Dear Baron Partners Fund Shareholder:
Performance
During the three-month period ended September 30, 2016, Baron Partners Fund (the “Fund”) advanced 3.72% (Institutional Shares), trailing slightly the Russell Midcap Growth Index, the benchmark against which we compare the performance of this Fund, which increased 4.59%. The Fund’s performance was in line with the S&P 500 Index, which measures the performance of large cap companies, which rose 3.85%.
We provide the information in Table I above to comply with FINRA and SEC performance advertising rules. Regardless, we believe the over 24 years since the Fund’s inception divided into the four periods described in Table II below are more relevant. That table depicts how the Fund performed during periods of euphoria and stress. Such periods have generally resulted from events that could not be foreseen and that significantly affected economies and markets.
During the quarter, lower quality stocks led the market higher. Those stocks had performed poorly in the first half of the year due to global growth concerns, falling oil prices, and uncertainty caused by Brexit. The Fund’s lower exposure to Health Care, specifically biotechnology stocks, which this Fund does not own, detracted from performance. As a sub-industry, biotechnology stocks surged 19% during the third quarter. The Fund’s larger exposure to Consumer Discretionary companies and stock selection in the Information Technology sector hurt performance on a relative basis during the quarter. The Fund was penalized in the period by share price declines in several long-term holdings about which we remain optimistic in the long term, including Inovalon Holdings, Inc. and Tesla Motors, Inc.
Although the Fund is underperforming year-to-date, its consistent long-term approach to investing in what we believe are high quality, competitively advantaged, growth businesses of any market capitalization run by exceptional managers has generated substantial excess returns since inception. We think we can continue to achieve substantial excess returns per year, on average, though there can be no guarantee we can achieve our goal.
Over the long term, the Fund has outperformed its benchmark by 1.68% per year on average since its conversion from a partnership to a mutual fund on April 30, 2003, and by 3.08% per year annualized since its inception on January 31, 1992. When Baron Partners Fund is compared to the 38 funds currently in the Morningstar Mid-Cap Growth Category since the Fund’s inception in 1992, Baron Partners Fund is the #1 performing fund in that category.**
We think two periods since December 31, 1999 are especially interesting. The first is the nine years ended December 2008 when stock markets performed poorly. This period, “The Long and Winding Road” included the bursting of the Internet bubble, 9/11, wars in Iraq and Afghanistan, the housing bubble and a financial panic. During this period, the Fund, unlike the market, had positive returns and outperformed its benchmark by 6.23% per year annualized.
The second period is the seven years ended December 2015 when stocks performed exceptionally well, the “Here Comes the Sun” years. The most important development during this period was an economic recovery driven by the U.S. Federal Reserve’s quantitative easing. The Fund (Institutional Shares) trailed its benchmark by 1.15% per year annualized during this period but outperformed the large-cap S&P 500 Index by 2.08% per year annualized. The Fund earned annualized returns of 16.89% for these seven years, about tripling in value, a period marked by highly correlated stock prices regardless of business fundamentals. The absence of biotechnology stocks and “FANG” tech stocks in the portfolio disadvantaged the Fund relative to our benchmark index during the period. Regardless, the Fund performed in the top 25th percentile against its peers in the Morningstar Mid-Cap Growth Category during the period.
