Baron Focused Growth Fund (the “Fund”) increased in value 1.37% (Institutional Shares) during the second quarter of 2016. The Russell 2500 Growth Index, the small- and mid-cap benchmark against which we compare the performance of this Fund, increased 2.70%. The S&P 500 Index, which measures the performance principally of economically dependent, large-cap, cyclical companies, increased 2.46%. The Morningstar US OE Mid-Cap Growth Category increased 1.98% over the past three months.
The Fund’s year-to-date relative performance was slightly better. The Fund (Institutional Shares) increased in value 0.53% during the past six months. Its benchmark fell 0.03%. Large-cap stocks continued to outperform as they have in recent years. The S&P 500 Index increased 3.84% during the first half of 2016, while the Morningstar US OE Mid-Cap Growth Category Average gained only 0.04% and the Morningstar US OE Small Growth Category Average lost 0.66% Large-cap stocks’ and value stocks’ recent relative outperformance has attracted assets. Investors have continued to increase their purchases of index funds that passively invest principally in large-cap value stocks. Large-cap value stocks’ price earnings ratios, a measure of whether their valuations are cheap or expensive, are now at 104% of their 20-year average. In contrast, investors have been less interested in funds that invest in small-cap, faster growing businesses. Small-cap growth stocks’ price earnings ratios are 92% of their 20-year average levels. As of June 30, 2016, the percentage of passive large-cap funds to all large-cap funds is about 44%, while the percentage of passive small-cap growth funds to all small-cap funds is 14%. The percentage of passive mid-cap growth funds to all mid-cap funds, is just 10%.
Small-and mid-sized companies in general grow much faster than large-cap, businesses. Small-cap growth stocks have outperformed large-cap stocks about 76% of the time over the past 90 years, and they have underperformed 65% of the time in the past 38 years. Based on this long history, we think the recent underperformance of mid- and small-cap growth funds is a cyclical phenomenon and likely will reverse.
We believe that actively managed funds investing in small- and mid-cap growth businesses that have outperformed over the long term like we have, continue to have the best opportunities to outperform over the long term. Of course, we cannot assure you this will be the case.
After unusual volatility at the beginning of 2016, domestic stock markets rose steadily for most of the second quarter. Favorable economic data including growth in employment, wages and home prices have boosted investor confidence. Oil prices nearly doubled from their low point in February. Lower oil prices, while a boon to consumers and users of energy, have had a negative impact on energy businesses and many industrial firms whose customers are energy businesses. We believe energy prices have partially recovered during the past six months because demand is increasing modestly while supply is stable or declining, due to the postponement of many exploration & production projects. Energy prices remain 60% lower than the levels they achieved during 2011.
The relative calm in U.S. stock markets this spring was disturbed when the unexpected positive Brexit referendum vote in England in late June left investors confused about growth implications for the global economy. In our opinion, interest rates are unlikely to increase significantly any time soon. This is since that would make the massive and still increasing world debt more difficult to service. Rising rates would also dampen growth prospects for many businesses worldwide that are already growing less rapidly than desired.
The Fund invests principally in competitively advantaged growth businesses whose operational results are relatively insulated from the global macro concerns, and we believe these companies are trading at attractive prices due to investor concerns.
