Equity markets were strong during the quarter ended September 30, 2016. Baron Asset Fund (the “Fund”) Retail Shares gained 5.06% and the Institutional Shares gained 5.15%; the Russell Midcap Growth Index (the “Index”) gained 4.59%, and the S&P 500 Index gained 3.85%.
As discussed below, the investments that had the most significant positive impact on performance included businesses in the Consumer Discretionary sector that rose on both encouraging company-specific earnings, as well as the market’s more optimistic outlook for ongoing strength in consumer spending patterns on a global basis. Beneficiaries included ski resort owner Vail Resorts, Inc., online travel agency The Priceline Group, Inc. and jewelry retailer Tiffany & Co. Rising equity markets and increased speculation that the Federal Reserve would raise interest rates provided a tailwind for most of the Fund’s Financials sector investments. These included brokerage firm The Charles Schwab Corp., insurer Arch Capital Group Ltd., and MarketAxess Holdings Inc., an electronic trading platform for fixed-income securities. Several stocks in the Health Care sector gained on good earnings results, including IDEXX Laboratories, Inc., a veterinary diagnostic firm, and Mettler-Toledo International, Inc., which manufacturers advanced weighing devices.
The worst performers included stocks in the Information Technology (IT, Financial) sector that reported earnings Wall Street perceived to be disappointing. These included IT research firm Gartner, Inc. and Guidewire Software, Inc., which sells various solutions to the global insurance industry. Retailer Tractor Supply Co. also reported weak earnings, and Verisign, Inc., which operates internet domain name registries, fell on fears of adverse regulatory changes.
Shares of veterinary diagnostics leader IDEXX Laboratories, Inc. (IDXX, Financial) increased after the company reported impressive financial results, which led to a meaningful expansion in its trading multiple. We believe the company’s competitive position is strong and improving, as evidenced by its accelerating organic revenue growth, the robust placements of its diagnostic instruments into veterinary clinics, and the higher prices it is capturing across its product portfolio. In addition, IDEXX’s results demonstrated operating margin expansion, which is finally being recognized after several years of intensive investment into its business. Looking forward, we expect to witness sustained double-digit organic revenue growth during the next several years, driven by productivity benefits from its move to a direct sales model in the U.S., the company’s persistent innovation pipeline, and returns on its intensive investment into international markets.
Shares of Illumina, Inc. (ILMN, Financial), the leading provider of DNA sequencing technology to academic and commercial laboratories, gained after the company reported financial results that exceeded Wall Street’s expectations. The results confirmed strong demand both for the company’s sequencing instruments in the Americas and China, as well as for its products in clinical applications, such as oncology screening and diagnosis. Management also demonstrated its ability to rein in expenses, which helped lead to accelerating EPS growth. We continue to believe Illumina has a long runway for growth, driven by increasing adoption of DNA sequencing technologies, particularly in clinical markets.
Shares of brokerage firm The Charles Schwab Corp. (SCHW, Financial) appreciated as rising equity markets led to growth in its client assets and the revenue streams stemming from those assets. The firm also continued to grow its percentage of assets that charge for fee-based advice, a move that we believe creates greater revenue visibility and the potential for increased profitability. In addition, ongoing speculation of an interest rate hike by the U.S. Federal Reserve was a positive for Schwab, which we believe would experience significant, rapid profit growth should interest rates increase to higher historical levels.
FleetCor Technologies, Inc. (FLT, Financial) issues commercial charge cards that allow the employees of primarily small- and mid-sized businesses to buy fuel and maintenance at participating gasoline retailers. Fleetcor also manages commercial fleet card programs for major oil companies (such as BP, Arco, Chevron, and Citgo), which themselves maintain a great many end-customer relationships. Its shares performed well after the company reported good quarterly results and raised its full-year earnings guidance. FleetCor also benefited from its recent acquisition of STP, the leading electronic toll company in Brazil. We believe that improved results at its Comdata division, the likelihood of further acquisitions, rising fuel prices, and stabilizing foreign exchange rates could lead to an ongoing acceleration in FleetCor’s earnings.
Shares of Vail Resorts, Inc. (MTN, Financial), the largest operator of ski resorts, increased principally on news that Vail had entered into an agreement to acquire Whistler Blackcomb, a major Canadian ski resort operator. After this transaction closes, Vail will own several of the leading ski resorts in North America, including, of course, Vail, Beaver Creek, Park City, and now Whistler. The acquisition affords Vail not only greater scale to leverage its corporate infrastructure, but also the chance to expand its successful Epic Pass season ticket offering (which allows ticket holders to ski at all of the company’s resorts) to a larger group of skiers.
Shares of Gartner, Inc. (IT, Financial), a provider of syndicated information technology research, fell after reporting results that were challenged by tougher annual comparisons and slightly more challenging macroeconomic conditions. We believe that Gartner’s key revenue metrics remain solid. The company has significant financial flexibility, and we believe it will aggressively deploy capital for ongoing share repurchases or accretive acquisitions. We believe that over time Gartner will demonstrate accelerating revenue growth, faster growth in its earnings and free cash flow, and persistent returns of capital to shareholders.