We believe the outlook for stocks and the U.S. economy remains favorable. Jobless claims are in a range consistent with moderate growth and unemployment is holding steady at around 5%, the lowest level since the recession began in late 2007. Housing starts and existing home sales are strong, while affordability, given the continued low interest rate environment, has never been higher. Given this backdrop, stocks remain attractively valued, in our opinion, trading approximately 17 times next year’s earnings. Historically, stocks have provided protection against inflation and better returns than other asset classes. We think that will continue to be the case
Shares of veterinary diagnostics leader IDEXX Laboratories, Inc. (IDXX, Financial) increased in the third quarter. The stock continued to rally on strong financial results and multiple expansion. Competitive trends are strong and improving, highlighted by instrument revenue growth, domestic lab growth, rising sales productivity, and stability in rapid assays. We believe that IDEXX’s direct go-to-market model coupled with research and development-driven product enhancements will put steady upward pressure on organic revenue and earnings growth over time. (Neal Rosenberg)
Shares of brokerage business The Charles Schwab Corp. (SCHW, Financial) appreciated in the third quarter on continued strong asset growth. The business continued to shift to fee-based advice from trading activity, a move that we believe creates more stability and the potential for increased profitability. Speculation of an interest rate hike by the U.S. Federal Reserve also helped boost the stock price as a rate increase would likely improve earnings for the company. (Michael Baron)
Shares of ski resort company Vail Resorts, Inc. (MTN, Financial) increased in the third quarter on news that the company had entered into an agreement to acquire Whistler Blackcomb in Canada. Vail owns among the best ski resorts in North America, including Vail, Beaver Creek, Park City, and now Whistler. The deal gives the company greater scale, which we think it will be able to leverage in its bid to continue to grow its season pass sales. (David Baron)
Shares of health care data and analytics vendor Inovalon Holdings, Inc. (INOV, Financial) fell in the third quarter on weak financial results and reduced guidance through year end. Management attributed the revenue shortfall to price reductions in its retrospective risk adjustment business, and the margin shortfall to investments aimed at long-term growth. We think the recent poor performance is temporary. Inovalon has high quality products that generate solid return on investment for its customers, and we think it is well positioned to capitalize on the need for robust data and analytics in health care. (Neal Rosenberg)
Shares of electric vehicle company Tesla Motors, Inc. (TSLA, Financial) fell during the third quarter as the market continued to evaluate the potential merger with SolarCity. An investigation into a fatal accident involving Tesla’s autopilot and the possibility of an additional equity round by year end also pressured the stock. We feel good about the brand Tesla has built and its ability to bring substantial innovation to its products. Tesla has received over 370,000 Model 3 reservations, representing close to $18 billion in backlog and the largest product launch in history. (Gilad Shany)
Zillow Group, Inc. (ZG, Financial) is the leading online real estate company in the U.S. Shares fell in the third quarter as investors paused prior to a new product roll out. While investors appear cautious about the near-term impact of this roll out, we expect that after a short transition period, the program will have a positive impact on revenue growth. Zillow continues to invest in its brand as the leader in an $8 billion real estate advertising market. We believe that, as the leader of a highly fragmented market, Zillow remains well positioned to grow its share going forward. (Ashim Mehra)
An attractive entry point led us to establish a position in Robert Half International, Inc. (RHI, Financial), a company we have admired for many years and owned in various accounts since 1990. Founded in 1948, Robert Half is the first and largest provider of specialized staffing services, competing globally in some of the most attractive, highest margin segments of the staffing industry–finance, accounting, and IT- which are benefiting from strong secular demand and skilled worker shortages. We believe Robert Half has unique competitive advantages including its market positioning, strong brand name, and best-in-class management. Its focus on small- and middle-market clients, rather than large national accounts supports premium pricing leading to higher margins. Robert Half continues to invest in sophisticated technologies to improve its candidate sourcing and management and job placement capabilities. In addition to its staffing business, we believe the competitive advantages of Robert Half’s Protiviti subsidiary, a leading independent internal audit and business and technology risk consulting firm, make for an exciting story. We believe the $750 million in annual revenue Protiviti generated has the potential to be much larger, its growth driven by a stricter regulatory environment, especially since the financial crisis and the ever increasing need for enhanced data security and privacy. The independence of Protiviti’s internal audit practice is uniquely positioned to benefit from the heightened scrutiny of businesses’ internal financial controls with regulators routinely inspecting the work of larger public accounting firms. Robert Half generates a high ROIC, and its strong free cash flow is returned to shareholders through consistent share repurchases and dividends. We believe Robert Half will be able to continue to grow its revenue and margins. (Susan Robbins)
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 the shift to value-based health care 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 addressable market by three-to-four times. (Neal Rosenberg)
We initiated a position in Netflix, Inc. (NFLX, Financial) in the quarter. Netflix is the leading provider of on-demand streaming media that is now available in over 100 countries worldwide. We view that this form of Internet TV, which is on demand, personalized, and available anywhere, is replacing the linear TV experience. Netflix management has targeted 60 to 90 million U.S. subscribers long term and approximately twice that number globally. We view recent partnerships with multi-channel video programming distributors such as Comcast, DISH, and Virgin, who have integrated the Netflix offering on to their platforms as another positive. As the company scales subscribers as it has in the U.S., we expect margin expansion to follow accordingly. (Ashim Mehra)
Investment Strategy
Baron Partners Fund is a concentrated portfolio that invests for the long term in what we believe are competitively advantaged, well-managed, growing businesses at what we think are attractive prices. Often, we have opportunities to purchase stocks of businesses we have researched extensively, which we believe are mispriced or have fallen in price due to what we perceive to be temporary issues. This quarter, we continued to add to our stake in sportswear brand Under Armour, Inc., health care analytics company Inovalon, and cruise operator Norwegian Cruise Line Holdings, Ltd. for just these reasons. We initiated new positions in staffing firm Robert Half International, which we have owned previously for many years and streaming video and content subscription leader Netflix. Our objective is to purchase shares of what we believe are well-established, appropriately capitalized, growing companies, with strong positions in markets with growing demand for their products and services. The Fund may use leverage with the goal of enhancing its investment returns. Leverage also increases risk, of course.