Shares of CoStar Group, Inc. (CSGP, Financial), a real estate information and marketing services company, increased on outstanding financial results. Revenue growth accelerated to 25%, margins expanded 14% year-over-year, and earnings almost tripled. CoStar grew in its core commercial real estate market and captured share in the multifamily space. We believe CoStar is poised to generate accelerating organic revenue growth and significant margin expansion as it leverages recent investments in sales headcount, product expansion, and multifamily marketing. (Neal Rosenberg)
Shares of benefits software vendor Benefitfocus, Inc. (BNFT, Financial) contributed to second quarter performance, driven by outstanding financial results. The company generated traction in new logo acquisition and cross-sales of new modules, including BenefitStore. Profitability also continues to scale ahead of expectations, and the company now expects to reach EBITDA breakeven in the fourth quarter in 2016. We believe Benefitfocus can continue to compound revenue at a low-to-mid 30% rate and generate substantial profitability over time. (Neal Rosenberg)
Shares of FactSet Research Systems, Inc. (FDS, Financial), a leading provider of investment management tools, rose in the second quarter on favorable investor reaction to stronger equity markets. FactSet’s financial results demonstrated consistent and accelerating market share gains. The company grew its annual subscription value by 9.5% and user base by more than 10.6%, well ahead of average market growth rates. The company also aggressively returned capital to shareholders, repurchasing almost $250 million in stock over the last year. (Neal Rosenberg)
Shares of electric vehicle company Tesla Motors, Inc. (TSLA, Financial) fell during the second quarter, due to concerns over the Model X ramp and execution risk of its significant growth plan. The market also appeared skeptical of Tesla’s announced intent to buy Solar City. We believe Tesla’s brand is strong; the company’s S sedan and X crossover vehicles are unusually attractive; and its production of Model X is increasing. Further, Tesla has received over 370,000 reservations for the $35,000 – $40,000 Model 3 which represented nearly $18 billion in backlog. We are favorably inclined to the Tesla acquisition of Solar City but are still evaluating the transaction. (Gilad Shany)
Shares of Financial Engines, Inc. (FNGN, Financial), a service provider to retirement plan participants, declined in the second quarter. The company has seen a slowdown in new assets under contract and has yet to see successful results from its revamped marketing campaign and increased advisor hours. Additionally, investors appear skeptical that the acquisition of The Mutual Fund Store will materially impact enrollment rates. We believe the acquisition is only now being integrated and will add to assets under management and double the addressable market over time. (Michael Baron)
Shares of Choice Hotels International, Inc. (CHH, Financial), the largest hotel franchisor in the U.S., fell in the second quarter due to slowed growth in revenue per available room (RevPAR) and unit growth that slightly missed Street estimates. While we agree RevPAR trends are a concern, Choice’s revenue is fee-driven and therefore is less impacted by RevPAR than its franchisees. We believe Choice will continue to generate strong cash flow and use it to repurchase shares, issue dividends, and invest in its new higher-end Cambria brand and vacation rental business. (David Baron)
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 11.3 billion medical events from 132 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.
The company addresses a $14 billion annual opportunity in its core markets, with growth driven by the need to reduce inexorable health care cost inflation and a shift to value-based from consumption-based health care. Inovalon has recently announced beachhead relationships with Quest Diagnostics to enter the provider market, with Kindred Healthcare to enter the post-acute care market, and with Bristol-Myers to enter the pharma market. We believe that addressing these adjacencies can increase Inovalon’s Total Adjustable Market by three-to-four times. (Neal Rosenberg)
Investment Strategy
The Fund seeks to double its per share value within five years. Our strategy to accomplish this goal is to invest for the long term in a portfolio of what we believe are appropriately capitalized, well-managed, small- and mid-cap growth businesses purchased at attractive prices. We endeavor to do this with a portfolio of fewer than 30 securities. These securities are diversified by GICS sectors that, in aggregate, we believe will be approximately 85% as volatile as the market. These businesses are identified by our firm’s proprietary research.
We think a major portion of the businesses in which the Fund has invested has the potential to double in size within approximately five years… and to double again over the following five years. We think these well-managed businesses have sustainable competitive advantages and significant long-term growth opportunities. Considering our portfolio investments’ current stock valuations, we believe we have the opportunity to meet our performance goals during the next decade. There can obviously be no guarantee that we will be successful.
As of June 30, 2016, the Fund held 19 investments. The weighted median market capitalization of these small- and mid-sized growth companies was $8.3 billion at quarter end.
The Fund’s portfolio has approximately 42% of its assets invested in young, extraordinarily fast growing businesses purchased between 2013 and 2015.
The Fund’s fast growing, small- and mid-sized businesses offer significant opportunity. To reduce the risk of this portfolio, 42% of which is concentrated in those small- and mid-sized growth businesses, the Fund has diversified its portfolio investments among seven sectors. The average allocation of our investments in these sectors, Consumer Discretionary (40.67%), Financials (17.07%), Information Technology (16.26%), Industrials (8.58%), Telecommunication Services (3.85%), Health Care (3.72%), and Consumer Staples (2.72%) is significantly different than that of the Russell 2500 Growth Index. That is the index against which we benchmark our performance. Our allocations will likely change over time depending upon those businesses’ prospects and their perceived investment opportunities.