Tractor Supply Co. (TSCO, Financial) is a chain of more than 1,500 stores that sell equipment, tools, feed, and clothing to a largely rural customer base of farmers and ranchers. The company’s shares declined after it reported weak results, partly influenced by depressed farm incomes due to unusually low crop prices and some stores’ exposure to deflated energy-related markets. Although we reduced our position, we believe these factors will prove largely transitory. We believe Tractor Supply offers the potential for ongoing earnings growth based on its ability to meaningfully expand its store base, while also growing its assortment of higher-margin private label goods and increasing its sales mix of consumable goods.
Shares of internet infrastructure services provider Verisign, Inc. (VRSN, Financial) fell over concerns that it might face difficulties extending its contract to administer the ‘.com’ domain registry with the National Telecommunications and Information Administration (NTIA) as the result of some U.S. senators’ objections. We believe this concern has been overblown and that Verisign will successfully extend this contract on favorable terms.
Shares of Henry Schein, Inc. (HSIC, Financial), a global distributor of dental, medical, and animal health products, declined after reporting an unexpected slowdown in its North American dental and equipment sales. No specific reasons for the slowdown have emerged, and we believe that it is too early to extrapolate a trend. While performance in other divisions was solid, Schein’s earnings guidance was revised downward for the first time in several years. We are monitoring events but remain positive given, in our opinion, the company’s strong management, consistent performance, and large market opportunities.
Shares of health care data and analytics vendor, Inovalon Holdings, Inc. (INOV, Financial), detracted from performance, as its financial results fell short of investor expectations and the company reduced its guidance for the remainder of 2016. Management attributed the shortfall to two issues: price reductions in its retrospective risk adjustment unit, and a margin shortfall stemming from investments designed to drive long-term growth. We are hopeful that the company’s latent earnings power will soon become apparent.
Portfolio Structure
At September 30, 2016, Baron Asset Fund held 55 positions. The Fund’s 10 largest holdings represented 43.0% of assets, and the 20 largest represented 65.9% of assets. The Fund’s largest weighting was the Health Care sector at 25.3% of assets. This sector includes life sciences companies, health care equipment and supplies companies, and health care technology companies. The Fund held 22.8% of its assets in the Information Technology sector, which includes investments in software companies, IT consulting firms, and data processing firms. The Fund held 16.7% of its assets in the Financials sector, which includes investments in insurance companies, investment brokers and financial exchanges. The Fund also had significant weightings in Industrials at 14.1% of assets and Consumer Discretionary at 11.7% of assets.
Rollins, Inc. (ROL, Financial) is a leading provider of pest and termite control services for more than two million residential and commercial customers, primarily located in North America. We believe that Rollins operates in an industry with high barriers to entry and a fragmented competitive landscape, and we believe Rollins should be able to consistently increase its market share over time. In North America, Rollins is the number one player in commercial and residential pest control and wildlife control, and the number two player in termite control. Developing a well-regarded national brand requires meaningful investment in sales, marketing, employee training and technology, which smaller players simply cannot afford.
Pests are a major headache for residential customers, and they can lead to meaningful business issues for commercial customers, like restaurants and hotels. Thus, customers are typically willing to pay for these services, regardless of how the economy is performing. As a result, Rollins has demonstrated impressive operating performance across all market conditions, including positive revenue growth during the 2008 and 2009 recession. Furthermore, Rollins has focused significant effort to improve its retention of employees and customers, which has led recurring revenues to represent approximately 80% of the company’s total.
We estimate that Rollins has just a 20% share of a large and growing addressable market. We think Rollins has several avenues for generating modest single-digit organic revenue growth, and believe it can supplement that growth with acquisitions. Industry price increases are estimated to be 1.5% to 2% per year, largely driven by the price insensitivity of customers. Commercial pest control volumes are likely to benefit from increasing regulation, with the Food Safety Modernization Act providing increased business opportunities in food and beverage segments. In addition, Rollins’ scale and financial resources should enable it to gain share by utilizing its brand building initiatives, internet search engine optimization capabilities, and BOSS, the company’s new customer and workforce management software platform. Furthermore, Rollins has expanded its product offerings into the wildlife, bed bug, and mosquito control segments. While smaller than the core business, we believe these markets represent high growth opportunities that can drive overall company growth as penetration increases. Moreover, Rollins can grow through international expansion, since international markets represented only 7% of 2015 revenue. Beyond organic growth, the company can leverage M&A to drive low-single digit incremental revenue growth. Rollins’ adjusted EBITDA margins are currently ~20%, but we believe that Rollins has the chance to grow EBITDA margins into the mid-20% range, through natural operating leverage, tight sales, general and administrative expense control, and the positive impact stemming from the new BOSS workforce management system.
The management team has impressive experience both at the company and in the pest and termite control business more generally. Moreover, the Rollins family has run the company for more than 50 years and still maintains greater than 50% ownership. We view the Rollins family ownership as an opportunity to invest alongside a controlling shareholder whose interests are aligned with ours.
Outlook
We continue to believe that high-quality, mid-sized growth stocks represent an attractive long-term investment opportunity. During the past 30 years, mid-cap growth stocks, as a category, have outperformed small-cap and large-cap growth stocks. We believe that this trend will continue.
The U.S. economy continues to rank among the world’s healthiest, and its equity market multiples are within the range of their long-term averages. Perhaps the most prevalent concern among equity investors is uncertainty about what will happen to stocks when interest rates finally begin to increase. We believe that equity markets often perform well during a rising rate environment. Separately, employment and housing trends have improved throughout 2016, and energy prices remain meaningfully below recent levels. We think 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
October XX, 2016
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.