Another common attribute of Baron Partners Fund is that we invest in businesses investing for growth, often at the expense of short-term profits. These businesses are investing in order to become much larger, more profitable businesses in the future. Virtually all the businesses in which we have invested are making such capital commitments. During the third quarter, two of our long-time holdings, Vail Resorts and Arch Capital Group Ltd., made significant acquisitions that are worth highlighting. Vail Resorts acquired Whistler Blackcomb, Canada’s premier ski resort. This deal helps diversify Vail’s portfolio and expand the base of customers to which it can market and sell its successful season pass product. After recently acquiring Park City, Canyons, and Perisher in Australia, Vail has built what we consider to be an unmatched portfolio of the best ski resorts in the world. In August, Arch Capital announced the acquisition of United Guaranty, AIG’s mortgage insurance subsidiary, which makes Arch the nation’s largest underwriter of mortgage insurance. Mortgage insurance offers some of the best risk-adjusted returns in the property & casualty insurance market and United Guaranty’s risk-based pricing methodology complements Arch’s underwriting philosophy. We expect both acquisitions to improve the earnings growth outlooks for both businesses and drive shareholder value.
Verisk Analytics, Inc. continues to make additional investments in its real estate data services, CarMax, Inc. continues to grow its superstores and wholesale auctions at a healthy clip while investing heavily in its digital strategy. Hyatt Hotels Corp.’s investment in renovations and improved guest services, as well as its ongoing expansion in Asia, are also noteworthy in this regard. As long-term investors who hold stocks for an average of over four years, we expect to benefit from these expenditures. In contrast, most growth-oriented mutual funds are trading oriented, turning over their entire portfolios on average every 17 months. Since these funds, in general, will not care about or benefit from such long-term, strategic investments by businesses, they accord them little or no value. This allows us to invest in these companies at prices we feel are especially attractive.
Baron Partners Fund also has significant investments in growing “C” corporations like Vail Resorts, Inc., whose shares we believe are undervalued when compared to similar businesses structured as REITs or master limited partnerships. We expect alternative money manager The Carlyle Group and financial intermediary The Charles Schwab Corp. to benefit as interest rates increase.
Managing risk is a key part of our investment process. We help manage risk from a company perspective by investing in businesses that we believe are conservatively financed with high barriers to entry. Our proprietary research regarding business’ long-term growth opportunities, competitive advantages, management teams, and risks determines how much we allocate to individual securities. We invest in different industries that are affected differently in the short term by various events. This is to achieve a portfolio of investments with risks that are not correlated. This is part of our effort to help reduce the volatility of this non-diversified and leveraged portfolio.
Portfolio Structure
The portfolio is currently invested in 30 businesses, principally in mid-cap companies. As of September 30, 2016, the weighted average market capitalization of its portfolio investments was $14.0 billion, compared with $13.2 billion for the Russell Midcap Growth Index. The Fund currently has significantly larger investments in the Financials and Consumer Discretionary sectors than the benchmark. The Fund’s investments in Industrials, Health Care and Information Technology are weighted less than the index. The Fund does not have investments in Consumer Staples, Energy, Materials, Telecommunication Services or Utilities. We are not attempting to mirror our benchmark or any other index with the Fund’s portfolio. The Fund’s top 10 holdings represent 64.8% of the Fund’s gross assets.
Thank you for investing in Baron Partners Fund.
Thank you for joining us as fellow shareholders in Baron Partners Fund. We believe the growth prospects for the businesses in which Baron Partners Fund has invested are favorable and improving. Since, in our opinion, the share prices of our businesses do not reflect their prospects, we believe they remain attractive. Of course, there can be no guarantee this will be the case.
We are continuing to work hard to justify your confidence and trust in our stewardship of your family’s hard-earned savings. We also remain dedicated to continuing to provide you with the information I would like to have if our roles were reversed. This is so you will be able to make an informed decision about whether this Fund remains an appropriate investment for you and your family.
Respectfully,
Ronald Baron
CEO and Portfolio Manager
October 17, 2016
The discussions of the companies herein is 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.
