Dear Baron Partners Fund Shareholder:
Performance
Baron Partners Fund (the “Fund”) performed well on an absolute and relative basis during the three months ended December 31, 2019. The Fund gained 17.74% (Institutional Shares) per share in the period. The Russell Midcap Growth Index (the “Benchmark”) rose 8.17%, the Morningstar US Fund Mid-Cap Growth Category Average increased 8.05%, and the S&P 500 Index gained 9.07%.
For the year 2019, Baron Partners Fund’s returns were also favorable. The Fund rose 45.38% per share. That compares to the Russell Midcap Growth Index and the Morningstar US Fund Mid-Cap Growth Category Average, which gained 35.47% and 32.52%, respectively. The S&P 500 Index rose 31.49%.
Markets continued the bull market run that began immediately following the 2008 Financial Crisis. The Fund’s performance has exceeded its benchmark’s returns over that period as well as since inception on January 31, 1992. The Fund’s returns have also surpassed its benchmark’s returns over the past 1-, 3-, 5- and 10-year periods.
While Baron Partners Fund has a “concentrated” portfolio (30 holdings with its top 10 positions accounting for 94.1% of net assets), the Fund is diversified across four basic categories. We believe this reduces the Fund’s portfolio volatility since each category tends to behave differently in different economic environments. Very fast-growing companies, which we define as Disruptive Growth, are 52.4% of average weighted assets; Core Growth investments are 15.5%; Real/Irreplaceable Asset businesses are 32.1%; and, Financials companies account for 26.9%.
The Disruptive Growth category had the largest favorable impact on results during the last quarter. The group gained 20.86% largely driven by the performance of Tesla, Inc. (TSLA, Financial) and Zillow Group, Inc. (ZG, Financial). Both companies are entering a new phase of their growth cycles and the companies are achieving impressive results.
There have been (and continue to be) many skeptics of Tesla. Most of them believed the company could not develop the technology, generate demand for and cost-effectively produce electric vehicles at scale, and obtain financing for its growth ambitions (to name a few of the often-cited criticisms). Tesla has shown these concerns to be unfounded. The company delivered 303,000 of its economically priced Model 3 vehicles in 2019, double the amount delivered in 2018. We believe total deliveries can grow approximately 50% again in 2020 as its newly opened China facility ramps up production and its U.S. plant continues to increase its output. We believe the company will continue to experience growth with new facilities planned in Europe and new vehicle model launches that we think can be even more popular than its existing lineup. Tesla’s manufacturing costs have also declined as it is implementing lessons learned to make the production more efficient and benefits from its scale. Tesla’s solar panel and energy storage businesses could bring added benefits.
Zillow’s shift in its strategic business plan is also bearing results. Its core business has seen a re-acceleration in growth with the introduction and user acceptance of its Premier Agent product. This tool moves the company from generating revenue based on real estate leads to participating in the commissions of sales agents. That has increased the productivity, caliber, and retention of its independent agents. Further, we expect the company to expand its Homes business line to a national footprint this coming year. Early results are promising, and investors have so far underestimated the ancillary revenue achievable through Zillow’s ability to purchase and sell homes.
Tesla and Zillow demonstrate the benefits of long-term investing. We purchased shares of both companies during periods of great investor skepticism. This was when their business plans were questioned making their prospects seem uncertain. This created opportunity for long-term investors like us who do our own research rather than rely upon recommendations based upon what we believed were inaccurate narratives. Those purchases are what drove the Fund’s exceptional returns in the quarter.
However, we believe such significant long-term investments can only be successfully made if there are other more stable holdings in the portfolio to minimize volatility. Core Growth businesses like IDEXX Laboratories, Inc. (IDXX, Financial) and Gartner, Inc. (IT, Financial) have steadier growth prospects. Real/Irreplaceable Assets businesses have tangible properties that are less subject to competition. Companies like Hyatt Hotels Corp. (H, Financial) and Vail Resorts, Inc. (MTN, Financial) invest in their properties to offer a superior service vs. their competitors, which also increases asset values. Financial businesses’ returns are generally more correlated with the economy and interest rates (factors that we feel are unpredictable in the short run). However, the Fund’s Financials holdings tend to be “capital-light” businesses that are gaining market share (The Charles Schwab Corp. (SCHW, Financial)), offering deeper product sets (FactSet Research Systems, Inc. (FDS, Financial)) and are selectively increasing price (Arch Capital Group Ltd. (ACGL, Financial)).
