Dear Baron Focused Growth Fund Shareholder:
Performance
Baron Focused Growth Fund performed in line with its benchmark in the third quarter of 2014.The Fund decreased in value by 4.19% while the mid cap Russell 2500 Growth Index fell 4.21%. The large cap S&P 500 Index gained 1.13%. Year-to-date, large cap businesses have continued to outperform small cap and mid cap growth companies.
Geopolitical turmoil plagued equity markets during the quarter. In addition to the backdrop of war, the Ebola crisis, student protests in Hong Kong, the slowdown in China, and the end of domestic fiscal easing all acted as catalysts for the market’s downturn during the period. Many investors apparently sold smaller and mid-sized growth companies to invest in “safer” larger firms, which, as a result, outperformed. Portfolio companies with lower debt-to-earnings ratios performed better than firms with greater leverage.
We believe the domestic economy is improving. Falling energy prices reduce the burden on consumers and reduce transportation and distribution costs for businesses. Unemployment continues to decline. Vehicle purchases are improving. Continued growth seems likely. Housing starts have rebounded to only 850,000 while the long term average has been 1.5 million, and the peak in 2006 was 2.1 million.
We took advantage of weaker stock prices to add to positions in CoStar Group, Inc. and The Carlyle Group. Shares of CoStar (CSGP), an information and marketing services provider to the multifamily and commercial real estate industry, fell, largely due to questions surrounding the health of the multifamily market end market, competitive concerns, and declines in productivity in its core information services business due to aggressive hiring. We believe CoStar will successfully to integrate its recent acquisition, Apartments.com, with its existing data set to create a competitively advantaged asset with significantly more listings than its nearest competitor. We are also confident that productivity will recover as new hires gain experience. Carlyle (CG)’s weak performance in the quarter was attributable to investor fears surrounding the possibility of increased regulation and higher financing costs that could impact its funds’ performance. We believe the company’s diversifying product set and strong client relationships should yield increased assets over the coming years and set it apart from its competitors.
We also invested in two companies held in other Baron portfolios at what we believe are attractive prices due to the market turmoil. These important investments include Tesla Motors, Inc. (TSLA) and Financial Engines, Inc (FNGN). We participated in the initial public offering of Mobileye N.V. (MBLY), a developer of automated driver assistance technologies. We believe that Mobileye has a significant lead in R&D investments through its vision-based systems, and is well-positioned to take advantage of what we believe will be a revolution in autonomous driving.
We are disappointed in the relative performance of Baron Focused Growth Fund for the past six years, and especially during the last 12 months, when mid-sized companies so dramatically underperformed larger companies. Since the businesses in which Baron Focused Growth Fund has invested have grown much more rapidly than those on the S&P 500 Index, we believe it is likely this underperformance will end soon.
Shares of Concur Technologies, Inc. (CNQR) increased in the third quarter. Concur is a leading provider of travel booking and expense management software. On September 18, SAP SE announced an agreement to acquire Concur for $129 per share, a 28% premium to the closing price on September 2, the day before Bloomberg reported that Concur was exploring a sale. The $8.3 billion acquisition implied a valuation of roughly 9.7 times Concur’s estimated fiscal year 2015 revenue and confirmed our view that Concur is a valuable strategic asset. (Neal Kaufman)
Shares of Vail Resorts, Inc. (MTN), the largest ski resort operator in the U.S., increased in the third quarter after the company resolved its litigation with the owners of Park City and bought the resort from them at what we believe is an attractive price. The resort gives Vail access to two adjacent resorts in Utah which, when combined, will make it the largest ski resort in the U.S. The company believes that by adding Park City to its season pass, it should be able to increase sales, which would help insulate it from weather abnormalities. (David Baron)
Mobileye N.V. (MBLY) is a software and systems design leader for camera-based advanced driver assistance systems (ADAS). The share price increased after we participated in Mobileye’s IPO in the quarter. We believe the company has the potential to become a multi-decade leader in the race to autonomous driving, a trend that we believe will improve transportation safety and efficiencies.
