Dear Baron Focused Growth Fund Shareholder:
Performance
Baron Focused Growth Fund (the “Fund”) declined 0.44% (Institutional Shares) in the third quarter. The Russell 2500 Growth Index (the “Index”), the benchmark against which we compare the performance of the Fund, declined 3.18% and the S&P 500 Index rose by 1.70%. The Fund’s outperformance in the period versus its benchmark index was driven by gains in three of the Fund’s top five positions. These three stocks were responsible for 200 basis points (“bps”) of gains in the quarter. These investments were CoStar Group, Inc., Tesla, Inc., and Vail Resorts, Inc. CoStar shares increased 7.1% due to continued strong growth in bookings and its investment in apartments.com, which should accelerate growth over time. Tesla shares rose 7.8% due to stronger demand from Europe and China for its Model 3 cars as well as the soon-to-open new manufacturing facility in China. The factory should improve Tesla’s Model 3 production rates and lower its delivery costs. Vail’s stock price increased 2.0% on stronger-than-expected season pass sales during the summer of 2019. Vail’s strong pass sales could increase further since its recent acquisition of Peak Resorts, the owner of Mount Snow and Hunter Mountain. With millions of Northeast skiers, these mountain resorts should provide Vail with additional demand for its Epic season passes.
We classify the holdings of the Fund as one of three types: rapid, early stage growth businesses that are disruptive to their industries; companies with real, irreplaceable assets that offer pricing power and a hedge against inflation; and finally, foundational, long-term, core growth holdings that continue to steadily grow sales and earnings while using excess free cash to return value to shareholders. Please see Table II. In the quarter, our Disruptive Growth companies outperformed as these companies benefited from their prior investments and experienced accelerated growth in earnings and cash flow. Along with Tesla and CoStar, Guidewire Software, Inc., a provider of software for the property and casualty insurance industry, increased 3.9% in the quarter. It launched a series of new applications for its insurer customers. Our Core Growth and Real/Irreplaceable Assets investments experienced weaker stock performance as two of the Fund’s top five investments declined and penalized quarterly performance by 169 bps. FactSet Research Systems, Inc., a provider of financial intelligence to the investment community, declined 15.0% in the quarter as it began a two-year investment cycle in new products and services that should accelerate revenue growth once completed. We believe these investments will generate approximately 50% returns on capital. Hyatt Hotels Corp., an 11% position in the Fund, declined 3.0% in the quarter despite continuing to sell assets at accretive prices and using the proceeds to buy its stock. We believe investors have been concerned with the cyclicality of Hyatt’s business. The company is currently transforming into an increasingly “asset-light,” less capital-intensive business. It is selling hotels, retaining management agreements, and repurchasing its stock. We think both Hyatt and Vail are significantly undervalued, and believe the stocks should rebound strongly. We have not changed position sizing of these investments in the Fund.
From 2014 through 2016, the Fund invested in several businesses whose stocks underperformed when they were investing in themselves to grow. CoStar Group, Inc. and Guidewire Software, Inc. are examples. These companies’ stocks outperformed in 2018 and year-to-date in 2019 as investments they made during the past five years began to generate returns. While the Fund’s 5- and 10-year performance lag the Index, most of this was due to investments made from 2014 through 2016.
We believe the Fund’s underperformance from 2014 through 2016 is analogous to instances when after brief periods of underperformance, the Fund subsequently outperformed for an extended period. For example, in the 18-month period from October 1998 through March 2000, at the height of the Internet Bubble, the Fund, which owned no internet stocks, increased 41.77% annualized while the benchmark increased 126.53% annualized. This was immediately prior to the Internet Bubble bursting and the Index falling materially over the next eight years while the Fund increased in value. Please see Tables III and IV.
Similar to the Fund’s relatively strong performance in the post-Internet Bubble period, we expect the Fund to perform well over the next several years. This is despite our expectation that there will be periods when value stocks outperform the growth stocks in which we have invested. However, we can certainly make no guarantee this will be the case.
Since its inception on May 31, 1996, the Fund’s 10.94% annualized performance has exceeded that of its benchmark by an average of over 300 bps per year. This means that a hypothetical $10,000 investment in Baron Focused Growth Fund over 23 years ago would now be worth approximately $113,000! If an investor had instead hypothetically invested $10,000 in the Russell 2500 Growth Index, it would be worth approximately $59,000. Please see Tables I and IV.
