The Baron Fifth Avenue Growth Fund (the “Fund”) declined 6.3% (Institutional Shares) during the fourth quarter and 1.8% for the year, which compared to gains of 1.0% and 7.1% for the Russell 1000 Growth Index and 3.8% and 12.0% for the S&P 500 Index, respectively. The portfolio performed particularly poorly during the quarter which led to a disappointing year.
The quarter began predictably enough with most of our investments “muddling” along, digesting the double-digit gains of the prior three months. Illumina, Under Armour, and FireEye (again) reported disappointing quarterly results and their stocks were hit hard, but the damage was contained with Facebook, Alibaba, and Priceline Group reporting excellent numbers and offsetting most of the losses. Headwinds from assets continuing to flood to passive investments (a record $375 billion into ETFs, while active managers saw outflows of $288 billion) and propping up index returns made it difficult for us to keep up, but we emerged from the fourth quarter reporting season trailing the benchmarks modestly, which is not unusual for us after a period of strong outperformance. The unexpected results of the U.S. presidential election caused a significant shift in market sentiment and a powerful rotation from global growth businesses, which are the companies in which we primarily invest, into domestic companies that were likely going to benefit from U.S. corporate tax cuts, infrastructure investments, military build-up, and trade protectionism. It was bad enough that stocks of the investment banks, industrials, materials, and defense companies were suddenly surging, their run up was being funded by
investors selling Amazon, Facebook, Google, and other global growth companies. A challenging environment for our portfolio and for the way we invest–to say the least.
The top four contributors to performance this quarter–Charles Schwab,
First Republic Bank, CME Group, and Synchrony Financial, were all Financials. They went up for the right reasons as they are full U.S. taxpayers, will benefit from significantly lower regulatory hurdles and the likely persistent rise in interest rates that seems even more inevitable now, given expected fiscal stimulus, wage inflation, and the plainly inflationary policies of the incoming administration. However, these were medium to small size positions, and the gains were not nearly enough to offset the “carnage” (to borrow a term from our new leader’s inauguration speech) that we saw in our Information Technology and Consumer Discretionary investments which comprise almost 70% of the Fund. Amazon, Facebook, FireEye, Red Hat, and Mobileye sold off because of perceived dependence on foreign workers (H-1B visas, which now will be more difficult to obtain); Alibaba, Naspers (think Tencent), and Ctrip–on fears of a trade war with China. Illumina, Allergan, Biogen, and Regeneron were hit over angry presidential tweets regarding drug prices and the uncertainty/likelihood of the repeal of the Affordable Care Act. But most importantly, all of these companies are global growth businesses that would not benefit from the new administration’s stated and perceived priorities, so their shares were used to fund the purchases of the companies that would.
It is tempting to blame a disappointing result on the unpredictable election and adverse sector rotation or some short-term market dislocation. However, it is more prudent to take a step back and try to evaluate objectively the quality of the investment decisions that were made. We operate in a business that is characterized by incomplete information, high degree of uncertainty, and unpredictable events that frequently have a material impact on final results. In other words, we accept that a good or a bad result is not really in our control, especially over shorter periods of time. To use a sports analogy, a player cannot control if her shot will go in or how many goals she will score (the opposition, referees, and even the weather can have significant impact on that and the game’s outcome). But she can control the quality of her shots. Similarly, we try to worry less about the score and worry more about the quality of the decisions that we make. So over the last few weeks, we went back and tried to re-evaluate every significant investment decision that we have made over the last three years. All 58 of them. The point was not to figure out what worked and what didn’t. That part was obvious enough. The question was why, and what can we learn from it?
We made a few surprising discoveries. While we fully expected cognitive mistakes arising from overconfidence, for instance (since over the years we have developed significant expertise in the field of investments and all experts are prone to an exaggerated sense of how well they understand their world), we did not expect systematic errors. Our process has been developed and tested over a multi-decade period of time and is the foundation upon which our investment decisions are based. It is rare for us to find flaws in it, so we’re pretty excited about that.
Here is an example. Quality of the management team is an integral part of any investment thesis. We assess the CEO’s ability to set a vision, create a culture, and execute the business to create and maximize shareholder value over the long term. We met with Ahmad Chatila, the CEO of SunEdison, on multiple occasions. We think it was a cognitive mistake to assign him the highest marks at the peak of his company’s success, the kind of mistake that only becomes apparent in hindsight. However, it was a systematic error to not reduce the weight or the importance that we assign to great managements in the case of SunEdison. Think of Jeff Bezos of Amazon, or Howard Schultz of Starbucks, or Bruce Flatt of Brookfield Asset Management. These are proven leaders with long track records of great capital allocation and shareholder value creation. The kind of track record that Ahmad Chatila did not have. Knowing what we knew at the time, and having done as much work on SunEdison as we did, it was unlikely that we could have avoided investing in it (and this investment could have turned out differently if the price of oil did not collapse creating the liquidity crisis when it did), but had we weighted our conviction in management lower among all other variables we would have owned less, and it would have mattered. We found a couple of things like this.
