What a year! Baron Discovery Fund (the “Fund”) turned in a really nice performance in 2016, up 21.73% (Institutional Shares), or 10.41% ahead (after fees) of the Russell 2000 Growth Index. In the fourth quarter, the Fund’s performance was flat, and the Fund lagged the index by 3.57%.
The Fund lagged in the fourth quarter due to some very unusual circumstances that we do not believe will affect its potential to outperform the benchmark on a long-term basis. Whether or not the election of Donald Trump as the 45th President of the United States will unleash significant GDP growth in the U.S. economy, it has certainly uncaged a lot of animal spirits in the market. This was a head-snapping finish to the year. The Fund’s industry exposures match where we believe there will be secular growth in the economy, but they do not sync with a violent upswing in cyclicals (banks, commodities and materials, and industrials, to name a few). According to a December report from Bank of America, in the first half of that month “investors rotated out of ‘growth’ (tech, health care) and ‘bond proxies’ (utilities, telecommunications, staples) and into resources, banks and cyclicals, with a big majority of investors expecting cyclical value to beat quality growth until ‘well into next year.’”
Some of the statistics are mind bending. Trim Tabs, which tracks fund industry flows, said that U.S. equity ETFs “received a record $97.6 billion from Tuesday, November 8 through Thursday, December 15.” To put this in context, this flow is equal to one and a half times the $61.4 billion inflow in all of 2015. In other words, investors jammed into equity exposure as fast as they could. And where did the money go? In small cap, it went to value as opposed to growth. According to a Jefferies report from December 19, 2016, over the last month (approximating the post-election period highlighted by Trim Tabs), ETF flows into small-cap value were $2.83 billion versus inflows of $858 million into small-cap growth. Therefore, value flows exceeded growth flows by a 3:1 ratio – and that’s what outperformed in the quarter (the Russell 2000 Value Index was up 14.07%, while the Russell 2000 Growth Index (our benchmark) was up 3.57%.
We believe that the performance disparity in the fourth quarter due to sector rotation will reverse sooner rather than later. But we never rest. While we are excited about our performance during 2016, we know that the scoreboard resets on January 1. Given that we are being trusted by you, our investors, as well as our wives (given our own substantial holdings of the Fund), we feel compelled to explain why we continue to be bullish into 2017. In a recent presentation to our sales team, we laid out the catalyst
rich year we can see through our windshield, in an effort to answer the perennial question: “Why buy now?” We take pride in our deep and detailed research process. And we’ve seeded the portfolio with a lot of investments that we consider to be “terrific” under the Baron lexicon (great managements, strategies, market opportunities, competitive advantages and cash flow growth potential – all at a reasonable valuation). Our long-term viewpoint means that, by definition, not everything is hitting on all cylinders when we make a purchase (because it would then have to be at least fully-valued in the short term as the market discounts all known information). Thus, we are always waiting for strategic growth initiatives to germinate within our companies in order to unlock incremental value. These initiatives ripen at different times, among different investments in the portfolio. While we always hope to have a good spread of catalysts across a given time horizon, we believe that the current portfolio is extremely rich in 2017.
This catalyst heat map becomes all the more important given the dramatic sector rotations we laid out above. While smart beta allocations and hot sectors come and go, what remains evergreen is a high medium-to-long-term correlation of equity values with cash flow generation. And that’s our game. So let’s examine our catalyst menu.
Conventionally, Health Care is viewed as defensive, but it’s also facing the headwind of the uncertainty of the reform of the Affordable Care Act (“Obamacare”). To try to mitigate the political risk in the sector, we look for companies that we believe can provide better patient outcomes for lower overall costs. That way all stakeholders can win. In the space we own:
- Flexion Therapeutics Inc. (FLXN), which has a potential $4 billion market for injectable treatment of osteoarthritis. It expects FDA approval of its drug Zilretta by the second half of 2017 (phase 3 data from last June was positive).
- TherapeuticsMD, Inc. (TXMD) has a potential $1-$2 billion market in vulvar-vaginal atrophy treatments (VVA), and a $3-$4 billion market in drugs for the treatment of hot flash symptoms related to menopause. VVA should be approved in May 2017, and we expect the menopause drug to be approved in early 2018 (phase 3 clinical results for both drugs were excellent).