We believe the 19% of the Fund’s investments allocated to companies in later stages of their growth trajectories also reduces portfolio investment risk. These investments were purchased between 2003 and 2009 when their businesses were growing unusually rapidly. While these companies are no longer growing as fast as they were then, the Fund continues to hold these long-term “foundational investments.” This is since those businesses are continuing to steadily grow their earnings while using their excess free cash flows to buy back stock and pay dividends…and still have the ability to provide our Fund with double-digit annualized returns.
The Fund also has 29% of its assets invested in real estate and media businesses with irreplaceable assets that are an important hedge against inflation. We believe these businesses purchased between 2009 and 2013 with their moderate, better-than-inflation growth prospects, dividends and share repurchases also offer the Fund potential double-digit returns.
Finally, the Fund has 3.4% of its assets invested in undervalued financial firms with significant growth prospects and increasing dividend yields.
The Fund’s assets invested in rapidly growing, competitively advantaged, younger businesses are uniformly penalizing their current earnings by investing in their businesses to create and meet exceptional future demand. On current metrics, these businesses may look expensive; however, we believe these companies will continue to grow rapidly and, as a result, in the not too distant future will provide exceptional long-term returns. That would be just like the 3 times, 5 times and 6 times returns we have earned on the Fund’s 19% assets under management, “foundational” Baron Focused Growth Fund investments made between 2003 and 2009. Since short-term investors either do not seek to capitalize on such long-term investment opportunities, or are unable to do so, we feel the Fund is uniquely advantaged. Such investment opportunities include companies like Guidewire that is providing the software system for property and casualty insurers’ claims management which had historically been done using antiquated, legacy internal systems that have become obsolete and expensive to maintain. Such opportunities are also exemplified by Iridium, whose expensive satellite program penalizes near-term results but should revolutionize essential communication for our defense department, the “Internet of Things,” and tracking airline locations that will save fuel and make air transportation safer.
Companies with, in our view, unassailable competitive advantages that also protect us against inflation represent approximately 29% of assets. These investments comprise companies like Vail Resorts, Inc. which cannot be disrupted due to its superior ski mountains that are impossible to duplicate. Vail has been significantly investing in its towns and mountains to create improved services and amenities to make their properties more attractive for skiers. It also includes Manchester United plc which has developed a loyal and dedicated fan base through its 135 plus year history. Manchester now has the opportunity to monetize fan interest in its team with improved sponsorship arrangements, media contracts and game day sales.
We call the steady growers that regularly return excess free cash to its shareholders foundational investments and represent approximately 19% of the Fund’s portfolio. Consumer products company, Church & Dwight Co., Inc. (CHD, Financial), which the Fund originally purchased in September 2007 at a split-adjusted price of $22.91 ended the quarter at $102.89. Church & Dwight’s value oriented products continue to gain share due to innovation and improved marketing. Acquisitions supplement this growth. When acquisitions are not available at attractive prices or they do not meet high synergy, growth and margin hurdles, the company has been steadily increasing its dividend and reducing its share count.
Finally, financial businesses we regard as undervalued constitute about 3.5% of the Fund. They comprise companies like The Carlyle Group and Virtu Financial, Inc. that both have dividend yields of 6%. While a good portion of the Carlyle dividend is generated through its low taxed incentive income, the diversified nature of its products, we believe, make this income stream unusually valuable.
Market volatility gave the Fund an opportunity to increase exposure to companies at favorable prices with unique products that are benefiting from long-term and sustainable trends. The Fund increased its position in Hyatt Hotels, Inovalon, Tesla Motors, CaesarStone and Virtu Financial during the first half of the year. We also added to our investment in the health care data and analytics company, Inovalon, which is trading significantly below its IPO price level in early 2015. Investors are focused on the company’s earnings falling slightly short of expectations due to investments in the company’s sales, marketing and connectivity area. However, we believe that company is enhancing its competitive advantage for its essential health care data analytics through its size and product offering.
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
July 19, 2016
The Adviser believes that there is more potential for capital appreciation in small and medium-sized companies and using non-diversification, but there also may be more risk. Specific risks associated with non-diversification include increased volatility of the Fund’s returns and exposure of the Fund to greater risk of loss in any given period. Securities of small and medium-sized companies may be thinly traded and they may be more difficult to sell during market downturns. The Fund may not achieve its objectives. Portfolio holdings are subject to change. Current and future holdings are subject to risk.
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.
