During the three-month period ended December 31, 2015, market indexes rebounded sharply from their retreat during the previous quarter to end the year in modestly positive territory. Baron Asset Fund (the “Fund”) Retail Shares gained 4.63% and the Institutional Shares gained 4.70%; the Russell Midcap Growth Index (the “Index”) gained 4.12%, and the S&P 500 Index gained 7.04%. The biggest news during the quarter was the Federal Reserve’s decision to increase short-term interest rates for the first time since the financial crisis. Although widely expected, the stock market appeared to accept the Fed’s view that the economy was now strong enough to continue growing in the face of moderately increasing rates.
As discussed below, the investments that had the most significant positive impact on performance included companies that were perceived to benefit from rising interest rates, like discount brokerage The Charles Schwab Corp.; Consumer Discretionary companies that are largely dependent on domestic customers, like ski resort operator Vail Resorts, Inc. or Choice Hotels International, Inc.; and Information Technology (IT, Financial) businesses with a high percentage of recurring revenues, like Gartner, Inc., an IT research firm, VeriSign, Inc., which operates registries of Internet domain names, and Guidewire Software, Inc., which sells mission critical software to insurance companies.
As is often the case, the worst performers included stocks that missed Wall Street earnings expectations, generally as a result of company-specific challenges. These included railway equipment manufacturer Westinghouse Air Brake Technologies Corporation, Health Care companies Inovalon Shares of Vail Resorts, Inc., the operator of well-known ski resorts across the U.S. and Australia, increased, as the company reported robust season pass sales for the 2015-2016 ski season. Vail also reported good results at Perisher, the Australian ski resort that it recently acquired. Early season snow storms across its key U.S. markets (Tahoe, Colorado and Utah) also encouraged investors about the prospects for a good start to the upcoming ski season. In addition, Vail continued to generate significant free cash flow, which it uses both to pay an attractive dividend and to repurchase its shares.
Shares of Mettler-Toledo International, Inc. (MTD, Financial), the leading provider of weighing instruments for laboratory, industrial and food retailing applications, rose after the company reported good results and offered an encouraging assessment of its near-term prospects. Although macroeconomic trends pressured Mettler’s Brazilian, Russian and Chinese divisions in the recent quarter, the rest of its business grew revenues a respectable 7%, and its earnings beat Wall Street estimates. Management also provided solid guidance for 2016 despite ongoing pressure in overseas’ markets. We think Mettler-Toledo’s diversified, stable business can continue generating solid growth despite isolated areas of geographic weakness.
Shares of Towers Watson & Co. (TW, Financial), a global benefits consultancy, gained on developments related to its now-completed merger with Willis Group Holdings plc. In late November, Willis more than doubled the special dividend payable to Towers Watson shareholders to $10/share, as part of the merger consideration. This proved sufficient to achieve shareholder approval for a “merger of equals” between these two public companies, leading to the formation of Willis Towers Watson plc. We believe the merger could result in meaningful cost synergies, accelerate revenue growth, increase free cash flow generation, reduce the corporate tax rate, and drive modest multiple expansion.
Shares of The Charles Schwab Corp. (SCHW, Financial), the discount brokerage firm, benefited from the dual tailwinds of rising interest rates and rising equity markets. Higher interest rates benefit Schwab both by driving up its net interest revenue and also by leading to reductions in waivers on its money market products. Higher equity markets result in higher revenues from its products, such as mutual funds, that charge fees based on underlying asset levels. Trading volume and the associated trading fees also generally increase in rising equity markets. Schwab also continues to benefit from the ongoing trend of investment advisors leaving large wirehouses to become independent advisors, many of whom conduct their business through Schwab.
