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Holly LaFon
Holly LaFon
Articles (7135) 

Baron Opportunity Fund 3rd Quarter Commentary

Overview of market and holdings

DEAR BARON OPPORTUNITY FUND SHAREHOLDER:

PERFORMANCE

Baron Opportunity Fund (the “Fund”) had a solid third quarter, advancing 6.47% (Institutional Shares). The Fund outperformed both the Russell 3000 Growth Index, which rose 4.92%, and the S&P 500 Index, which rose 3.85%.

REVIEW & OUTLOOK

As mentioned above, the Fund performed well during the third quarter, continuing a steady improvement from a challenging start to the year. In January and February, investors appeared to put significant weight on macro downside risks: a sharp economic slowdown in China, the end of the U.S. economic recovery, persistent low and even negative sovereign interest rates, collapsing oil prices, etc… As we have progressed through the year, concerns over those fears have turned more optimistic and the market environment has been more favorable for the Fund. But as I write every quarter, macro uncertainties always exist. Today they involve such issues as whether the Federal Reserve will raise interest rates before the end of the year, the outcome of one of our nation’s most troubling presidential elections (at least since I have been politically aware), the persistent challenges in the Middle East (Syria, Iraq, ISIS, etc...) and the seemingly ever-present threats of terrorist attacks, and, of course, what the next move in the stock market will be. While we try to stay abreast of all these issues, we really do remain laser focused on what we can control: our industry and company research and portfolio construction decisions.

The consistent strategy of the Fund has been to invest in high growth, innovative businesses capitalizing on powerful secular trends. This is how we strive to distinguish ourselves from a passive index or ETF, as well as generalized growth funds, and to provide our shareholders with what we believe is a unique investment vehicle in today’s increasingly passive, index-driven investment mindset. In a world and market concerned about where growth will come from, we aim to differentiate not by trying to figure out the next bend in the cyclical growth curve, but by identifying powerful secular trends–generational, paradigm or tectonic shifts across industries and society–that will drive robust long-term growth regardless of the short-term fluctuations of the underlying economy. These trends are visible, impactful, and persistent. They are where the world’s going, not where it’s been (paraphrasing the great hockey player Wayne Gretzky). We believe many of the businesses that emerge as winners will possess significant growth opportunities, considerable moats to sustain their leadership and capture large profit pools from the legacy way of doing things.

Some of the powerful secular themes in which we invest include:

  • Cloud computing and software-as-a-service (SaaS)
  • Mobile
  • Big data and analytics
  • Digital (Internet-delivered) media
  • E-commerce
  • Genetics
  • Electronic medical records
  • Immuno-oncology
  • Targeted digital advertising
  • Cybersecurity
  • Electric drive vehicles and autonomous driving
  • Electronic payments

By investing in this way, our portfolio companies have consistently delivered top-line growth rates that are orders of magnitude above the general economy, as reflected in broad market indexes. Below we show the revenue growth rates of the S&P 500 Index, the Russell 3000 Index, and the Russell 3000 Growth Index as compared to our portfolio for the first and second quarters of this year:

Here are some highlights from the recent reports of several of our longer-term holdings:

  • CoStar Group, Inc.

– Leading provider of commercial real estate information, analytics and online marketplaces

– 15-year investment for the Fund

– Total revenue grew 21%

– Core Information and Analytics Suite revenue rose 14%, an acceleration from 12.5% last quarter

– Multifamily Online Marketplace segment, a key growth driver, expanded revenue 54%, or about 24% adjusted for acquisitions

  • Guidewire Software, Inc.

– Leading provider of software products for property and casualty insurers

– Four-year investment for the Fund

– Software license revenue grew 23%

– Rolling four-quarter recurring revenue (a key metric for the company) increased 22%

  • Benefitfocus, Inc.