Shares of industrial machinery company Colfax Corp. (CFX) fell in the wake of weaker-than-expected second quarter results. Strong margins in welding were offset by operational missteps in the legacy fluid handling business combined with a weak macro environment. Colfax recently announced a new president for the fluid handling business, and we expect this business to get back on track soon. We believe that Colfax will continue to use its proven business strategy to improve operations at acquired companies, generating substantial shareholder value over time. (Rebecca Ellin)
Shares of Benefitfocus, Inc. (BNFT) fell in the third quarter, partly due to a secondary offering in July that increased the public float by more than 30%. Benefitfocus is the leading provider of cloud-based benefits software, offering an integrated suite of solutions to help customers more efficiently shop, enroll, manage, and exchange benefits information. We think Benefitfocus serves an addressable market more than 100 times larger than its current business, which should allow it to compound revenue at more than 30% annually. (Neal Rosenberg)
Helmerich & Payne, Inc. (HP) is the leading land drilling contractor in the U.S. Shares fell in the quarter despite the fact that rising demand for its new rigs spurred clients to continue to add to the company’s record backlog of new rig contracts. The company’s fiscal third quarter earnings were a bit below expectations, which contributed to the stock weakness, but it appears that most of the weakness was related to concerns that lower oil prices would short-circuit the upturn in U.S. drilling. (Jamie Stone)
During the quarter we purchased shares in Tesla Motors, Inc (TSLA). The pace of innovation at Tesla is head spinning and the progress being made towards the goal of revolutionizing the auto industry is impressive. Recently, Tesla announced an all-wheel-drive (AWD) model with two electric motors. Tesla’s model D has a longer range due to its dual motor performance optimization! In addition, Tesla announced initial Autonomous Driving capabilities and the potential for the car to serve as a valet for its driver. For those of you who used to watch David Hasselhoff in “Knight Rider,” it must bring a smile to your face. Tesla continues to delight customers and out-innovate its competition. (Gilad Shany)
The Fund opportunistically added to its position in CoStar Group, Inc. (CSGP), the leading provider of information and marketing services to the $50 trillion commercial real estate (CRE) industry. The company has spent 25 years building a proprietary CRE database, which has grown to include information on over four million properties and nine billion square feet of listings.The company monetizes its data through subscriptions to analytical tools that are deeply integrated into clients’ workflows. Ongoing investments in R&D and a doubling of the sales force should allow CoStar to sell an expanded array of tools to new and existing customers. Additionally, the acquisitions of LoopNet and Apartments.com extend CoStar’s reach into marketing services and multi-family lead generation, creating vast new opportunities and offering the company dramatic revenue and cost synergies. Finally, the company’s high fixed cost base creates significant operating leverage, which should help drive significant margin expansion. (Neal Rosenberg)
The share price of Financial Engines, Inc. (FNGN), a service provider to defined contribution plans and individual investors, has declined by approximately 50% year-to-date. The valuation had been justified by its strong growth prospects. However, lower profit yield in 2014 and investor rotation away from smaller growth businesses led to the drop in share value. Baron Focused Growth Fund took advantage of the attractive stock price to initiate a position. We believe the long-term investment premise still holds. The company is the dominant player in a $5 trillion market, with roughly $900 billion in plan assets under contract and $100 billion in assets under management. Significant potential exists to add to these amounts through increased sales to plan sponsors, improved marketing to plan participants, and broadened product offerings. Additionally, we think the company should eventually be able to use its expertise to service the IRA and defined benefit markets, each of which represents an additional $5 trillion in assets. We believe that Financial Engines’ essential advice offering and plan connectivity advantage will result in significant client growth and highly profitable recurring revenue streams. (Michael Baron)
Portfolio Structure
The objective of Baron Focused Growth Fund is to double its value per share within five years. Of course, the Fund may not achieve this objective. Our strategy to accomplish this goal is to invest for the long term in a focused portfolio of appropriately capitalized, well-managed, small and mid cap businesses at attractive prices. We attempt to create a portfolio of less than 30 securities diversified by GICS sectors that will be approximately 80% as volatile as the market. These businesses are identified by our proprietary research.
We think the businesses in which Baron Focused Growth Fund has invested have the potential to double in size within approximately five years and double again over the subsequent five years. We think these well-managed businesses have sustainable competitive advantages and strong, long-term growth opportunities. Considering current stock price valuations, we believe we have the opportunity to meet our performance goals during the next decade, although there is no guarantee that we will do so.
As of September 30, 2014, Baron Focused Growth Fund held 29 investments. The median market capitalization of those small and mid-sized growth companies was $5.13 billion. Compared to its benchmark, the Fund’s investments have higher profitability (as exhibited through greater operating margin, EBITDA margin and net margin). They also exhibit better internal returns (higher return on invested capital, return on equity and return on assets).And, they are more conservatively financed (lower debt to market capitalization ratio) and more consistent (lower standard deviation of earnings growth and lower beta). We find these metrics important in limiting risk for a focused portfolio.
Interestingly, the Fund’s holdings lag on a free cash flow margin (cash flow from operations minus capital expenditures). This metric is often cited as crucial for today’s investors who value a company’s ability to return cash to shareholders through dividends and/or buybacks. While not trying to diminish the importance of cash generation, we often prefer companies that reinvest in their business for future growth. We think of ourselves as long-term owners of businesses that we believe can double in value over the next four to five years. Without reinvesting in their businesses, these companies stand little chance of fulfilling their ambitious growth plans. Examples include Hyatt Hotels Corp. (H), which is investing approximately $300 million annually to improve its properties and attain increased rates; Manchester United plc (MANU), which has increased its capital spending associated with player acquisitions to improve its on-field product; and Tesla Motors, Inc. (TSLA), which is focusing its capital spend on more than doubling its production capacity and building a plant for battery packaging and cell manufacturing. While these investments result in lower free cash flow margin today, we believe they are positioning the companies for future growth. We believe that investing in companies with strong financial positions that are improving their products to attack large opportunities gives the Fund the best chance to achieve its long-term return goals.
Thank you for investing in Baron Focused Growth Fund.
We are continuing to work hard to justify your confidence and trust in our stewardship of your family’s hard-earned savings. We are also continuing to try to provide you with information I 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 Portfolio Manager
October 20, 2014