Shares of Gartner, Inc. (IT, Financial), a provider of syndicated IT research, gained after reporting several impressive forward-looking metrics. We believe that growth in the contract value of its research subscriptions and trends in its salesforce productivity are approaching levels sufficient to drive margin expansion. In addition, its client retention rates are at all-time highs. We believe that Gartner has potential to generate accelerating revenue growth and significant growth in earnings and free cash flow. We believe this will continue to lead to consistent return of capital in the form of ongoing share buybacks.
commercial railroads and municipal transit systems, reported mixed quarterly results, which weighed on its stock. Though management reaffirmed its near-term earnings guidance, investors became more concerned about volatility in the global railroad market, which has been impacted by the swift and significant decline in industrial commodity demand. In addition, with approximately half of its revenues generated outside the U.S., Wabtec has faced significant foreign currency headwinds from the strong U.S. dollar. Despite these issues, we believe that Wabtec remains the leader in a growing market for products that improve railway safety and productivity.
Despite reporting organic revenue growth of 18%, shares of Inovalon Holdings, Inc., a vendor of data and analytics to health care providers, fell after its results were slightly below Wall Street expectations. While recent financial performance has been disappointing, we remain optimistic about the company’s ability to compound its revenues at mid-to-high-teens rates and drive sustained margin expansion. We believe that the company offers highly valuable analytic solutions that will continue to allow its customers to reduce their health care costs while also enabling better patient outcomes.
Shares of The Cooper Companies, Inc., a global contact lens manufacturer, fell after its earnings fell short of Wall Street expectations. Results were negatively impacted by missteps in integrating its recent acquisition of Sauflon Pharmaceuticals Ltd., a British contact lens company, as well as fallout from new competitive lenses. Management projected moderating market share gains and lowered the company’s targeted five-year growth rate. Although disappointed, we remain cautiously optimistic, given Cooper’s reduced valuation and our belief that its revised earnings targets are achievable. Furthermore, we believe that shifts in the contact lens market toward greater adoption of silicon hydrogel lenses and daily modalities will play to Cooper’s strengths.
Shares of Arch Capital Group Ltd. (ACGL, Financial), a specialty insurance and reinsurance company, fell despite reporting what we believe to be good financial results. Arch continued to generate above-average returns because of profitable underwriting, benign catastrophe losses, and favorable reserve development. In addition, its recently-acquired mortgage insurance business is scaling up, and we believe it has a long runway for growth.
Shares of Stericycle, Inc. (SRCL, Financial), whose primary business is collecting regulated medical waste from hospitals and medical offices, detracted from performance. The company reported weak financial results and provided weak guidance for 2016 due to decreased volumes in its non-core unit that collects hazardous industrial waste. Through a series of acquisitions, Stericycle’s business has become more diverse and more economically sensitive than when we first invested. As a result, we reduced the position size.
Portfolio Structure
At December 31, 2015, Baron Asset Fund held 58 positions. The Fund’s 10 largest holdings represented 39.3% of assets, and the 20 largest represented 61.9% of assets. The Fund’s largest weighting was the Health Care sector at 22.8% of assets. This sector includes life sciences companies, health care equipment and supplies companies, and health care technology companies. The Fund held 20.7% of its assets in the Information Technology sector, which includes investments in software companies, IT consulting firms, and credit card processors. The Fund held 17.9% of its assets in the Financials sector, which includes investments in insurance companies, investment brokers and specialized finance firms. The Fund also had significant weightings in Industrials at 16.1% of assets and Consumer Discretionary at 14.0% of assets.
Recent Activity
During the past quarter, the Fund established one new position and added to nine others. The Fund also sold three positions and reduced its holdings of 16 others.
We re-established an investment in Perrigo Company Plc (PRGO, Financial) during the quarter. Perrigo is a leading global over-the-counter (OTC) consumer goods and specialty pharmaceutical manufacturer. The company is the world’s largest manufacturer of store brand OTC health care products (such as store brand ibuprofen, the active ingredient in Advil), which are sold in virtually all leading U.S. drug retailers, including Walgreens and CVS. We previously owned Perrigo in the Fund. In early 2015, the company became the subject of a hostile takeover bid by Mylan N.V., a large manufacturer of generic pharmaceuticals. After Perrigo shareholders rejected Mylan’s proposal, Perrigo’s stock fell to a price that we believed was attractive in light of the company’s growth potential, competitive advantages and impressive management team.