– Leading provider of cloud-based benefits management software

– A nearly three-year investment for the Fund

– Total revenue grew 36%

– Employer revenue (direct sales to enterprises), its key growth engine, rose 75% (roughly 58% adjusted for certain one-time revenue)

  • Acxiom Corporation

– Marketing data, analytics and software-as-a-service company

– Four-year investment for the Fund

– Fast-growing and differentiated Connectivity division grew sales 52%

  • Tesla, Inc.

– World leader in electric drive vehicles

– Two-year investment for the Fund

– Delivered approximately 24,500 vehicles in the third quarter, up 111% year-over-year

  1. Model S, now in its fourth year since launch, hit 15,800 units, up 36% year-over-year
  1. Model X, in just its fourth full quarter since launch, ramp to 8,700 vehicles, up 70% quarter-on-quarter
  • Equinix, Inc

– Leading global interconnection and data center business

– 13-year investment for the Fund

– Total revenue grew 35%, or 15% adjusted for acquisitions and currency fluctuations.

I believe wholeheartedly in the strategy for the Fund: growth based on powerful, long-term, innovation-driven secular growth trends. In the highly uncertain world we live in, we believe non-cyclical, sustainable, and resilient growth should be part of investors’ portfolios.

Shares of Amazon.com, Inc. (NASDAQ:AMZN), the world’s largest online retailer and cloud services provider, rose in the third quarter after reporting strong revenue growth (28% year-over-year) and improving margins in its core e-commerce business. Amazon’s other major business segment, Amazon Web Services (AWS), the disruptive cloud computing offering, continues to gain traction with enterprise customers, and had another strong quarter of growth (58% year-over-year in currency-neutral dollars). Given our belief that the shift in enterprise IT spending has passed the tipping point towards cloud computing, we expect AWS to be an even larger contributor to value creation than Amazon’s core e-commerce segment. (Ashim Mehra)

Alphabet Inc. (NASDAQ:GOOGL) is the world’s largest search and digital advertising company. Shares of Alphabet were up in the third quarter, driven by quarterly results that surpassed Wall Street expectations. We continue to believe that even while desktop search is becoming a more mature business for the company, Alphabet is well positioned to benefit from substantial growth in mobile and online video advertising. (Ashim Mehra)

Acxiom Corporation (NASDAQ:ACXM) is a critical player in the data-driven, people-based advertising industry, whose technology, data, and connections help advertisers significantly improve the targeting and productivity of their digital advertising spend. Shares of Acxiom were up in the third quarter, driven by rapid growth in the company’s cloud-based connectivity and identity business, branded LiveRamp. LiveRamp’s products enable advertisers to resolve the hundreds of different identifiers for consumers used on devices (smart phone, tablet, computer, TV), marketing platforms (such as Facebook or Instagram) and their own internal systems to a real person in a privacy-compliant manner. (Ashim Mehra)

Shares of Illumina, Inc. (NASDAQ:ILMN), the leading provider of DNA sequencing technology to academic and commercial laboratories, contributed to performance in the third quarter. The company reported financial results that beat Wall Street expectations and reiterated guidance for the year. Unfortunately, after quarter end, Illumina pre-announced weaker-than-expected third quarter results and guided down its fourth quarter, and its stock has retreated. While we acknowledge that Illumina may be in a soft patch until we hit an inflection point in the adoption of genetic sequencing for actual patient care, with oncology being the largest opportunity, we continue to believe Illumina has strong moats around its DNA sequencing platform and a long runway for growth. (Neal Kaufman)

Shares of Alibaba Group Holding Limited (BABA), the largest e-commerce company in China, performed well in the third quarter following strong quarterly results. Alibaba’s core China retail commerce business grew revenues 49% – driven by the continued shift to mobile transactions and improvements in mobile monetization – and its cloud business (same as AWS) grew sales 156%. Enhanced financial disclosure helped investors to understand better the profitability of the core commerce business – which has over 60% operating margins – and thereby attribute a higher value to it. We expect that mobile monetization will continue to improve through 2016 and beyond, and that the company will continue to profit from investments in new areas such as online grocery and cloud computing. (Ashim Mehra)

