 50%. When the CFO announced in late January that he was resigning to pursue other interests, we sold most of our position in the mid-$20s as we were unsure of the implications of this on the growth prospects for the company. Yet we still admired the business and its prodigious cash flow. Therefore, when shares overreacted to what we viewed as the inevitable (but relatively modest at 2%) guidance reduction when fourth-quarter results were announced in early February, we bought back some of what we had sold at bargain prices in the high teens. We surmised that the business was fine, and was trading at only nine times free cash flow after adjusting for balance sheet cash. This proved to be a good investment as shares have rebounded to about $25. We continue to believe that this is a great business and still only trades at 13 times this year’s free cash flow (adjusting for balance sheet cash) and nine times next year’s. Yet we expect cash flow to grow at nearly 20% for the next couple of years, and the customers are diverse, with over 100% revenue renewal rates (in other words, existing customers increase their spending with Qualys at a level that more than offsets any lost customer revenue). Plus the revenues are nearly all recurring subscription fees for a critical cybersecurity function that needs to be continuously refreshed. We believe our investment will earn handsome returns from here.
Portfolio structure
As of March 31, the Fund had $29.1 million under management and was invested in 53 publicly traded stocks. At the end of the quarter, the top 10 positions represented 42.9% of the Fund’s assets.
Our key sector weightings at the end of March were 28.4% Information Technology (2.8% above the Russell 2000 Growth Index), 26.1% Health Care (2.4% greater than the Index), 20.9% Consumer Discretionary (2.7% greater than the Index) and 8.7% Financials (in line with the Index).
Health Care was a drag on the portfolio in the quarter as our stocks in this sector were down 11.4%. However, this compared favorably to the Russell 2000 Growth index which was down 18.4%. We believe the sector was hampered largely due to macro rather than micro factors. The current populist election environment has caused a significant degree of consternation in the sector, in particular impacting pharmaceutical and biotech companies (these subindustries were down 23.2% and 30.6% in the Russell 2000 Growth Index). With politicians constantly hawking drug price cuts, it makes for a tough investing backdrop.
In addition, the mismanagement situation involving Valeant Pharmaceuticals (VRX), a large cap, highly financially engineered drug company that has lost about 90% of its value since last fall),has unsettled the drug market. While there can be no gainsaying that drug companies that relied primarily on pricing to grow have dim future prospects, the particular companies in which the Fund is invested should not be overly affected by this issue. Revenue and profit growth for all of our Health Care investments are predicated upon increased market share penetration for novel solutions versus increased pricing in a stagnant unit growth environment.
Overall, we are seeking to find companies that we believe provide better outcomes for lower overall system costs than what currently exists. We think that this will provide a win-win situation for patients and payers and that we can profit handsomely by investing in a socially beneficial manner.
We thought it would be useful to lay out a couple of our investments in Health Care to give some quick examples of investments that keep us excited about the prospects for growth in the sector and have led to our continued sector overweight.
Cerus Corporation (CERS) has an FDA- and EU-approved device that “inactivates” pathogens such as viruses and bacteria in donated blood. This generally means that once treated with the Cerus device, donated blood won’t cause infection in a transfused patient. The device works and has been validated specifically for viruses including HIV, hepatitis C and even Zika (new incidences of this potential birth defect-causing virus are rising rapidly). Current regulatory approvals cover use of the Cerus device for platelets and plasma from donated blood (an $800 million market opportunity, for which Cerus has signed up over 80% of all U.S. blood centers). If additional approvals for usage with the red blood cell (RBC) components are obtained, Cerus will add an estimated $2.5 billion in market opportunity, for which there is no current competition. Cerus is targeting EU approval for RBC in the second half of 2017, and we believe that U.S. approval could be obtained for RBC in 2019. We believe growth prospects for Cerus are significant for 2016 and beyond.
Inogen Inc. (INGN) manufactures FDA-approved portable oxygen concentrators (POCs) used by patients who need oxygen therapy. Its products are highly consumer oriented, as they are light and are approved for air travel by the FAA. Ultimately, we believe that POCs will disintermediate the large (and expensive) tank delivery industry (making overall cost of provision cheaper for payers and easing the anxiety patients might have about running out of oxygen). As Inogen has only penetrated about 5% of the U.S. market (it will sell about $190 million into a $3 billion to $4 billion U.S. market in 2016) and less outside the U.S., we believe it has many years of growth ahead of it.
Easterly Government Properties Inc. (DEA) is a high-growth real estate investment trust. It owns 36 office properties comprising 2.6 million square feet that are almost entirely let to the U.S. government under long-term leases with high renewal rates. The company completed its IPO in February 2015 and has since pursued a high growth acquisition strategy that targets approximately 70 million square feet of addressable opportunities. Most acquisitions are negotiated “off-market,” leading to more attractive yields than those achieved in comparable auction processes.
We believe Easterly’s unique focus on the U.S. government is an attractive strategy for several reasons. First, the government is the largest employer in the U.S. and increasingly prefers to rent rather than own its real estate. Second, the U.S. government has a top-notch credit rating, which enhances the security of rental payments for in-place leases. Third, strong relationships between Easterly and the General Service Administration and U.S. government agencies create high barriers to entry that limit the number of landlord competitors. Management has a proven track record of execution and owns 18% of the company.
We believe valuation is attractive relative to the high quality of the platform and the significant growth we expect to see over the next several years.
Acxiom Corp. is a leading provider of database marketing solutions, identity resolution and data sales. We recently purchased shares in the company based on its leadership position in identity resolution, which helps marketers identify and track their customers across online and offline channels. We expect the company’s legacy marketing and data solutions business to accelerate and that LiveRamp, the company’s high-growth business, has the potential to be multiple times larger in the years to come.
Penn National Gaming Inc. (PENN), an operator of regional casinos, is a new investment for the Fund. We like Penn for two primary reasons. First, we have seen an uptick in consumer spending (as reported by state gaming control boards) at regional casinos. We believe this is being driven by lower gas prices and a stronger job market and most importantly, we think that this increased spending can continue. Second, we are excited by the growth opportunities that Penn has in front of it. In mid-2016, the company will open the Hollywood Casino Jamul near San Diego. This tribal casino has a large opportunity as it is the best positioned tribal casino in terms of its location within the San Diego market (it is closest to the population center). Penn will operate the casino for the tribe and receive a management fee in return. We are also excited by its upgrade of the recently purchased Tropicana Hotel on the Las Vegas strip. We believe that the company has a large opportunity to mine its database of regional customers to help drive incremental business to this newly upgraded casino resort.
We sold the majority of our Rexford Industrial Realty Inc. (REXR) as it hit our price target, and we felt it was appropriate to trim. We sold our Essent Group Ltd. (ESNT) position as we became concerned about competitors becoming more aggressive in their pricing. We sold our Chesapeake Lodging Trust (CHSP) position as we became more concerned about the overall lodging environment where we have seen industry trends deteriorate in both the fourth quarter of 2015 and the first quarter of 2016. We sold the majority of our position in Flotek Industries as we are still anxious about the macro environment in energy. That being said, we think Flotek is executing extremely well in what is a difficult energy environment.
Outlook
We continue to be very excited about the opportunities our companies have in front of them. While the markets have been somewhat volatile, we think that volatility is an advantage for long-term investors as it gives us chances to buy what we believe are great businesses at valuations we typically don’t get in more normal market environments.
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