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Baron Opportunity Fund Commentary on PLCM, PPO, PEGA, CRR, EQIX, WBMD, NILE, RATE, VLT, EW


The reasons for the market's selloff are well known and have been well covered: the debt ceiling impasse; the European sovereign debt crisis; the slowing U.S. (and global) economy; the growing risk of prolonged economic weakness or even recession; the S&P's downgrade of the U.S.'s triple-A credit rating; and the impact on market volatility of ETF's and algorithmic trading. What I'm sure you, our Baron Fund shareholders, want to know is: what are we doing about it? Let me first, in all candor, acknowledge what we don't know.We don't know what the market will do tomorrow, next week or next year; what Chairman Bernanke will say in his upcoming Jackson Hole speech and whether the Fed will embark on another round of quantitative easing (QE3); whether the Super Committee of Congress will find the courage to reach a historic compromise later this year; what the Europeans (particularly France, Germany and the ECB) will do to address their own sovereign debt issues; or when the U.S. economy will stabilize and begin to improve.

So what do we know and what are we doing? First, we believe that, over the long term, the best run, fastest growing, most profitable companies are accorded the highest market valuations. Second, our collective experience as analysts and investors tells us that those businesses with powerful secular growth drivers, predictable and/or recurring revenue streams, strong balance sheets, positive operating cash flows, and who sell products and services that are critical to their customers are the ones best positioned to withstand and even grow through a challenging economic environment. These are the types of businesses we are focused on identifying, investing in and according the highest weightings in our portfolio.

For growth businesses, total revenue growth can be viewed as the sum of cyclical growth (based on the underlying rate of growth of the broader economy) and secular growth (independent of the broader economy, such as growth produced by capital formation, innovation, market-share gains, etc.). While we always focus on secular growth businesses, in light of the current economic uncertainty,we are putting even more weight on identifying those companies with the highest ratio of secular growth to cyclical growth. We are also emphasizing businesses with sustainable, recurring revenues; attractive valuations; products and services that will remain in high demand and critical to customers even during periods of economic weakness; strong balance sheets (appropriate debt levels, no short-term maturities); and positive and predictable cash flow from operations.

We believe a key driver of secular growth for any business is innovation. That is why we devote much of our research to identifying powerful, long-term innovative trends across all industries. These trends can be thought of as growth niches within the overall economy — like veins of gold in a mountain of rock — with many of these innovative themes yielding 20%-plus growth in an economy expanding just above the flat line.

By way of example, some of the themes we're most excited about include cloud computing applications (both consumer and enterprise), services and infrastructure; smart phones and related mobile platforms, apps and advertising; advanced medical diagnostics; minimally invasive medical procedures; electric vehicles; clean or renewable energy; unconventional oil and gas exploration; digital media content; Internet services and advertising; e-commerce; software as a service; information services based on proprietary data; and financial analytics and risk management tools.

Polycom, Inc. (NASDAQ:PLCM) develops and manufactures unified collaboration (UC) and video communication infrastructure, end points and software. During last quarter, Polycom demonstrated robust growth and strengthened its strategic alliance network. The company grew revenues over 20% while expanding operating margins and annual net profit by more than 30%.We believe UC market development is at an early stage and that Polycom is well positioned to capitalize on this growth and gain share from its competitors. (Gilad Shany)

Shares of Polypore International, Inc. (PPO) gained as the company announced earnings results that were stronger than expected. Earnings were driven by growth in all parts of its business, but particularly separators for lead-acid and lithium-ion batteries. Margins expanded due to operational efficiency and a product mix shift toward more profitable lithium-ion separators. Growth in Polypore's lithium-ion business is being driven by meaningful orders from the electric vehicle industry. (Randy Gwirtzman)

Pegasystems, Inc.'s (NASDAQ:PEGA) shares soared as bookings for its transformative business process management (BPM) software grew almost 90% year over year. Pegasystems continues to perform well with its core financial services, insurance and healthcare customers, and has recently signed initial deals with new customers in retail, consumer products, manufacturing, and energy. Over the long term, we expect the BPM market to grow at 12% to 15% annually, with Pegasystems growing significantly faster due, in our view, to its superior products, growing sales force, expanding product set and strategic partnerships. (Neal Rosenberg)

Other strong performers include CARBO Ceramics, Inc., (NYSE:CRR) whose ceramic proppant significantly increases the productivity of shale oil and gas plays; and Internet and cloud computing infrastructure provider, Equinix, Inc., (NASDAQ:EQIX) who recently reported stronger-than-expected revenues and cash flows, and increased its forecasts for the back half of the year.