We think Perrigo can generate sustainable mid-to-high single digit organic revenue growth, driven by a trend favoring store brand OTC drugs over national brands. Perrigo management estimates its business saves consumers more than $7.5 billion annually in their health care spending ($1 savings for every person in the world). This is because store brand OTC drugs are comparable in quality and effectiveness to the national brands but cost significantly less. Store brand OTC drugs also generate higher gross margins for retailers.
We think Perrigo’s business should also benefit as more prescription drugs move to OTC status. This trend is being driven by branded drug manufacturers seeking to capture ongoing product sales after the products lose patent protection. Perrigo has dominant market share in the store brand OTC drug business. We believe the company’s competitive advantages include long-standing customer relationships, low cost manufacturing and an ability to mass customize thousands of products and support retailers in marketing their store brands.
Perrigo’s management team has a strong record of creating shareholder value. They have a disciplined approach to deploying capital with a focus on meeting return on invested capital hurdles. We think management will continue to pursue acquisitions which should add to the company’s growth. These acquisitions could include products that Perrigo could add to its distribution network at high incremental margin, products in new categories, or companies in new geographies. In addition, in its defense against the Mylan hostile takeover attempt, Perrigo management committed to several shareholder value creating initiatives that are expected to add to earnings over the next few years.
As discussed, we reduced our position in long-time holding Stericycle, Inc. The company missed earnings expectations, and we grew concerned that the company’s recent string of acquisitions outside its core business has made its earnings stream much less consistent and visible. We reduced our holdings in Universal Health Services, Inc., which operates acute care and psychiatric hospitals, on concerns that admissions trends were moderating. We exited our position in energy services firm Core Laboratories N.V. and reduced our holdings of MLP Shell Midstream Partners, L.P. in the face of weak commodity prices and the impact on their end-markets. We also reduced our position in used car retailer CarMax, Inc. over concerns about its valuation.
Outlook
Despite the recent stock market volatility, we continue to believe that high-quality, mid-sized growth stocks represent an attractive long-term investment opportunity. The U.S. economy is among the world’s healthiest, and, particularly after January’s stock market correction, its equity market
multiples are within the range of their long-term averages. Interest rates remain at historic lows, and we believe that equity markets often perform well, even after rates begin to increase. Employment and housing trends continue to improve, and energy prices remain meaningfully below their recent levels. We think that our portfolio of what we believe are well-managed, competitively advantaged, fast growing companies will continue to perform well in this environment, although we cannot guarantee that they will.
Thank you for investing in Baron Asset Fund.
Our entire Firm and our research department, in particular, are committed to justifying your ongoing confidence and support. I remain a significant investor in the Fund alongside you.
Sincerely,
Andrew Peck
Portfolio Manager
January 25, 2016
Investors should consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The prospectus and summary prospectus contains this and other information about the Funds. You may obtain them from its distributor, Baron Capital, Inc., by calling 1-800-99BARON or visiting www.BaronFunds.com. Please read them carefully before investing.
The Adviser believes that there is more potential for capital appreciation in mid-sized companies, but there also may be more risk. Specific risks associated with investing in mid-sized companies include that the securities may be thinly traded and they may be more difficult to sell during market downturns. Prior to February 15, 2007, the Fund’s strategy was to invest primarily in small and mid-sized growth companies. Since then, the Fund’s investment strategy has shifted to mid-sized companies. The Fund may not achieve its objectives. Portfolio holdings are subject to change. Current and future portfolio holdings are subject to risk.
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 Asset Fund by anyone in any jurisdiction where it would be unlawful under the laws of that jurisdiction to make such offer or solicitation.
