Dear Baron Asset Fund Shareholder:
During the three-month period ended September 30, 2015, most market indexes dropped sharply. Stocks began their decline in late-August, before partly recovering, and then falling sharply again in late-September. Baron Asset Fund Retail Shares fell 8.31% and Baron Asset Fund Institutional Shares fell 8.25%; the Russell Midcap Growth Index (the “Index”) declined 7.99%, and the S&P 500 Index declined 6.44%. The reasons for the market decline included increased uncertainty about the health of the Chinese economy and the potential ramifications this might have on global growth; the continued decline in energy and commodity prices; and, the shockwaves from a rapid decline in biotechnology shares, driven by concerns about that industry’s pricing trends. Although we believe the Fund had limited direct exposure to these developments, many of our investments suffered over these concerns, nonetheless.
As discussed below, the investments that performed best against this challenging backdrop included Health Care companies that lacked even tangential exposure to the drug pricing concerns that impacted many important participants in the sector. These included IDEXX Laboratories, Inc., a veterinary diagnostic firm. Several businesses that serve Information Technology (IT) end-markets reported good results, indicating that they were insulated against these issues. These included VeriSign, Inc., SS&C Technologies, Inc. and Equinix, Inc. Finally, companies with proprietary data and analytics, characterized by highly-recurring, largely subscriptionbased revenues, also were relative outperformers. These included Verisk Analytics, Inc., Nielsen Holdings Plc and Gartner, Inc.
The worst performers included the manufacturer of DNA sequencers, Illumina, Inc., which suffered from both company-specific issues, as well as fall-out from the sell-off in biotechnology shares. China-related concerns impacted Mettler-Toledo, Inc., a manufacturer of weighing devices, that has an important presence in that market. The continued drop in energy prices hurt master limited partnerships (MLPs) that own midstream energy infrastructure assets, Shell Midstream Partners, L.P. and Tallgrass Energy GP, LP, as well as FleetCor Technologies, Inc., which primarily provides credit card processing services for large oil companies.
Shares of veterinary diagnostics manufacturer IDEXX Laboratories, Inc. gained as the company reported strong quarterly results that demonstrated continuing market share gains in its in-clinic instruments business. In particular, new placements of its flagship Catalyst instruments grew 44% in the third quarter, driven by the launch of the improved CatalystOne device in the U.S. and Europe; and, placements of premium hematology instruments grew 30%, a meaningful increase from last quarter’s results. IDEXX’s reference laboratory segment also posted good results, which suggested ongoing market share gains. Finally, the company’s results also assuaged many investors’ recent concerns about a potentially diminished competitive position in IDEXX’s rapid assay segment.
Arch Capital Group Ltd. (ACGL, Financial) is a Bermuda-based specialty insurance and reinsurance company. The company’s shares rose on reports of good quarterly financial results, highlighted by the 9% growth in its book value per share, a key metric for insurance industry investors. Despite soft pricing trends across its industry, Arch continues to generate above-average returns because of its profitable underwriting experience, benign catastrophe losses, and favorable developments in its historic treatment of reserves. The company’s recently acquired mortgage insurance business also is scaling up, and we believe this will provide a new avenue for growth. In addition, recent merger activity in the property and casualty insurance industry has boosted share prices across the sector.
Verisign, Inc. (VRSN, Financial) oversees domain registrations for many of the most common Internet address suffixes, including .com and .net. Its shares gained after reporting better-than-expected financial results, which exceeded expectations of both revenues and profit margins. In addition, the company is poised to introduce a new series of domain names for international markets that we believe should generate a highly-profitable revenue stream. We believe that Verisign’s exclusive contract with the Internet Corporation for Assigned Names and Numbers (ICANN), a key regulatory body overseeing the operations of the Internet, creates a substantial barrier for competitors. In uncertain markets, stocks with stable businesses and highly-visible revenues tend to outperform, although past performance is no guarantee of future performance.