We re-evaluated our investment inputs and tinkered with how we weight them. That process is never easy. We believe this is necessary if one hopes to improve. We continually implement fixes that we hope lead to better, more consistent decision making. Although, there can be no assurance that it will, in fact, be the case.
Shares of brokerage business The Charles Schwab Corp. (SCHW, Financial) rose over 25% in the fourth quarter on the expectation of multiple interest rate increases in 2017, which should bode well for the company’s earnings. Charles Schwab also reported solid asset growth reaching over $2.7 trillion. 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.
First Republic Bank (FRC, Financial) provides banking and wealth management services to affluent clients in metropolitan areas of the U.S. The stock appreciated 19% during the quarter as it participated in the post-election rally for financial companies and on expectations for faster economic growth and higher inflation. In addition, First Republic reported good financial results with 18% loan growth and 24% deposit growth. We added to our investment during the quarter and continue to believe the bank has an advantaged business model and a long runway for growth.
CME Group, Inc. (CME, Financial), operates the world’s largest and most diversified financial exchanges for trading derivatives. Shares increased 14% in the December quarter due to greater post-election trading activity with average daily volumes up 24%. CME is also benefiting from investor expectations for a more normalized interest rate environment and greater hedging activity. We continue to own the stock because we expect solid earnings growth from higher trading and clearing volumes.
Shares of our most recent investment, Synchrony Financial (SYF, Financial), the largest U.S. issuer of private label credit cards, were up 16%. Synchrony benefited from the post-election rally for financial stocks and on hopes for faster economic growth and higher inflation. In addition, Synchrony reported financial results that beat Street estimates, with 12% growth in net interest income, significant margin expansion, and the initiation of a capital return program. We believe Synchrony operates in a highly profitable market niche and has a long runway for growth.
Yum China Holdings, Inc. (YUMC, Financial) is YUM! Brands, Inc.’s master franchisee in China, operating all KFC and Pizza Hut branded restaurants there. The company was spun out of YUM! Brands in October 2016 and appreciated by over 20% by late November due in part to the depressed price at which it started trading in its early days as a public company. We liquidated the shares as the very strong initial performance brought the price closer to our estimate if its intrinsic value. We continue to monitor Yum for possible future ownership and its potential for attractive long-term unit growth.
Shares of Amazon.com, Inc. (AMZN, Financial), declined 10% during the fourth quarter. After a streak of stellar quarterly earnings reports, which showed meaningful margin and profitability upside, Amazon reported mixed results with operating margins and guidance slightly below Street’s heightened expectations driven by weaker retail margins and investments in India and abroad. Amazon is continuing to invest heavily in several growth initiatives, including Amazon studios, Alexa, India, Amazon Web Services, and distribution and fulfilment center expansions. We see the company as the undisputed global leader in the two, secularly growing, multi-trillion dollar markets of e-commerce and cloud computing, and it remains our highest conviction long-term investment idea.
Shares of Illumina, Inc. (ILMN, Financial), the leading provider of DNA sequencing technology to academic and commercial laboratories, fell almost 30% after reporting disappointing third quarter financial results. The shortfall was caused primarily by weak high-throughput instrument sales in North America and general weakness in Europe. Illumina’s growth is very much driven by new product introductions, and in 2016 sales suffered as the high- throughput instrument line reached the end of its life cycle. In early 2017, Illumina launched a new high- throughput sequencing platform that should re-accelerate growth. In addition, Grail, the start-up funded by Illumina which is developing a blood-based cancer screening test, announced it received capital commitments of $1 billion and would become one of Illumina’s largest customers over time. We continue to believe Illumina has a long runway for growth driven by increasing adoption of DNA sequencing in clinical markets such as cancer screening, diagnosis, and treatment.
Alibaba Group Holding Limited (BABA) is the largest e-commerce and cloud services provider in China and the second largest one in the world. Its stock price declined 17% during the quarter despite reporting strong financial results. Concerns regarding the weakening Chinese economy and the further depreciation of the Yuan were weighing on investors’ confidence, which were further exacerbated by the U.S. election results. We continue to believe that Alibaba represents a unique and compelling opportunity to invest in the long-term growth of e-commerce, mobile, and cloud-computing in China.