Lamar Advertising Co.'s (LAMR) shares were weak in the quarter, as local advertising remains stubbornly soft, growing in the low-single digits through the first half of the year. Lamar derives roughly 80% of its revenue from local advertisers, and the slow pace of this recovery is unusual compared to prior periods.We also concerned that certain local advertising verticals are under threat from new mobile services and applications.We exited our Lamar position during the quarter. (Richard Rosenstein)

Shares of WebMD Health Corp. (NASDAQ:WBMD) underperformed in the June quarter. WebMD is a leading provider of online health information through WebMD.com, Medscape.com, and other owned and operated web sites. Although the company reported good quarterly results, management lowered guidance for the second half of the year due primarily to delayed implementation of previously sold advertising programs. Many large pharmaceutical companies are operating under corporate integrity agreements with the government and are taking longer than usual to conduct internal medical-legal reviews of new marketing programs. This has happened in the past, and we believe it will be a temporary phenomenon once again.We continue to have conviction in the fundamental long-term growth drivers for WebMD's business. (Neal Kaufman)

Online jewelry retailer Blue Nile, Inc. (NASDAQ:NILE) was a weak performer during the second quarter. Blue Nile reported a solid first quarter, with revenues slightly above and earnings in line with expectations. The company's margins were slightly lower than the Street was looking for, however, as the company decided to make additional investments in marketing. Moreover, investors were disappointed with the company's second quarter guidance, which came in slightly below Street consensus.

Portfolio Structure

Baron Opportunity Fund had $320.3 million of assets under management as of June 30, 2011. The Fund had investments in 60 securities.The top 10 positions accounted for 31.8% of the portfolio and the Fund's cash position was 2.8% at quarter end.We have no shortage of good ideas for the Fund, and the recent market pullback has only made valuations even more attractive for investors with a long-term horizon. Our challenge has been prioritizing the very best ideas for inclusion in the Fund.

The Fund emphasizes sectors and individual businesses that provide significant secular growth rates. As compared to the Russell Midcap Growth Index, we have favored the Information Technology sector, and have underweighted Industrials, Materials, and Consumer Staples. In our opinion, several of our investments categorized in the Information Technology sector by GICS are more properly viewed as Consumer Discretionary companies, and we therefore consider our Consumer Discretionary weighting to be in line. We do have a higher concentration in the Telecommunications sector than the midcap index. But this is not because we are making a Telecommunications "bet." Rather, we simply have high conviction in our two investments in the space, SBA Communications Corp. and NII Holdings, Inc., both long-term investments for the Fund. The median market cap of the Fund was $3.85 billion at the end of the quarter.

Recent Activity

During the quarter we invested in two IPO's: Bankrate, Inc., (NYSE:RATE) a leading operator of personal finance websites, including the top mortgage, deposit, insurance and credit card platforms (we were shareholders of Bankrate when it was taken private in 2008); and HomeAway, Inc., the operator of the #1 online marketplace for vacation rental listings.We also initiated positions, among others, in Orbotech, Ltd., a leading manufacturer of yield enhancement tools for the electronics industry; Micros Systems, Inc. (MCRS), a leading provider of front- and back-office software and systems to the hotel, restaurant and retail markets; Ritchie Bros. Auctioneers, Inc. (RBA), the world's largest (physical and virtual) auctioneer of used industrial, agricultural and transportation equipment; and Velti plc (VELT), a leading provider of mobile marketing and advertising technology for brands, advertising agencies, mobile operators and media companies. We also re-established a position in Edwards Lifesciences Corp. (NYSE:EW), the leading global provider of heart valve technology, including transcatheter heart valves.

Given that flows in the quarter were fairly stable, most of our sales were made to fund other investments, not because we lost confidence in the company. Simply put, sometimes we sell a company we like to buy more of one we like better. That was the case for our sales of TOTVS, Google, Activision Bizzard, Citrix Systems, Informatica, and HMS Holdings. We exited our Gen- Probe position when the stock price rose significantly over a short period of time on take-out rumors, as risk-arbitrage is not what we do. As it turned out, a deal never took place and Gen-Probe's stock price retreated to its former levels. We sold NetSpend, WMS Industries and Lamar Advertising (as discussed above) for fundamental reasons.

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

About the author:

Charlie Tian, Ph.D. - Founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

Rating: 2.6/5 (8 votes)


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