Tesla, Inc. designs, manufactures, and sells fully electric vehicles, solar products, and energy storage solutions. Strong quarterly results increased investor confidence and generated stock appreciation. Tesla noted strong demand trends, market share growth, and improved gross margins, cost controls, and cash generation, leading to increased revenue and free cash flow. Tesla’s China factory project is moving ahead of schedule, and investors are anticipating that the new Model Y will positively impact the company’s P&L.
Zillow Group, Inc. operates leading U.S. real estate sites, a mortgage marketplace, and the Zillow Offers home-buying business. Shares appreciated on strong quarterly results due to acceleration in the core Premier Agent business and continued traction in the Offers business. We believe Zillow is well positioned to capitalize on the large opportunity in online real estate advertising, with substantial upside from its Offers business which we think can grow Zillow’s addressable market in homes for sale and generate additional leads for Zillow Premier Agents.
Shares of global hotelier Hyatt Hotels Corp. increased in the fourth quarter on news that the company sold two assets while retaining the management contracts. Hyatt continues to execute on its asset-light strategy and use the proceeds from the sales for share repurchases, a sign it sees value in its stock. Hyatt expects that two-thirds of EBITDA will be generated from fees and one-third from owned properties upon completion of an expected $1.5 billion in asset sales over the next two years. The company also has a strong balance sheet and trades at an attractive valuation.
Shares of timeshare company Marriott Vacations Worldwide Corp. (VAC, Financial) increased in the fourth quarter as the company’s Starwood timeshare contract sales continued to accelerate and the company increased synergies from its acquisition of Interval Leisure. The combined company continues to generate significant free cash flow that it is using to buy back its stock, a sign that it sees value in the equity even after the run-up in the share price during 2019.
FactSet Research Systems, Inc., a leading provider of investment management tools, contributed to performance. The company announced fiscal fourth quarter earnings in late September that included weak guidance for fiscal year 2020 and a new three year investment plan. The stock fell on this news that came at the end of the third quarter, but has since recovered nicely in the fourth quarter on limited incremental news. We retain conviction in FactSet due to the large addressable market, consistent execution on both new product development and financial results, and robust free cash flow generation.
Shares of veterinary diagnostics leader IDEXX Laboratories, Inc. detracted from performance as investors rotated out of high-multiple veterinary health care stocks. In addition, a potential new lab competitor raised investor concerns. We retain conviction as competitive trends are outstanding, highlighted by instrument installed base growth of 18%, domestic lab growth more than twice its primary competitor, and improving sales productivity. Margins are moving significantly higher, and we believe they could approach 30% over the next several years.
HEICO Corporation (HEI, Financial) is an aerospace & defense company that manufactures FAA-approved parts and system sub-components. The stock price pulled back on profit taking and conservative guidance after a significant run-up in the first three quarters of 2019. We expect HEICO’s defense business to grow over the long term as government budget increases flow through to outlays. In addition, the aerospace business should ramp for the next decade as aircraft deliveries from a decade ago reach prime aftermarket maintenance age. The Boeing 737 MAX grounding also continues to help the aftermarket.
Shares of benefits enrollment platform Benefitfocus, Inc. (BNFT, Financial) detracted from performance in the fourth quarter due to financial results that missed Street expectations. We retain conviction, as we believe this is a short-term issue. The company has pivoted to signing larger, more complex employee and carrier customers during the 2019 selling season. While this is accretive to growth in the long term, larger customers take longer to implement, thereby delaying revenue recognition by several quarters.