- Foundation Medicine, Inc. (FMI, Financial) provides state-of-the-art next generation genomic sequencing tests for advanced cancers. It has a $2-$3 billion potential market and revenues could accelerate in the second half of 2017 if the FDA approves its solid tumor test according to current timelines (which would be the first approval of its kind), and the test gets simultaneously reimbursed by CMS (Medicare payer) as part of the same process.
- Sientra, Inc. (SIEN) is a medical device company that manufactures breast implants and sells related surgical products. It expects to get a major U.S.-based manufacturing facility approved by the FDA in the second half of 2017.
Technology is ever changing, so we like companies with protected intellectual property and big market opportunities:
- MACOM Technology Solutions Holdings, Inc. (MTSI) is an analog semiconductor design and manufacturing company. In 2017 it has the potential to see huge growth in applications of its technology to optical networking (a multi-billion dollar market), cell phone tower transmission power amplifiers (a $1 billion market in which MACOM has patent protection), defense and civil radars, and other opportunities. We see 20% revenue growth for years to come.
- Everspin Technologies, Inc. (MRAM) is expected to launch a chip which will open up a $500 million memory market in which we believe the company has a multi-year lead.
- Impinj, Inc. (PI), a manufacturer of radio-frequency identification (RFID) solutions for asset tracking, continues to make progress in its core retailer channel, and we expect more retailer customers to go live in 2017. In addition, we expect other emerging channels, such as airlines and hospitals, to show continued progress.
Consumer also has some exciting surprises in store:
- Wingstop Inc. (WING), a franchisor of chicken wing focused take out restaurants, is launching a national advertising campaign for the first time in March. Historically, when other chains have launched national ad campaigns, they have seen a significant pickup in same store sales over the next couple of years.
- Red Rock Resorts, Inc. (RRR), an operator of casinos catering to Las Vegas residents, is expected to announce its property improvement plan for the newly acquired Palms casino. The Palms’ profitability is less than half of where it was at its peak, and we believe with new amenities and upgrades (and under the management of the Red Rock team), the property can return to peak profit levels.
- Liberty Media Group (LMCA) will complete its purchase of the Formula 1 car racing series in the first half of 2017. We then expect Formula 1’s new management to lay out an operational and profitability improvement plan that will boost profitability for the series in 2018 and beyond. We are excited for the potential of this series given that we believe it has not been fully exploited over the last few years.
- Barfresh Food Group, Inc., a manufacturer of ready-to-blend beverages, continues to run product trials with large quick service restaurant customers. Trials are advancing toward full chain rollouts, with initial announcements to come this year.
We could write similar bullets for nearly every one of the Fund’s investments, but we hope this gives our investors a good sense as to why we are so optimistic about our portfolio for the coming year.
Mercury Systems, Inc. (MRCY, Financial) is a provider of complex electronic subsystems to major defense contractors. 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). During the fourth quarter, shares performed well as Mercury continued to win contract awards. This was aided by the sentiment that a Republican administration will be more likely to increase defense spending. We agree with this theory, but believe that Mercury’s growth is likely to be driven as much, or more, by market share gains as more work is outsourced to it by major defense prime contractors.
Kinsale Captial Group, Inc. (KNSL, Financial) is a specialty insurance company that focuses exclusively on excess and surplus lines, which includes risks that are unique or hard to place in the standard insurance market. The company, which went public in July 2016, outperformed in the fourth quarter after reporting excellent financial results. Earnings were much higher than expected thanks to strong underwriting and favorable reserve development. The stock also benefited from a secondary offering that increased float and a sector rotation into small-cap financials following the U.S. elections on expectations for faster economic growth, higher interest rates, and lower corporate tax rates. We continue to own the stock because of Kinsale’s niche market focus, industry-leading growth, industry-leading ROE, and experienced management team.
BlackLine, Inc. (BL, Financial) modernizes manual accounting processes through a cloud solution, providing better visibility and efficiency to customers. BlackLine’s shares outperformed this quarter, as the company continued to grow its market share both in the mid- and high-end portions of the market and continued to expand its strategic partnerships. With its growing product line and investments in sales capacity, we believe that BlackLine should continue its rapid sales growth going forward.
Dominion Midstream Partners, L.P. (DM, Financial), a holder of natural gas storage, processing and transportation assets, was a contributor in the quarter. The company acquired assets of Questar pipeline during the quarter, which was highly accretive to unit holders. The announced deal also removed the overhang of an equity offering that was also concluded during the quarter. We believe the company still has a large pipeline of future drop downs, and we remain comfortable with management’s 22% distribution growth guidance.