Baron Focused Growth Fund’s beta has averaged 0.77 since inception. This means the Fund has been 77% as volatile as the benchmark. As a result of the Fund’s strong absolute and relative returns and lower risk, the Fund has achieved 4.92% annual “alpha,” a measure of risk-adjusted performance, since inception.
Baron Focused Growth Fund didn’t make much money from the peak of the Internet Bubble on December 31, 1999 through the trough of the Financial Crisis on December 31, 2008. But…we did make something…which gave you a much better outcome than if you had invested in a passive index fund mirroring either the Russell 2500 Growth Index, our benchmark, or the S&P 500 Index. Both indexes lost money during that period.
Due to the “magic” of compounding and of not losing money during the Millennium Internet Bubble to Financial Panic period, $10,000 hypothetically invested in Baron Focused Growth Fund on December 31, 1999 is worth 4.7 times that amount or $46,681 on September 30, 2019. That is 41.7% more than an investment in the Russell 2500 Growth Index.
Shares of CoStar Group, Inc., a real estate information and marketing services company, contributed to performance. Business trends are excellent, with the company’s bookings improving by approximately 31% year-over-year in its most recently reported quarter to a record $59 million. We see a path for quarterly bookings to improve toward $70 million, driving revenue acceleration toward 20%. The company now has over $1.3 billion of cash on its balance sheet, which we expect it to use for opportunistic acquisitions, which should expand CoStar’s addressable market.
Shares of Tesla, Inc., which designs, manufactures, and sells fully electric vehicles, solar products, and energy storage solutions, contributed to performance. Tesla’s stock has stabilized as investors gain conviction around Model 3 demand trends and the expanding Model 3 margins profile. Demand for Tesla’s Model S and Model X is increasing and construction of the company’s factory in China is ahead of schedule. We believe Tesla’s soon to be introduced Model Y crossover will positively impact the company’s gross margin. We continue to expect significant value creation for Tesla’s stakeholders.
Arch Capital Group Ltd. is a specialty insurance and reinsurance company based in Bermuda. Shares appreciated due to improving market conditions for commercial insurance and continued strength in mortgage insurance. Management is taking advantage of higher rates by selectively writing more business. The company reported solid earnings and its book value per share increased 19%.
Shares of Vail Resorts, Inc., a global owner and operator of ski resorts, increased in the quarter on strong growth in pass sales for the upcoming ski season. The recent closing of the Peak Resorts acquisition, which provides access to 17 additional ski resorts across the U.S., should drive more season pass sales. Growth in season pass sales helps lock in revenue earlier in the year, giving strong visibility to earnings and cash flow. The company used its cash to bring down debt from recent deals and pay a 3% dividend.
Shares of Choice Hotels International, Inc., a hotel franchisor in the economy and mid-scale segment, rose in the quarter. The company reported strong unit growth of its new Cambria brand and said it was in the process of completing its Comfort brand renovations. That should add to unit growth and revenue per available room in 2020. Management also accelerated its buybacks and received board authorization for additional share repurchases due to strong cash flow generation. Choice’s balance sheet remains strong, and we think Choice will soon experience an acceleration in growth.
Shares of FactSet Research Systems, Inc., a leading provider of investment management tools, detracted during the quarter after the company reported weak guidance for fiscal year 2020 and announced a new three-year investment plan to accelerate revenue growth. This negatively impacted its stock price in the near term due to the perception that margins will not
increase for two years. We retain conviction in FactSet due to its large addressable market, consistent execution on both new product development and financial results, and robust free cash flow.
Manchester United plc is the best-known team in the English Premier League. It generates revenue from broadcasting, sponsorship, and licensing. Shares declined in the quarter likely driven by weak on-pitch performance and the absence of Champions League revenue next year. We believe Manchester United is a unique media company with broad global appeal and its shares should benefit as the company continues its robust commercial partnership strategy. Manchester United’s upcoming shirt licensing renewal contract as well as its investments in player recruiting and training have the potential to enhance results.
Shares of global hotelier Hyatt Hotels Corp. detracted in the quarter on investor concerns over the potential impact of the company’s owned assets on earnings in the event that markets decline. Hyatt continues to execute on its strategy to become “asset-light” by selling assets at accretive prices. The company’s strong balance sheet positions it well should an economic slowdown occur. Hyatt continues to buy back stock with sales proceeds.
Shares of benefits enrollment platform Benefitfocus, Inc. detracted from performance due to revenue growth that missed expectations. We believe this is a short-term issue. The company 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.
