Baron Discovery Fund achieved what we believe was excellent relative performance versus our benchmark, the Russell 2000 Growth Index. The Fund (Institutional Shares) exceeded the index by nearly 7% in the second quarter. Importantly to us, our longer-term numbers show significant outperformance versus the index. We have shown nearly 3% excess performance per year, on an annualized basis, since inception. We believe that this validates our long-term investing process.
Any number of factors can affect shorter-term absolute and relative performance, including style (growth, value, momentum), industry type (defensive, cyclical, etc.), market capitalization size, technical factors, and even reflexivity (where a feedback loop is effectively created that creates virtuous or destructive cycles that perpetuate themselves). And of course, macroeconomic shocks, like the recent Brexit vote, can cause massive market dislocations. The relative weighting of any of these given factors and/or exogenous shocks or stimulants versus our portfolio can vary radically in a short period of time. We are not market timers because we do not believe that we can accurately predict and modify the portfolio to respond constantly to the vagaries of such changes in these multiple variables. Most of the time, the overall market in the short term is affected by the story of the day. But often times, that story turns out to be not very meaningful on an ex-post basis (remember Y2K?). Generally it is uncertainty, rather than an actual known bad event, that causes the biggest market dislocations. Uncertainty dramatically affects the style factor of the day, and can cause wide variations in actual versus expected performance given a set of fundamentals for a particular company or portfolio.
In this vein, we have had an interesting reversion in the past two quarters, whereby we have “normalized” the poor performance we had in 2015. Many of the stocks in which we saw significant losses during 2015 have rebounded by similar amounts or even more. These include ExamWorks Group, Inc., Amber Road, Inc., The Spectranetics Corporation, The KEYW Holding Corporation, Quotient Technology Inc. and DigitalGlobe, Inc. The dramatic swing in prices for these stocks is listed below (with the contribution to return on 2015 / year-to-date 2016 portfolio performance listed afterward). This small cohort of stocks was responsible for 9.5% of negative performance for the Fund in 2015, but positive 5.6% in 2016¹.
ExamWorks (health care services) was down 36% in 2015 and was up 32% in 2016 (-1.2% / 1.6%)
Amber Road (trade management software) was down 50% in 2015 and was up 50% in 2016 (-1.5% / 1.0%)
Spectranetics (arterial clearing medical devices) was down 57% in 2015 and was up 23% in 2016 (-2.0% / 0.2%)
KEYW Corp. (government IT services) was down 43% in 2015 and was up 64% in 2016 ( -0.4% / 1.3%)
DigitalGlobe (high resolution satellite imagery services) was down 49% in 2015 and was up 37% in 2016 (-1.6% / 0.3%)
Quotient Technology (digital retail couponing) was down 65% in 2015 and was up 93% in 2016 (-0.8% / 0.7%)
Envestnet (software for financial advisors) was down 39% in 2015 and was up 10% in 2016 (-0.8% / 0.3%)
Varonis Systems (cybersecurity software) was down 41% in 2015 and was up 22% in 2016 (-1.2% / 0.1%)
Did some of those businesses have hiccups in 2015 – yes, but not of the magnitude reflected in the prices. We believe, although we can’t be sure, that a lot of the excess negative stock performance in 2015 was the result of a disfavor of certain styles or industries (software, health care, companies with leverage and smaller capitalization stocks) rather than the result of poor investment fundamentals. Our strict fundamental focus has helped us generally to avoid panic selling at the bottom of such “style” cycles, and has enabled us to retain conviction, lower overall portfolio turnover and re-capture lost performance in such investments. Clearly not every stock rebounds, and we have strived to prune lower-quality names (and the occasional mistakes) from the portfolio, which, on balance, we believe we have replaced with higher-quality, higher cash-flow oriented investments.
Another positive effect of our longer-term strategy is that our turnover has come down significantly as the portfolio has “seasoned.”
At present, while we are constantly striving to improve the overall portfolio, we like what we own. We believe that our largest positions are very high conviction ideas that have stable businesses with relatively low (in our belief) potential for revenue volatility. More exciting, but inherently riskier, ideas are sized much smaller on a relative basis.
Press Ganey Holdings, Inc. (PGND, Financial) is a leading provider of patient experience and employee engagement measurement, analytics, and strategic advisory services for health care organizations. The foundation of the business is its proprietary data set, which it collects from surveys of patients, doctors, nurses, administrators, and employees. In 2015, it distributed 105 million surveys, including 33 million electronically and 72 million by mail or phone.
We believe the available market for these services exceeds $1 billion. The company is also working on exciting new products that would dramatically expand that opportunity, including a “transparency” product that will give patient derived quality assessments of doctors and hospitals. Press Ganey generates mid-30% cash flow margins now that could expand by 10% as it leverages its fixed cost base. We believe we have nice upside to our investment given high single-digit topline growth and expanding margins.