ESCO Technologies, Inc. (ESE, Financial) posted an impressive 20% earnings per share increase in its September quarter. Management drove solid organic growth, supplemented by four announced acquisitions that should be accretive. In addition, a major comparable company operating in its filtration segment was purchased at a very high multiple, highlighting that much value still remains in ESCO’s equity. In November, ESCO offered positive guidance for its upcoming fiscal year. Also, like many industrial stocks, it has benefited from the perception that the proposed policies of President-elect Trump will be positive for the economy.
Novadaq Technologies Inc. (NVDQ, Financial) is a medical imaging company. Its tools, which show blood flow (perfusion), have been clinically proven to dramatically improve outcomes in many types of surgeries, including colon resection (where a segment of colon is removed and the ends are re-attached), breast reconstruction (typically in cancer surgeries), and many other general surgeries. Significant clinical trials are underway with leading medical institutions that will assess the ability of Novadaq devices in guiding complex lymph node surgeries related to the spread of cancer. The company also sells human-based tissue replacement (complementary to breast reconstruction, and potentially useful for diabetic foot ulcer treatment). Shares fell in the fourth quarter due to, what in our opinion was, a misunderstanding of the halting of a clinical trial in colon resection. The company halted the trial (which was to be a larger version of a prior successful trial in the space) because its devices have been proven to be so good that the company couldn’t find doctors willing to forego its use on surgeries needed to create a control group cohort. Another issue holding back the shares is a change of business plan to sell capital equipment to customers over three-to-four years versus an upfront payment, which defers revenue and cash flow. Thus, despite recurring revenues growing at 40-50% rates (half the business), equipment sales growth has slowed to single digits. This has caused overall revenue growth to slow to 25% from about 30%-40% growth. We are assessing the situation, but believe the current multiple reflects the change in business dynamics. Also, because of the model change, more of the company’s revenues will be recurring, making Novadaq more attractive to potential acquirers, particularly at its current valuation.
Qualys, Inc. (QLYS, Financial) is a cloud-based cybersecurity services provider that specializes in assessing software vulnerabilities of hardware attached to internet networks. Shares were down in the quarter as investors worried that the costs of launching new products would hamper operating margins in 2017. The company has been very successful with new product offerings, particularly its cloud agent technology, which allows customers to see changes to hardware configurations in a rapid and dynamic manner. This allows for quicker responses to potential cyber-intrusions. We are not concerned, and we applaud this kind of value-generating investment. Qualys is accelerating its revenue growth to nearly 20% and continues to trade at a very reasonable multiple of real free cash flow whereas many of its cyber peers are still losing money.
Flotek Industries, Inc. (FTK, Financial) is primarily a supplier of chemical additives to the global oil & gas industry with some other ancillary oilfield service operations. The company has a proprietary product dubbed “complex nano-fluid (CnF)” that is proving to be extremely effective at increasing oil & gas shale well productivity. The company’s shares fell in the quarter following the assertion by a short-seller that independent consultant studies commissioned by Flotek earlier in 2016 were based on incomplete data and therefore the short-seller questioned the efficacy of the CnF product. In response to these allegations, the independent consultants referenced above later incorporated additional data and still reiterated their conclusions about the positive impact of CnF on customer well productivity. We expect Flotek’s shares to rebound as the company demonstrates that customer demand for CnF remains strong.
Cerus Corporation (CERS, Financial) has an FDA and EU approved device that inactivates pathogens such as viruses and bacteria in donated blood. Current regulatory approvals cover use of the Cerus device for platelets and plasma from donated blood (an $800 million worldwide, and $350 million U.S. market opportunity, for which Cerus has signed up over 80% of all U.S. blood centers). If additional approvals for usage with red blood cell (RBC) components are obtained, Cerus will add an estimated $2.5 billion in market opportunity ($1 billion in the U.S., in the same blood centers), for which there is no current competition. Shares slipped in the fourth quarter as the company slightly extended its timeline (by what we estimate might be one to two quarters) to get the RBC product to market. We believe Cerus is targeting EU approval for RBC in early 2018, and we believe that U.S. approval could be obtained for RBC in 2019. We believe growth prospects for Cerus are significant for 2017 and beyond.