Iridium Communications Inc. is the second largest provider by revenue of mobile voice and data communications services via satellite, and the only commercial provider of communications services offering true global coverage. The stock fell after its renewal with the Department of Defense took longer than the company expected. In addition, management reduced its Certus guidance, the device they sell for use on maritime ships and now expect it to ramp up to 15% of the business over the next two years from just 5% today. Iridium’s satellite architecture is unique. We believe the company will benefit from growing market share in existing and new markets and leveraging its new NEXT constellation.
Investment Strategy & Portfolio Structure
The strategy of Baron Focused Growth Fund is to invest for the long term in a focused portfolio of what we believe are appropriately capitalized, well-managed, small- and mid-cap growth businesses at attractive prices. We attempt to create a portfolio of less than 20 securities diversified by GICS sectors that will be approximately 80% as volatile (beta) as the market. The Fund historically generates 90% of the upside when the market rises but just 77% of the downside when the market declines. Businesses in which the Fund invests are identified by our Firm’s proprietary research and time-tested investment approach.
As of September 30, 2019, the Fund held 15 investments. The Fund’s average portfolio turnover for the past three years was 7.8%. This means the Fund has an average holding period for its investments of almost 13 years. This contrasts sharply with the average mid-cap growth mutual fund which typically turns over its portfolio every 21 months. From a quality standpoint, the Fund’s investments have higher earnings growth than the average holdings in the benchmark, stronger returns on invested capital, are more conservatively financed (evidenced by lower debt-to-market capitalization ratio) and offer lower beta. We believe these metrics are important to help limit risk for this concentrated portfolio.
While focused, the Fund is diversified by sector. The Fund’s weightings are significantly different than those of the Russell 2500 Growth Index. For example, the Fund is heavily weighted in Consumer Discretionary businesses with 46.6% of the portfolio in this sector versus just 13.7% for the Index and has no Health Care exposure versus 22.3% for the Index. The Fund is further diversified by investments in businesses at different stages of growth and development as discussed above and shown below.
Rapidly growing firms account for 42.9% of the Fund’s net assets. On current metrics, these businesses look expensive; however, we think they will continue to grow and have the potential to generate exceptional returns over time. Examples of these companies include electric vehicle leader Tesla, Inc., commercial satellite company Iridium Communications Inc., commercial real estate data supplier CoStar Group, Inc., and systems software provider to the insurance industry Guidewire Software, Inc.
Companies that own what we believe are irreplaceable assets represented 37.7% of net assets. Vail Resorts, Inc., owner of the premier ski resort portfolio in the world, upscale lodging brand Hyatt Hotels Corp., and storied English Premier League sports franchise Manchester United plc are all examples of companies we believe possess meaningful brand equity and barriers to entry that equate to pricing power over time.
Steady growers that continually return excess free cash to shareholders represent 19.5% of net assets. For example, Choice Hotels International, Inc. employs a capital-light franchise model for its economy and upscale hotel brands, and this model allows the company to return cash to shareholders through buybacks and dividends while still achieving strong revenue and earnings growth no matter the stage of the lodging cycle. As one of the leading financial intelligence systems for the asset management industry, FactSet Research Systems, Inc. continues to grow into new areas via fixed income, risk management, and most recently wealth management. This should enable the company to grow while generating a steady stream of recurring cash flow that it uses for acquisitions and share buybacks.
Portfolio Holdings
For the quarter ended September 30, 2019, the Fund’s top 10 holdings represented 84.7% of total investments. A number of these investments have been successful and were purchased when they were smaller businesses. We believe they continue to offer significant further appreciation potential although we cannot guarantee that will be the case.
The top five positions in the portfolio, CoStar Group, Inc., Vail Resorts, Inc., Hyatt Hotels Corp., Tesla, Inc., and FactSet Research Systems, Inc. all have, in our view, significant competitive advantages due to irreplaceable assets, strong brand awareness, technologically superior know-how or exclusive data that is integral to their operations. We think these businesses cannot be easily duplicated, which enhances their potential for superior earnings growth and returns over time.
Thank you for investing in Baron Focused Growth Fund. We continue to work hard to justify your confidence and trust in our stewardship of your family’s hard-earned savings. We also continue to try to provide you with information we would like to have if our roles were reversed. This is so you can make an informed judgment about whether Baron Focused Growth Fund remains an appropriate investment for your family.
Respectfully,
Ronald Baron, CEO and Lead Portfolio Manager
David 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 Focused Growth Fund by anyone in any jurisdiction where it would be unlawful under the laws of that jurisdiction to make such offer or solicitation.