Shares of Facebook, Inc. (FB, Financial), the world’s largest social network, fell 10% over the fourth quarter due to concerns over slowing revenue growth after management announced that ad inventory is not expected to be a major driver of growth starting mid-2017. We think the company will be able to grow revenue through improved targeting, higher pricing, and greater video consumption. Facebook is in the early stages of monetizing online video and Instagram, which are both starting to contribute to revenue growth, and taking advantage of WhatsApp and Oculus as additional growth opportunities.
Shares of Naspers Limited (NPN, Financial), a South African internet and media platform company, fell 15% during the quarter largely due to the weakness of Tencent Holdings, a company in which Naspers has a large ownership stake. Additionally, the company’s pay TV business was impacted by the devaluation of the South African Rand. We believe that shares will recover as Tencent grows and Naspers takes steps to provide visibility into its internet investments.
Portfolio Structure
The Fund’s portfolio is constructed on a bottom-up basis with the quality of ideas and conviction level (rather than benchmark weights) determining the size of each individual investment. Sector weights tend to be an outcome of the portfolio construction process and are not meant to indicate a positive or a negative “view.”
During the quarter we initiated two new investments (Intuitive Surgical and Synchrony Financial) and closed out five others (Yum! Brands, FireEye, Bristol-Myers Squibb, athenahealth, and TerraForm Global). For the calendar year 2016, we purchased six new investments and eliminated 11 others.
The top 10 positions represented 57.6% of the Fund, the top 20 were 80.9%, and we exited the quarter with 32 holdings.
After a multi-year hiatus, we re-initiated an investment in Intuitive Surgical, Inc. (ISRG, Financial) Intuitive sells the da Vinci robotic surgical system, which enables surgeons to perform minimally-invasive surgery in a number of different procedure categories. Minimally-invasive surgery benefits patients because they generally experience less pain and faster recovery after the procedure. Intuitive has held an effective monopoly on robotic-assisted surgery for many years. We believe the company has durable competitive advantages consisting of patents, technology, regulatory approvals, a worldwide installed base of systems, large salesforce, and balance sheet with over $4 billion in net cash. Although Intuitive is expected to face competitors in the future, we believe it will be difficult for competitors to displace the company and the company will maintain its leadership position. In 2016, roughly 750,000 procedures were performed worldwide using Intuitive’s robotic systems, an increase of 15% year-over-year. Intuitive generates revenue from instruments/accessories every time a procedure is performed using its robotic system, which together with annual service fees provides recurring revenue. Management has defined its current addressable market as four million procedures, but we believe Intuitive will continue to expand its addressable market by entering new procedure areas. The company has an exciting pipeline of new products, including a single port system that will enable new procedures and a robotic catheter system that will enable lung tissue biopsies to be taken minimally invasively. In the fourth quarter, the stock pulled back despite a strong fundamental outlook because investors became concerned that the repeal of the Affordable Care Act would cause Intuitive’s hospital customers to cut capital spending, which would negatively impact Intuitive’s system sales. We saw this pull-back as short-sighted and bought the stock. We think Intuitive can grow revenue and earnings at attractive rates over the long term.
We initiated a position in Synchrony Financial (SYF, Financial), the largest provider of private label credit cards in the U.S. Synchrony partners with leading retailers such as Lowe’s, Walmart, and Amazon to offer their customers credit products to finance the purchase of goods and services. These partnerships are win-win since merchants benefit from increased sales and stronger customer loyalty, customers enjoy access to credit and promotional offers, and Synchrony earns high margins and returns on capital. We believe that Synchrony will be a prime beneficiary of the secular growth of private label credit cards. Private label card spending is growing two to three times faster than overall retail sales and has a long runway for growth given that private label represents only 3% of total card spending in the U.S. Synchrony is the largest player in a consolidated industry with meaningful barriers to entry including economies of scale, the importance of marketing expertise, close integration with merchants, and long-term contracts. Synchrony has a long track record of success under GE’s prior ownership that we believe will continue for many more years.
We continued to ramp up our investment in Expedia, Inc. (EXPE), which we initiated in the third quarter. Expedia is the largest global online travel agency in the U.S., and the second largest in the world. The company generates over $60 billion of global bookings and revenues of $6.6 billion. Expedia operates in 75 different countries and has over 18,000 employees globally. Expedia operates over 20 global brands including Expedia, Trivago, Hotels.com, Travelocity, CheapTickets, Wotif, Hotwire, and Venere. The company also recently acquired Orbitz and HomeAway. We believe Expedia is a leading player in a large and secularly growing online travel market where the penetration rate is still relatively low (Priceline Group and Expedia, the two largest players, account for less than 10% of the $1.4 trillion global travel market). Expedia has grown its supply of properties by 73,000 in the last two years (it now has 180,000 compared to 800,000 for Priceline) and improved its user interface leading to better conversion rates. We further believe that Expedia’s margins and overall profitability, which have been running at about half those of Priceline, are poised for significant improvement over the next few years.