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 than if they did it completely on their own. Such systems collect, process, store, and send information from devices on 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. This unit added “embedded protection” capabilities that are like military hardware cybersecurity, as well as solid state storage capabilities for its systems (versus using hard disk drives). As occurred in the first quarter, the market continued to reward Mercury for this highly strategic, accretive acquisition.
The KEYW Holding Corporation (KEYW, Financial) is a government services company that specializes in cybersecurity and intelligence gathering applications. Shares have increased dramatically since fourth quarter earnings. At that time, the incoming CEO announced his strategic initiatives to drive growth in the core services business, and to stem operating losses and/or sell KEYW’s money losing commercial cybersecurity software business. In the second quarter, management executed against this strategy by completing the divestiture of the commercial software business, and by significantly increasing its backlog of government services business. This has started to unlock what he have always believed is the hidden value in the company. The market has finally recognized this as well, and the stock now trades at a more reasonable sector valuation.
We sold ExamWorks Group, Inc. (EXAM, Financial) in the quarter after it announced that it would be acquired by a private equity firm. This was another one of the stocks that had gone down dramatically in 2015 (it was down 36% in 2015 and it was a significant holding in the Fund), which rebounded sharply in 2016 (up 32% for the year to the acquisition price). Holding the investment during this period was possible only because we had such confidence in our fundamental research.
Wingstop, Inc (WING, Financial)., a franchisor of chicken wing restaurants, was a contributor in the quarter. The company continues to report better than expected earnings. The company also announced a $2.90 special dividend, which is large relative to the recent stock price ($27.25 at June 30, 2016). We continue to believe the company, which has around 900 stores today, can grow to 2500 stores domestically and an additional 3,000 stores internationally.
MACOM Technology Solutions Holdings, Inc. (MTSI, Financial) designs and manufactures high end analog semiconductors used for industrial, military, and communications end markets. It has no consumer (handset) exposure, and it has significant opportunities in a number of new markets that each dwarf its existing $500 million in revenue. We believe that MACOM has unique radio-frequency technology based on Gallium-Nitride on Silicon (GaN), that will lead to near-term revenue growth in markets such as cellular tower power amplifiers, microwave oven and dryer components, and military and civilian radars that are worth billions of dollars in new market opportunity. In addition, the company has a multi-billion dollar market opportunity in optical networking components that connect data networks that span from the ultra-long distance, to short distance data center interconnections. We believe that MACOM possesses some unique proprietary laser technology that will enable it to capture meaningful market share in metro and data center optical markets. We think that communications-related growth is already starting, and that we will see progress in the GaN markets starting in the second half of this year. If MACOM executes its business plan, we are likely to see 20% revenue growth for years to come. Despite these exciting prospects, shares have traded down for a number of reasons including concerns about Chinese end markets, given its economy, economic prospects in Europe, given the Brexit vote, and general industrial conditions worldwide. We have done a significant amount of due diligence on the company and firmly believe that all of the company’s fundamental opportunities are intact. Given the company’s current valuation, we are very excited about prospects for the shares.
Pacira Pharmaceuticals, Inc. (PCRX, Financial) is a specialty pharmaceutical company that sells an injectable drug for local post-surgical analgesia (localized pain relief) called EXPAREL. In the fourth quarter of 2015, Pacira reached a very favorable resolution with the FDA concerning certain issues which had previously impeded its ability to market its drug to hospital customers. We re-established our investment in the company in the third quarter of 2015 as it appeared from public reports that the company was making significant progress on this front (and the FDA removed the warning letter from its site in September). Shares have been weak in the second quarter of 2016 as Pacira has not yet seen a re-acceleration in the growth of the drug (management has always guided to a late 2016 effect). In our opinion, Pacira still retains its large multi-billion dollar market opportunity, and we should start to see accelerating revenues by year-end.
Barfresh Food Group, Inc. (OTCPK:BRFH, Financial), a manufacturer and distributor of ready-to-blend beverages, was a detractor in the quarter. The company continues to make progress with its larger partners, PepsiCo and Sysco, but is still early in its product roll out, which may have disappointed some investors this quarter. We expect that to change as we get into early 2017, when we believe larger customers will move from the “testing phase” to the “roll-out phase.” We believe the potential opportunity for Barfresh is massive, so we continue to remain patient as the company executes on its business plan.
Mellanox Technologies, Ltd. (MLNX, Financial) is a provider of high speed networking switches and related equipment. Its products serve two general markets with Infiniband products, typically used for “high performance” computing applications, and its standardized Ethernet products, used for general networking applications. We believe that, combined with the recent acquisition of EZChip (which produces specialized network protocol chips that help direct data traffic), Mellanox has a very strong technology market position. Shares were weak in the quarter due to concerns that Intel is incorporating Infiniband networking functionality in its own chips. While we account for some share loss in the company’s high performance markets, Mellanox is just starting its Ethernet penetration, and we believe that increased growth in Ethernet will more than compensate for this competitive threat. We believe shares are inexpensive, particularly after expected accretion on the EZChip deal, and we believe there is a lot of growth ahead for the company.