Bristol-Myers Squibb Company (NYSE:BMY) is a large diversified pharmaceutical company that is one of the leaders in the development of immune-system-stimulating therapies to fight cancer. These efforts are spearheaded by its product Opdivo, now approved to treat several types of cancer. After positive data was released on a rival drug to treat first-line advanced non-small-cell lung cancer, Bristol-Myers revealed that Opdivo did not meet the primary endpoint in a Phase III trial in the same indication, and its shares fell. We have exited our Bristol-Myers position, but are continuing to research the budding immuno-oncology space carefully. (Josh Riegelhaupt)

Shares of Gartner, Inc. (NYSE:IT), a provider of syndicated IT research, relinquished some gains due to tougher comparisons and slightly more challenging macro conditions. We believe Gartner’s key metrics are solid. The company has significant financial flexibility, and we think it will aggressively deploy capital for repurchases or mergers and acquisitions. Over time, in our view, Gartner will generate accelerating top line growth, significant growth in earnings and free cash flow, and persistent return of capital. We added to our Gartner position during the quarter. (Neal Rosenberg)

Shares of cloud computing pioneer salesforce.com, inc. (NYSE:CRM) decreased in the third quarter. The company reported mixed bookings results due to what management called transitory execution issues in the domestic market in the last month of the quarter. We believe that salesforce’s addressable market is more than 10-times larger than its current run-rate revenue, giving it ample opportunity to compound revenue in excess of 20% annually. We believe the company is highly innovative, and has a strong track record of disrupting legacy environments with next-generation software. We added to our salesforce position during the quarter. (Neal Rosenberg/Ishay Levin)

Shares of cybersecurity software vendor FireEye, Inc. (NASDAQ:FEYE) fell during the third quarter on disappointing guidance as new management reset expectations for 2016 in an effort to build a solid base for 2017. New management’s plan is to right-size the organization, launch new subscription products that expand the customer base and respond to customer needs driven by the shift to the cloud and mobile, and to fine tune go-to-market partnerships. We reduced our weighting in FireEye, but retain a smaller investment in light of the significant long-term opportunity we believe management is attacking with its leading technology. (Gilad Shany)

This quarter saw pressure in the data center segment, and Equinix, Inc. (NASDAQ:EQIX) was no exception. Reports of slowing industry activity and what was interpreted as cautious management commentary spurred some profit taking ahead of third quarter earnings. We like the growth prospects for Equinix and think management has a clear and sensible plan to keep growing at a solid pace while improving efficiencies and demonstrating margin leverage. We view 2016 as a digestion year, with two acquisitions and a divestiture, and expect 2017 to show significant leverage to shareholder profitability. (Gilad Shany)

Portfolio Structure

The Fund invests in high growth, innovative businesses across all market capitalizations. As of the end of the third quarter, the largest market cap holding in the Fund was $542.8 billion and the smallest was $731.7 million.

The median market cap of the Fund was $13.0 billion. The Fund had $250.8 million of assets under management. The Fund had investments in 45 securities. The Fund’s top 10 positions accounted for 44.4% of the portfolio.

Glaukos Corporation (GKOS) is the current market leader in the field of minimally-invasive glaucoma surgery or MIGS. As a pioneer in the field, Glaukos was the first to obtain FDA approval and insurance reimbursement for their eye stent, which they cleverly branded the iStent. Given the progressive nature of glaucoma that inevitably leads to blindness unless one’s eye pressure is effectively controlled, the iStent offers ophthalmologists a paradigm-shifting treatment option. Effectively, the iStent is a micro-sized plumbing solution that clears a blocked drain enabling a return of proper fluid flow. This allows for continuous pressure control and, as an ancillary benefit, a reduction in the need for concomitant glaucoma eye drops.

We highlighted Expedia, Inc. (EXPE) last quarter as a new purchase. We continued building our positon during the third quarter.