We added to our position in First Republic Bank (FRC, Financial) because our confidence in the company’s uniqueness, business model, and management continues to grow. The election results clearly suggest potential for higher interest rates, faster economic growth, lower corporate tax rates, and a more benign regulatory environment. We first purchased First Republic Bank earlier in the year because we believed it was a highly differentiated bank with a long runway for growth. First Republic Bank employs a unique, high-touch business model to serve wealthy customers in fast-growing, coastal markets of the U.S. A singular focus on client service leads to high customer retention and word-of-mouth referrals. Despite growing much faster than the overall banking industry, First Republic Bank is a disciplined underwriter with much lower credit losses than peers. We believe First Republic Bank can continue growing profitably for many years given its strong reputation and low penetration in large markets.
We decided to close out our FireEye, Inc. (FEYE) position this quarter. While we see long-term value potential in this asset, it was clear that harvesting this turn-around situation in a large-cap focused portfolio was problematic. We moved on and reallocated the funds to other ideas.
Bristol-Myers Squibb Company (BMY) is a leading developer in Immuno-Oncology, the new wave of therapeutics aimed at displacing chemotherapeutics in cancer care with both improved efficacy (measured via survival outcomes) and safety profiles. While the class as a whole represents a success for society, the race for class dominance is heated and has proven to be difficult to predict. Coming into mid-2016, Bristol was the clear leader. The company squandered this lead in July when a widely anticipated clinical trial whose outcome was expected to read out positively, failed. While few question the drug’s efficacy, statistics and poor clinical trial design submarined Bristol and allowed competitor Merck to take the pole position commercially. Given the dire need for this patient population, the FDA granted Merck a pathway to market by the first half of this year that will give Merck at least a one year commercial advantage in time to market versus its competition. As a result, we decided to exit our investment in Bristol. While Merck has become the consensus leader, we think that their combination employs the wrong science approach and that Bristol is one of two players (AstraZeneca, the other) that will have an opportunity to ultimately come out on top given its strategy of combining two immune-therapeutics. We intend to follow the situation closely while looking for a more appropriate time to potentially get back into the investment.
We modestly trimmed the size of our Amazon.com, Inc. position for purposes of risk management. Amazon continues to be our highest conviction long-term investment.
We eliminated our small investment in athenahealth, Inc. (ATHN) during the quarter. Although we think athena has a unique business model and best-in-class offering, we lack conviction in the company’s ability to overcome end market challenges (such as fewer opportunities and elongated sales cycles in the ambulatory market, and a trend among clients towards using one vendor for both hospital and ambulatory, a trend which favors competitors like Epic and Cerner) and decided to make room for other new ideas. We continue to monitor the company’s progress and may reconsider the investment thesis in the future.
Outlook
2017 is off to a good start and we were able to recover all of the fourth quarter losses and more than half of the relative performance shortfall in the first 17 trading days of the year. After declining in the first two quarters of the year, S&P 500 earnings increased 3.1% in the third quarter, with consensus looking for 3.2% growth in the December quarter. Economists are predicting earnings growth of between 11% and 12% for 2017, driven by a reduction in corporate tax rates, and an improved backdrop for Financials, Energy, and Industrials companies. More relevant to our portfolio, digital ad spending and e-commerce are expected to grow in excess of 15% with spending on cloud computing growing more than 80%. This should favor many of the companies in which we are invested that have been growing even faster.
Every day we live and invest in a world full of uncertainty. Fed policy, China’s economy, energy prices, politics, terrorism–these are all serious challenges with clearly uncertain outcomes. History would suggest that most will prove passing or manageable. The business of capital allocation (or investing) is the business of taking risk, managing the uncertainty, and taking advantage of the long-term opportunities that those risks and uncertainties create. We are confident that our process is the right one and that it will enable us to make good investment decisions over time.
Our goal remains to maximize long-term returns without taking significant risks of permanent loss of capital. We focus on identifying and investing in what we believe are unique companies with sustainable competitive advantages that have the ability to compound capital at high rates of return for extended periods of time. We are optimistic about the long-term prospects of the companies in which we are invested and continue to search for new ideas and investment opportunities.
Sincerely,
Alex Umansky,
Portfolio Manager