The Habit Restaurants, Inc., an operator of fast casual hamburger restaurants, was a detractor in the quarter. The company reported worse than expected sales as a result of a more competitive quick service restaurant (QSR) environment. We believe the company has executed well and that their results are not self-inflicted. That being said, we reduced the position in the quarter as we became less comfortable with the overall macro/ promotional environment in the QSR and fast casual restaurant subsectors.
Portfolio Structure
As of June 30, 2016, the Fund had $31.4 million under management and was invested in 57 publicly traded stocks. At the end of the quarter, the top 10 positions represented 39.5% of the Fund’s assets.
Our key sector weightings at the end of June 2016 were 27.8% Health Care (5.4% higher than the Russell 2000 Growth Index), 24.2% Information Technology (roughly in line with the Index), 13.9% Consumer Discretionary (2.5% lower than the Index), 13.0% Financials (2.5% greater than the Index), and 12.9% Industrials (2.6% less than the Index).
American Renal Associates Holdings, Inc. (ARA) is a health care services company that runs about two hundred dialysis centers in the United States. This was the first IPO we have participated in for a number of quarters, as it met our quality and return characteristic standards. American Renal Associates is far smaller than its two large competitors, but we believe that it has a solid business model that involves physician ownership in many of its centers. This leads to the company’s ability to attract and retain some of the best nephrologists in its markets.
Flotek Industries, Inc. (FTK), a manufacturer of specialty chemicals primarily for the oilfield service sector, was added to in the quarter. The company has been a long-term holding in the Fund but we increased the position size as oil recovered and the company’s prospects improved. We are very excited about the growth the company is showing, especially in the Permian Basin in Western Texas. We believe the company’s earnings are depressed today but will recover in time and when that happens, the stock will be worth significantly more than it is today.
Isle of Capri Casinos, Inc. (ISLE) is an operator of regional casinos primarily in the Midwest and Southeast. We have known the company for many years and became interested when a new CEO was named. We believe the new CEO and his management team have the ability to improve the margins and cash flow of the business. In addition, we think the current valuation does not reflect the inherent value of the company’s real estate.
Domino’s Pizza Group plc (DPZ) holds the exclusive master franchise for Domino’s Pizza stores in the U.K., Ireland and Switzerland. We became interested in the company when the stock traded lower due to Brexit fears. Our feeling is that the company still has great growth prospects with an opportunity to grow its store base in the U.K. from under 900 units to over 1,200 in five years. We also think that the company will continue to grow same store sales in the mid- to high-single digits. One reason why we believe this is that Domino’s Pizza customers in the U.S. and Australia order nine times per year on average. In the U.K., while rates have been increasing, customers currently order only five times per year. We think that, over time, this gap will continue to close, helping to lift same store sales in the process.
Amber Road, Inc. (AMBR) has been a long time holding of the Fund. It provides subscription software (SaaS) services delivered through the cloud that enables some of the largest companies in the world to navigate difficult trade regulation environments. Shares were crushed last year after revenue growth disappointed. But customer retention has been fantastic (in no small part due to the company’s unique database of tariffs, trade regulations and other laws which are constantly refreshed). And the order book is accelerating to the point where we believe that the company can start putting up high-teens revenue growth again. We had sold a majority of our position in 2015 (taking some tax losses when the business environment was uncertain). But we bought back the position near the lows (shares were trading at around 1.5x sales), when we perceived that the business was turning around.
Of our top five sales, only two of them were of meaningful size. We sold ExamWorks after it agreed to be acquired for $35.05 per share. We sold Krispy Kreme after it announced an agreement to be acquired for $21 per share.
Outlook
While financial markets continue to reap the volatility born from political tumult in Europe, we are quite excited about the prospects of the companies in which we hold investments. Our perspective is that the innovation being driven by these companies will lead to tremendous revenue and cash flow growth for years into the future. We believe that our investors will be amply rewarded as these plans are realized. While we cannot guarantee results, we continue to strive to earn compounded returns of at least 15% on an annualized basis by targeting investments in companies that we believe can grow cash flows at these rates with a high probability of conviction. This has been particularly difficult in the current state of the markets. However, we continue to believe this is possible and as such, we both have significant personal investments in the Fund.
Thank you for investing in the Fund.
Randy Gwirtzman & Laird Bieger
Portfolio Managers
July 19, 2016
1. 2015 represents calendar 2015 performance and 2016 represents performance year-to-date as of June 30, 2016.
The Adviser believes that there is more potential for capital appreciation in smaller companies, but there also may be more risk. Specific risks associated with investing in smaller companies include that the securities 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 portfolio 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 manager only through the end of the period stated in this report. The portfolio managers’ 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.