Foundation Medicine, Inc. (FMI, Financial) is a high end genomic cancer testing and information services company. Delays in obtaining reimbursement have caused guidance reductions, and shares have dropped significantly since Roche purchased over 50% of the company at $50 per share in early 2015. Now there is a definitive catalyst that we believe will be a game changer. Foundation Medicine has submitted an application to the FDA for approval of its tissue based test which could sanction its use as a companion diagnostic for FDA approved drugs covering over 40% of the metastatic cancer population in the U.S. Moreover, as part of the process, Foundation Medicine is simultaneously seeking CMS (the Medicare payer) coverage for the test. We expect approval to be obtained in the second half of 2017.
Portfolio Structure
Our key sector weightings at the end of December 2016 were 31.9% Information Technology (7.5% above the Russell 2000 Growth Index), 25.1% Health Care (4.2% above the Index), 14.1% Consumer Discretionary (1.3% below the Index), and 11.2% Industrials (5.6% below the Index).
We have been overweight Health Care and underweight Consumer Discretionary and Industrials pretty consistently over the last few quarters. This hurt us in the fourth quarter as Industrials rallied and Health Care lagged. Given current relative valuations in these sectors, we believe that this will reverse, and we are comfortable with the existing weightings. Information Technology is an above index weighting as it was last quarter (when we first moved overweight). We continue to find new and exciting growth ideas within that sector.
Our top 10 holdings at December 31, 2016 represented 28.2% of the portfolio. This is consistent with exposures that we’ve held over the life of the Fund at around 30%.
Liberty Expedia Holdings, Inc. (LEXEA, Financial) is a holding company where the majority of the value is derived from its stake in Expedia, Inc., and therefore the stock trades largely in tandem with Expedia. We are bullish on Expedia, the largest online travel agency (“OTA”) in the U.S. and the second largest in the world. We think the investments that Expedia is making in both its core OTA business and in its HomeAway business (acquired in December 2015) that caused a headwind to profitability this year, will ultimately show respectable returns in 2018. We believe we bought the company at a depressed multiple because of near-term earnings headwinds and, in time, we believe the stock has significant upside as these headwinds abate.
Dominion Midstream Partners, L.P., a holder of natural gas storage, processing, and transportation assets, was also a new purchase in the quarter. The company is a high growth MLP formed by Dominion Resources, Inc., a diversified energy company that provides electricity and natural gas to homes and businesses in the eastern U.S. Dominion Resources recently acquired Questar and as part of that transaction, Dominion Midstream completed its acquisition of Questar Pipelines and the related financing. The market anticipated the equity financing and pushed the stock lower ahead of the equity offering. We took advantage of the pressure to buy what we believe is a long-term growth opportunity at an attractive price. As Dominion Midstream completed the equity offering, the stock price appreciated, validating our belief that recent stock pressure was purely technical in nature. We continue to like Dominion Midstream both because of its 22% guided distribution growth and its large “drop down” inventory of assets that can be sold from Dominion Resources to Dominion Midstream over time.
On share weakness, we added to existing positions Qualys, Inc., Cerus Corporation, and MACOM Technology Solutions Holdings, Inc. (a terrific semiconductor company that we wrote about in detail in our June 2016 and March 2016 letters).
During the fourth quarter we sold our position in Gaming and Leisure Properties, Inc. We received Gaming and Leisure stock as a result of our investment in Pinnacle Entertainment, Inc. when Gaming and Leisure acquired Pinnacle’s real estate holdings. While we are believers in the long-term prospects of Gaming and Leisure, the market cap was significantly larger than the typical stocks in the Fund, so we used that holding as a source of cash for new smaller-cap ideas. We sold our positions in Easterly Government Properties, Inc., Kennedy-Wilson Holdings, Inc. and American Assets Trust, Inc. as we felt valuations were full in the context of the current interest rate environment. We also sold Sonic Corp., a franchisor and operator of quick service hamburger restaurants. While we are believers in the company’s strategy to go “asset light” by converting company stores into franchise stores, the company was unable to lessen its general and administrative costs to the level we felt was necessary to make the “asset light” strategy successful.
Outlook
We want to thank our investors, as well as all of the terrific people at Baron who have helped us get to our three year milestone with such success. In particular, we would like to thank Cliff Greenberg for his unwavering support and sage advice. We hope that this letter gives our present and prospective investors a taste of why we are so excited about the Fund’s prospects going into 2017. Let’s all have a profitable and healthy new year!
Randy Gwirtzman & Laird Bieger
Portfolio Managers
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.