Shares of financial technology vendor SS&C Technologies Holdings, Inc. (SSNC, Financial) performed well, as the company closed its acquisition of Advent Software and announced the acquisition of Citi Alternative Investor Services. We expect both acquisitions to enhance SS&C’s competitive positioning and be meaningfully accretive to its financial performance. We believe SS&C’s management team has an outstanding track record of value creation through M&A, and we believe that Advent could be its most significant acquisition yet.
Equinix, Inc. (EQIX, Financial) operates a global network of state-of-the-art data centers. Its shares performed well, as the company completed its long-awaited transformation into a REIT, thereby reducing its cost of capital and attracting an additional class of shareholders. Equinix also continued to be involved in expanding its network through accretive acquisitions. We continue to like the growth prospects for the data center business, and we believe that Equinix has a clear and sensible plan to continue growing revenues at a faster pace than its peers while improving business efficiencies and recognizing margin improvement.
Illumina, Inc. (ILMN, Financial) is the leading provider of next generation DNA sequencing instruments and consumables. The company reported disappointing financial results, but we do not believe they reflect a change in the company’s market opportunity. We continue to believe the addressable market for the company’s products and services is large (over $20 billion) and growing as new applications for DNA sequencing emerge. Competitively, we believe Illumina remains the dominant provider of sequencing instruments and consumables. Illumina continues to invest substantially in research and development, and we are optimistic that the company will retain its large technological lead over its potential competitors.
TerraForm Power, Inc. (TERP, Financial) is a ‘yieldco,’ a dividend growth-oriented company that bundles renewable long-term contracted operating assets to generate predictable cash flows. TerraForm is focused largely on the commercialscale development of solar and wind power projects. Its stock dropped after the announcement that TerraForm’s parent, Sun Edison, Inc., would acquire Vivint Solar, thereby expanding into the residential solar market. Investors questioned both the strategic aspects of the deal, as well as its $2.2 billion price tag. This contributed to a market-wide reassessment of the unit economics underlying Sun Edison’s solar development plans. Although we believe in the secular drivers behind the growth in renewable energy demand, we chose to exit our position in the company.
Mettler-Toledo International, Inc. (MTD, Financial) is the world’s largest provider of weighing instruments for use in laboratory, industrial, and food retailing applications. The company reported largely positive quarterly results, but weakness in the Chinese market, where Mettler has a large presence, resulted in a slight lowering of its constant currency revenue growth forecast for the year. We continue to believe Mettler is an exceptional business with an outstanding management team, and we remain confident in its longer-term prospects.
FleetCor Technologies, Inc. (FTL, Financial) provides payment processing services to vehicle fleet operators and large oil companies worldwide. Although FleetCor reported good quarterly results and raised its full-year earnings guidance, macroeconomic concerns, including weak fuel prices and a stronger U.S. dollar, outweighed these results and caused the stock price to drop. Without these macroeconomic headwinds, company management estimated that earnings growth would have been 39% instead of the 16% reported. As these headwinds eventually subside, we believe its earnings will improve meaningfully.
Shell Midstream Partners, L.P (SHLX, Financial) is the recent IPO of a midstream energy MLP formed by Royal Dutch Shell in 2014. Shares fell as the broad MLP market experienced significant selling pressure because of diminished growth expectations, the prospect of rising interest rates, and tax-loss selling. Shell Midstream belongs to a group of high growth, high multiple stocks that experienced even more selling pressure than the broader MLP market. We believe the company has substantial room to grow, while its cash flows should be relatively less sensitive to falling commodity prices.
Portfolio Structure
At September 30, 2015, Baron Asset Fund held 60 positions. The Fund’s 10 largest holdings represented 37.4% of assets, and the 20 largest represented 57.9% of assets. The Fund’s largest weighting was the Information Technology sector at 22.4% of assets. This sector includes software companies, IT consulting firms, and credit card processors. The Fund held 22.0% of its assets in the Health Care sector, which includes investments in life sciences companies, health care equipment and supplies companies, and health care technology companies. The Fund held 16.5% of its assets in the Industrials sector, which includes investments in manufacturers, distributors and information services firms. The Fund also had significant weightings in Financials at 14.2% of assets and Consumer Discretionary at 14.2% of assets.