We purchased shares of The Trade Desk (“TTD”) (TTD) in the quarter in connection with its IPO. TTD is the leading Demand Side Platform, whose targeting technology and connections enable advertising agencies to more efficiently purchase digital advertising on emerging real-time bidding platforms for display, mobile, and video ads. The company was founded by Jeff Green, the CEO who has built a unique culture of excellence and customer focus. As increasing amounts of advertising become more digital, targeted, and automated, we expect TTD to remain a key technology supplier benefiting from this shift. We estimate that the company has 10% market share in what the advertising industry calls programmatic buying. Programmatic buying today represents only $10 billion out of $640 billion in global advertising, and we believe it will take a far greater share in the years to come.

We added to our long-term Netflix, Inc. (NFLX) position during the quarter, at what we believed was an attractive price, as the stock fell on weaker-than-expected second quarter net subscriber adds. We have followed and/or been an investor in Netflix since its IPO, and have witnessed that its quarterly subscriber metrics are very difficult to predict and fluctuate for many reasons, including things like the Olympics, price increases and the timing of exciting content going live. We retain high conviction in our thesis that the way people watch TV is undergoing a major disruption from legacy time-based networks to on-demand streaming, and that Netflix will be a winner in this shift. Here is a quote from the CEO of one of the world’s most valuable media companies: “We are seeing change in media, and it’s mostly powered by technology. It’s powered by the shift that technology has created away from the distributor and the producer to the consumer. The consumer has much more authority than ever before to decide what they want to watch, when they want to watch, where they want to watch it; even how much they pay for it. We are already seeing that in so many other ways. Just think about Amazon and … Netflix as another example. It’s just a changing world and … We are not going to be able to stop it.” Guess who said it? Bob Iger, Chairman and CEO of Disney, at Fortune’s Brainstorm Tech conference earlier this year. We agree with Bob.

Foundation Medicine, Inc. (“FMI”) is a diagnostic lab company that specializes in analyzing the DNA sequence of the most complex cancers. It uses next generation genetic sequencing to find over 300 relevant cancer genes. On top of this, its information technology platform links pharmaceutical companies with oncologists and scientific research. Roche Holdings announced a broad strategic relationship with FMI in January 2015, buying over 50% of FMI’s shares at $50 per share. Included in the various agreements with Roche are plans to co-market FMI’s tests overseas, develop additional high value tests, and use Roche’s U.S. sales force to educate medical professionals about the advantages of FMI’s technology. We believe FMI is well positioned to take share in the emerging multi-billion dollar complex cancer diagnostics market.

We trimmed our The Priceline Group, Inc. position, in part, to fund our purchases of Expedia. Priceline remains a Top 20 position for the Fund.

We decreased our FireEye, Inc. position, as stated above, due to the fundamental business challenges facing the company and to harvest a tax loss. We retain a small position.

We exited our Bristol-Myers Squibb Company position, as discussed above.

We decided to exit our Inovalon Holdings, Inc. position based on our fundamental research into the business.

We trimmed our ANSYS, Inc. positon on strength. ANSYS remains a Top 25 position for the Fund.

Thank you for your support and for trusting us with your assets. We look forward to updating you in future letters.

Sincerely,

Michael A. Lippert

Portfolio Manager

October 17, 2016

The Adviser believes that there is more potential for capital appreciation in securities of high growth businesses benefiting from innovation through development of pioneering, transformative or technologically advanced products or services, but there also is more risk. Companies propelled by innovation, including technological advances and new business models, may present the risk of rapid change and product obsolescence and their successes may be difficult to predict for the long term. Securities issued by small and medium sized companies may be thinly traded and 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 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.

This report does not constitute an offer to sell or a solicitation of any offer to buy securities of Baron Opportunity Fund by anyone in any jurisdiction where it would be unlawful under the laws of that jurisdiction to make such offer or solicitation.


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