Shares of CoStar Group, Inc. (CSGP), a real estate information and marketing services company, detracted in the quarter after strong performance earlier in the year. Business trends are outstanding, with the company’s bookings improving by approximately 14% year-over-year in its most recently reported quarter. We are optimistic about the company’s incremental investment in the multi-family marketing space. While this investment will reduce earnings in 2020, we believe it will generate attractive returns for shareholders over the intermediate and long term.
Investment Strategy and Portfolio Structure
The objective of Baron Partners Fund is to double its value per share within five years. Our strategy to accomplish this goal is to invest for the long term in a focused portfolio of appropriately capitalized, well-managed growth businesses at attractive prices across market capitalizations. We attempt to create a portfolio of approximately 30 securities diversified by GICS sectors, with the top 10 positions representing a significant portion of net assets. The Fund uses leverage to enhance returns, although this may increase the volatility of returns. These businesses are identified by our Firm’s proprietary research. We think these well-managed businesses have sustainable competitive advantages and strong, long-term growth opportunities.
As of December 31, 2019, Baron Partners Fund held 30 investments. The median market capitalization of these growth companies was $9.8 billion. The top 10 positions represented 94.1% of net assets. Leverage was 27.0%.
The long-term absolute and relative performance of the Fund has been very good. The Fund has returned 13.39% annualized since its inception in 1992 beating its Benchmark by 3.34% per year. Absolute annualized returns over the past three years have surpassed the Fund’s historical average. Three-year annualized returns were 23.51%, beating the Benchmark by 6.15% annualized. The prior 10-year period has also been very strong with the Fund having an annualized return of 16.40%, 2.16% better than its Benchmark.
In addition to viewing the Fund’s returns in yearly periods, we believe it is helpful to understand how the Fund has performed in various economic cycles. We are amid an economic expansion following the 2008 Financial Panic. This 11-year period has seen steady financial growth and stock market appreciation. The Fund has performed very well in this period. Had you hypothetically invested $10,000 in the Fund on 12/31/2008, it would be worth $58,586 today. Had you mimicked the Benchmark returns, that $10,000 would be worth $55,380 if you hypothetically invested in the Russell Midcap Growth Index or $45,104 if you hypothetically invested in the S&P 500 Index. (Please see Table V – Financial Panic to Present.)
We believe it is equally important to understand how the Fund performed during more challenging economic times. The nine-year period from the internet bubble collapse through the financial panic (12/31/1999 to 12/31/2008) was an unusually difficult period. The Russell Midcap Growth Index and S&P 500 Index fell 4.69% and 3.60% annualized, respectively. A $10,000 hypothetical investment in these indexes would be worth only $6,488 and $7,188, respectively, at the end of that nine-year period. Baron Partners Fund, however gained 1.54% annualized. $10,000 hypothetically invested in the Fund was worth $11,479 after the nine years; the Fund preserved (and slightly grew) capital during this challenging economic time. This was because its investments in high-quality growth businesses at attractive prices were able to weather this difficult environment. (Please see Table V – Millennium Internet Bubble to Financial Panic.)
The capital preservation and modest growth during difficult times is what we believe sets the Fund apart and has made its long-term performance exceptional. A $10,000 hypothetical investment at the inception of theFund in 1992 would be worth $334,128 today. That same $10,000 would be worth less than half that amount had you hypothetically invested in the Russell Midcap Growth Index or the S&P 500 Index. Those investments would be worth only $144,849 and $139,232, respectively.
While we are extremely pleased with the returns generated last quarter, last year, and during the past 10-year moderate economic expansion, the Fund ranks in the top 1st percentile of its category since its conversion to a mutual fund on April 30, 2003.* Of course, we cannot assure you that this outperformance will continue. However, we can assure you that we will try as hard as we can to continue to outperform.
Thank you for joining us as fellow shareholders in Baron Partners Fund. We continue to work hard to justify your confidence and trust in our stewardship of your hard-earned savings. We remain dedicated to continuing to provide you with the information we 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 Lead Portfolio Manager
Michael Baron, Co-Portfolio Manager
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 Partners Fund by anyone in any jurisdiction where it would be unlawful under the laws of that jurisdiction to make such offer or solicitation.
